Are 70 per cent marginal income tax rates really impossible?

Alexandria Ocasio-Cortez, the newly-installed Democratic congresswoman for New York, has floated a top marginal tax rate of 60-70 per cent for those on very high incomes in an interview.

The proposal has been seized upon by her Republican opponents, who have labelled it as economic expropriation, akin to slavery. The former Federal Reserve chair, Alan Greenspan, has called it a “terrible idea” which would lead to “a significant drop in economic activity”.

But what does the economics literature actually say about these kinds of marginal rates? Is taxing the well-off in this way really impossible?

What is the current top marginal rate of income tax?

In the US those who receive more than $510,300 pay 37 per cent in tax on any income above that level.

But the top rate has been much higher than this in the past. In the immediate wake of the Second World War it was 91 per cent. It came down to 70 per cent in the 1970s and as low as 38 per cent in the late 1980s.

In her interview Ocasio-Cortez seemed to suggest that her 70 per cent marginal tax rate would kick in on annual earnings of more than $10m.

What damage could a higher rate do?

A Republican advisor called Arthur Laffer famously argued that when a government raises marginal tax rates above a certain threshold workers either stop working or find other ways to reduce their reported income, perhaps by taking it as capital gains instead, so the tax taken actually declines.

Most economists accept the theory of a so-called “Laffer curve” and the argument that excessive taxation of the wealthy can, at some point, become self-defeating in respect to raising revenue.

But there’s disagreement on whether that point comes.

While some economists claim that we are already at the threshold, others say that rates could, in fact, go much higher.

So where is the revenue-maximising optimum tax rate?

It ought to be an empirical, rather than an ideological, issue.

Two respected US-based researchers – Christine and David Romer – analysed data from between the two world wars, a time when marginal rates moved around a lot, and put it close to 80 per cent.

Emmanuel Saez and Peter Diamond – in 2011 estimated it at 73 per cent on incomes of more than $300,000.

And another paper by Saez, along with Stefanie Stancheva and Thomas Piketty, came up with a figure of 83 per cent. This paper added a new element to the theory of optimal rates, namely that lower tax rates encourage CEOs to “bargain” for more pay (in a way that doesn’t really help anyone) whereas in countries with higher rates they simply don’t bother.

The clear implication of this rigorous body of work is that it is by no means clear that Ocasio-Cortez’s mooted 70 per cent top tax rate would be an economic disaster for the US.

Do these lessons only apply to the US?

No. The same logic – of there being a revenue optimising top marginal rate – can apply in any country that collects income tax.

Here in the UK Labour created an “additional” 50 per cent rate of income tax on those earning more than £150,000 shortly before leaving office in 2010. George Osborne, of the Conservatives, in 2012 cut this rate from 50 per cent to 45 per cent, arguing that it would raise more money.

This was essentially an argument that the revenue maximising rate in the UK is lower than 50 per cent.

The independent Office for Budget Responsibility [OBR] estimated that the 2012 tax cut would not harm total UK revenues very much at all, suggesting that this was broadly right.

The OBR chair, Robert Chote, concluded at the time that we are “strolling across the summit of the Laffer curve”.

But the evidence is not definitive, as the OBR concedes.

Moreover, the question of where the optimum UK rate lies also depends on other factors, such as the rate at which capital gains are taxed and the ease with which wealthy people can move assets and earnings offshore.

It’s possible that if government clamps down in these areas, the revenue maximising top income tax rate could turn out to be substantially higher.