Why Adding a New Top Income Tax Rate Is a Bad Idea
By Rachel Greszler, Research Fellow in Economics, Budget and Entitlements at The Heritage Foundation.
One of the most critical ingredients in “pro-growth” tax reform is lowering tax rates for everyone.
Conservatives have championed this goal for a long time. But now, as tax reform approaches nearer and nearer, some Republican lawmakers seem ready to give up that goal.
Democrats have complained that the GOP tax plan adds too much to the deficit, and that it gives “wealthy” individuals the largest tax cuts. In response, some GOP lawmakers are considering adding on a fourth top rate above the currently proposed 35 percent maximum rate.
Presumably, that would mean keeping the top rate at its current level of 39.6 percent (43.8 percent including the Obamacare surtax).
But can tax reform really be “pro-growth” if it doesn’t lower the top individual income tax rate?
The short answer is yes, it can still increase growth—but not as much as it could.
That’s because the top marginal tax rate has a tremendous impact on how some of the most productive taxpayers decide to work, invest, and spend in our economy.
For instance, the top marginal rate disproportionately reduces the return that college students receive on their education. If getting an education makes them more likely to earn higher incomes—and statistically, it does—that means they’ll just end up paying steeper taxes if they make it to the top marginal income bracket.
The top marginal rate also has an outsized impact on investment, entrepreneurship, and risk taking because people in the top income tax bracket are much more likely to take part in those activities.
According to the most recent statistics from the IRS, only about one of every 150 taxpayers in the U.S. is subject to the top marginal tax rate, but those people earn over one-fifth of all taxable income in the U.S.
That means more than 1 of every 5 dollars of taxable income is subject to the top marginal rate. That’s more than twice as much income as is subject to the next two income tax brackets combined.
So while the top marginal tax rate may not apply to all that many individual taxpayers, it creates distortions that ripple across wide portions of the economy, affecting far more people than just the top income earners.
It’s also worth noting that about one-fifth of income subject to the top marginal tax rate is “pass-through” income, which means income derived from partnerships and S corporations (or closely held corporations) that file through the individual tax code.
A whopping 63 percent of taxpayers who face the top marginal tax rate have pass-through income.
When individuals and small businesses get to keep more of their income, they don’t just hide that income under mattresses. They put it back into the economy by doing things like investing in capital and technology that increase productivity and lead to higher incomes across the board.
They also spend it on goods and services that support jobs and incomes for workers of all income levels.
So yes, some near-certain elements of the GOP’s tax reform package, such as a healthy cut in the top corporate rate, lower tax rates for middle-income earners, and removal of special-interest tax breaks, will help add to economic growth.
But without lowering the top marginal income tax rate, tax reform will fall short of producing the kind of explosive growth that we all want to see.
*To read this piece on The Daily Signal website, click here.