So What Actually Happens When You Tax the Wealthy? A Review of the Literature

So What Actually Happens When You Tax the Wealthy? A Review of the Literature

In a gubernatorial campaign framed by a projected $6 billion state budget deficit, increasing income taxes on wealthier Minnesotans has received a lot of attention. Even though it has been demonstrated that such income tax hikes alone will not solve the entire budget problem, the idea clearly resonates with many Minnesotans who see this as a way to address the deficit in a manner that does the least amount of damage to the state.

It has also resonated in other parts of the country. Of the 42 states (including the District of Columbia) that impose an income tax, 9 have increased their top bracket rate since tax year 2007 (Table 1) in response to budget realities. In most cases the change was a bump in the top rate or creation of a new top bracket (or brackets) for the wealthiest taxpayers. However in Maryland, the state income tax was fundamentally restructured with the creation of several new income brackets to create a more progressive tax.

	State	Tax Year 2007			Tax Year 2010
		Top Bracket Rate	Top Bracket Income Threshhold	Number of Brackets	Top Bracket Rate	Top Bracket Income Threshhold	Number of Brackets
	California**	9.30%	$89,629	6	9.55%	NC	NC
	Connecticut	5.00%	$20,000	2	6.50%	$1 million	2
	Delaware	5.95%	$60,000	7	6.95%	NC	NC
	Hawaii	8.25%	$96,000	9	11.00%	$400,000	9
	Maryland	4.75%	$3,000	4	6.25%	$1 million	4
	New Jersey	8.97%	$500,000	6	10.75%	$1 million	6
	New York	6.85%	$40,000	5	8.97%	$500,000	5
	Oregon	9.00%	$14,300	3	11.00%	$500,000	3
	Wisconsin	6.75%	$190,210	4	7.75%	$295,551	4

Interestingly, as shown in Table 2, eight states have chosen the opposite policy path by reducing top income tax rates (or in Louisiana's case, doubling the threshold for the top bracket – effectively a tax decrease). Again, while most of the changes involved a modest lowering of the top rate, one major structural reform stands out: Utah's adoption of a flat tax which replaced its previous progressive income tax structure.

	State	Tax Year 2007			Tax Year 2010
		Top Bracket Rate	Top Bracket Income Threshhold	Number of Brackets	Top Bracket Rate	Top Bracket Income Threshhold	Number of Brackets
	Louisiana	6.00%	$50,000	3	6.00%	$100,000	NC
	New Mexico	5.30%	$24,000	4	4.90%	NC	NC
	North Carolina**	8.00%	$200,000	4	7.75%	$100,000	3
	North Dakota	5.54%	$349,700	5	4.86%	NC	NC
	Ohio	6.555%	$200,000	9	6.24%	$201,801	NC
	Oklahoma	5.65%	$15,000	7	5.50%	NC	NC
	Utah	6.98%	$11,000	6	5.00%	$0 (flat tax)	1
	Vermont	9.50%	$349,700	5	8.95%	NC	NC

This split in policy responses nicely captures the conflicted attitudes toward state personal income taxes in general and higher income taxes on the wealthy in particular. In some states concern over the impact of income taxes on economic growth – especially coming out of a deep recession – has trumped near-term revenue interests. In other states, the bet is that state economies can not only avoid any damaging fallout from higher income taxes on the wealthier citizens but be better for it.

The question is also front-and-center in Minnesota politics. Do higher income taxes on the wealthy have a negative impact on business and individual decision-making and harm state economic growth? Do the redistribution and spending benefits enabled by higher income taxes on the wealthy outweigh any negative investment and behavioral impacts that result from higher taxes? To shed some light on this debate we took a look at what tax and public finance scholars have had to say about this over the past few decades.

Our investigation was based on studies from public finance and tax journals. Not surprisingly the body of literature is immense, although studies focusing specifically on the wealthy are in shorter supply. Fortunately, some literature reviews and summaries have been devoted to the topic of income taxes and their effects which served as our primary resources. ¹ As might be expected, definitive answers or "final words" on this topic are elusive. Academic studies beget other studies with different methodological approaches or the inclusion of considerations and factors absent from earlier work. This results in conflicting findings, alternative conclusions, revisionism, abundant nuance – and (surprise) calls for more research. Nevertheless, some themes do emerge.

Personal Income Taxes and Behaviors

First, behavior changes among individuals in response to higher marginal income tax rates appear fairly modest at best. The two topics related to behavior change which have received the most attention from scholars are workforce participation and mobility. There is little evidence of individuals reducing work hours or effort in response to marginal tax rate increases – although those findings may be influenced by the magnitude of marginal rate changes being studied. However, when labor effects are measured more broadly, relationships do begin to emerge. Studies have documented both large increases in the taxable income of the wealthy that were proportionately larger than the size of rate reductions put in place and, conversely, large declines in the taxable income of the wealthy following tax hikes that were proportionately larger than the marginal tax rate increases enacted. The idea of this literature is that rate changes, even if they do not affect the number of hours worked, still prompts behaviors to switch income into or out of nontaxable forms.

But others have subsequently found that these significant taxable income changes among the wealthy are largely short-term effects based on various financial and accounting actions rather than changes in "real" behavior. For example, one national study of business executives (Goolsbee, 1999) found that a disproportionately large decline in their taxable income following marginal rate hikes was due to a restructuring of compensation in expectation of tax rate increases. Once these short-run changes are accounted for, little income decline was noted. Moreover, executives without options, those with relatively lower incomes, or those with more conventional forms of taxable compensation showed responsiveness to rate increases. These researchers have concluded that the real tax responsiveness is much more modest than income measures indicate.

Mobility of the wealthy is another issue which scholars have studied quite closely. A number of studies have concluded that the degree of flight in response to higher income taxation is quite modest, and that from a budgetary standpoint whatever flight and associated revenue loss that does occur is often offset by the collections from higher rates.

However, stronger relationships seem to exist with respect to higher income taxes and in-migration. One recent study found that after controlling for other key considerations like state climate, states with higher per capita income tax burdens had lower net inflows of migrants (Cebula, 2010). This suggests the primary concern for lawmakers contemplating income tax rate increases is not how much revenue may be lost from taxpayer flight, but rather how much tax base growth will be foregone by people who decide not to come to the state.

Business entrepreneurship seems to be one area that is most negatively affected by higher marginal tax rates, as the investment decisions of sole proprietors seem quite sensitive to tax rates. One study found that a 5 percentage point increase in the marginal tax rate reduced both the proportion of entrepreneurs willing to invest in physical capital and the mean investment in capital by 10% (Carroll et al., 2000). When marginal tax rates increase, entrepreneurs save little on losses but owe substantially more on profits requiring higher pre-tax rates of return.

One final area of behavioral change which has received scholarly attention is charitable giving. Studies show higher rates have encouraged the rich to give more to reduce their tax liability, however tax issues are not the primary factor in charitable giving decisions.

A high income state because of high income taxes?

Looking at the issue of state income taxation more broadly, marginal rates appear to influence overall state economic growth and performance. The caveat here is that the strongest evidence lies in changes in state tax rates (not average tax rates themselves) and in performance relative to other states. The reason: long-term absolute growth within states is dominated by federal policies and economic forces over which states have no control, but because state income taxes are added to federal taxes, the impact of state taxes takes on greater significance. Given this, it seems very prudent to place Minnesota income tax proposals in the context of what other states have done as in Tables 1 and 2.

A primary reason for these findings appears to be the wage effects of the personal income tax. Several influential studies have found that differences in personal income tax rates are an important determinant of wage differentials across the nation. This is because employers, especially for higher skilled occupations, often compensate employees for higher taxes by offering higher pre-tax wages. Since return on investment is affected by labor cost, personal income tax rates can influence the location of plant and facilities through the effect on pre-tax wages. Studies have shown such findings apply to both domestic firm investment and foreign direct investment.

A Roll of the Policy Die

In the debate over responses to higher tax rates, two additional factors also are worth considering. First, the timeframe of these studies typically constitute the 1980-2005 period – a time of relatively constant economic growth and prosperity – and very different macroeconomic context. Because of the greater mobility of capital and profits, there is general consensus that taxation matters more now than it did before. One wonders what similar studies would now show in our new economic reality. Second, some economists do not feel that the methodology of those who have studied the growth and income effects of rate change is very compelling regardless of their conclusions. Their criticism is based on the fact that that these studies all measure immediate effects whereas the "stuff" that really matters in response to tax policy – capital formation – occurs very gradually.

Research appears to conclude that increasing the progressivity of the state income tax would negatively affect investment and growth to some degree. As one study described the policy implications, "creating a less confiscatory tax structure, while maintaining the same average level of taxation, enables subnational governments to spur economic growth." ²

The unanswered question is how large that impact would be and whether the redistributive benefits outweigh the cost. The establishment of a marginal tax rate near the top of the nation and an income threshold for that high rate substantially lower than any other state strikes us as an extraordinarily risky and perilous proposition. One thing is certain – it would certainly make Minnesota a very popular destination for tax and public finance researchers for many years to come.