Alexandria Ocasio-Cortez deserves a big “Thank you.” In calling for top marginal tax rates of 70 percent, the freshman U.S. representative from New York is attracting attention to often-neglected issues linked to federal tax policy.
To be clear, this column is not endorsing Ocasio-Cortez’s proposal. A near doubling of the current top tax rate would be unwise.
Still, Ocasio-Cortez’s high profile — especially among younger voters — means that at least some AOC fans might be willing to devote time to learning facts about tax rates. Those who look into the topic might be surprised at what they learn.
Permitted since the adoption of the U.S. Constitution’s 16th Amendment, the modern federal income tax started in 1913 with a rate of 7 percent. Its top marginal rate reached as high as 94 percent during World War II. The top rate stood at 91 percent as recently as 1963. It didn’t dip below Ocasio-Cortez’s 70 percent standard until 1981.
Ronald Reagan entered the White House that same year and began a concerted campaign to lower tax rates across the board, including the top marginal rate. (Reagan’s jump from the Democratic Party to the Republicans had stemmed, in large part, from his own experience with high marginal tax rates. At the peak of his movie-star career, the Gipper had experienced firsthand the disincentives linked to sky-high rates. If he could keep less than a dime of each dollar he earned beyond a certain income threshold, why bother working on another movie?)
By the time Reagan left office, the top marginal rate stood at a postwar low of 28 percent. Rates have climbed since that time. The top rate has fluctuated between 35 percent and roughly 40 percent for the last quarter century.
Ocasio-Cortez and her supporters point to the pre-Reagan historical record. They see that the American economy thrived at times when tax rates topped out at 70 percent or higher. They are correct.
But as economist Milton Ezrati noted this month in New York’s City Journal, those higher rates accompanied a much different federal tax code. Deductions and exemptions “drastically reduced” the amount of income subject to the higher rates. Tax cuts enacted since the Reagan era have closed most of those “loopholes.”
“Taxpayers could write off all state and local taxes, with no limit — including sales taxes, licensing fees, property taxes, and income taxes,” Ezrati reminds us of the era of 70 percent top marginal rates. “They could also write off all interest expenses without limit — on their mortgages (no matter how many), all credit-card debt, auto loans, or home-improvement loans. Imagine the benefits to a plutocrat, buying a third home or a fifth Bentley.”
That’s not all. “The code included dividend exclusions and generous provisions for capital-gains preferences,” Ezrati adds. “Taxpayers back then could shelter unlimited amounts in IRAs. Social Security payouts were tax-free, no matter how high a person’s income. Individuals could write down their taxable income through averaging provisions and transfer as much income as they liked to their children, who paid at lower rates. There was no limit to rental-loss deduction. Business losses counted against all income.”
The end result: Few people paid 70 percent rates on any income. Ezrati cites a Tax Foundation estimate that the top 1 percent of taxpayers in the 1950s ended up paying an average effective tax rate of 17 percent. That was despite a top rate that hit 92 percent.
“If our highest earners today were offered the 2019 code or the old one, they might well go for the old rules, even at a 92 percent top rate,” Ezrati concludes.
The old rules might benefit those high earners, but it’s hard to argue that the increased complexity in the tax code would benefit the economy as a whole. Tax reformers argue fairly consistently for “neutrality and simplicity.” That means eliminating special credits and deductions that complicate the tax code and skew taxpayers’ economic decisions.
One suspects that Ocasio-Cortez has no interest in restoring the old special breaks and deals that helped high earners avoid much of the tax burden a 70 percent rate would imply. Instead she is likely to support higher rates alongside the current number — or even fewer — credits and deductions.
If that’s true, one can expect high earners to follow one of several courses in the face of a new sky-high tax bracket. First, they might emulate the moviemaking Reagan and simply curtail their income-generating activity. If they can’t keep more than 30 cents of every dollar they earn, they’ll have less incentive to earn that additional dollar. That means less economic activity overall and a hit to American economic growth.
Second, they might steer more of their earnings toward tax accountants and lawyers who will help them game the system. These are the very taxpayers who will be able to afford that type of specialized tax expertise. Money spent for tax-saving purposes won’t go into savings and investment that boost economic growth.
Third, high earners will hire lobbyists to help them win targeted tax relief from Congress. The higher the top marginal tax rate, the larger the incentive for prospective payers to seek a deal from Washington bureaucrats and elected officials. New breaks would undo many of the reforms that helped improve the American tax code over the past four decades.
It’s doubtful that Ocasio-Cortez has spent much time considering these potential consequences. One hopes at least some of her followers will dedicate more attention to these critical details.
Mitch Kokai is senior political analyst for the John Locke Foundation.