Good news for job creators! The Senate just voted against moving forward on legislation that would increase taxes on S corporations by $9 billion. The legislation was opposed by a broad coalition of business groups, led by the S Corporation Association, including the US Chamber of Commerce and the National Federation of Independent Business. A motion to close debate and proceed to the bill was defeated on a party-line vote — 52-45. (Sixty votes are required to end debate in the Senate.)

This is the second time in two years the business community has successfully blocked legislation to increase payroll taxes on S corporations and partnerships. Two years ago, a similar provision was blocked from moving forward on a 56-40 vote. This time, S-Corp was joined by 37 other business groups on a letter to Senate leadership detailing the negative impact this tax increase would have on closely-held businesses, and we’re happy to see that the Senate stood with us.

Just How High Can Rates Go?

A question we’re hearing increasingly raised, particularly by policymakers seeking to raise taxes, is just how high marginal rates can go before they start to impede economic growth and become counter-productive. That is, begin to cost the government revenue rather than raising it.

For example, Ezra Klein of the Washington Post polled several prominent economists back in 2010 and got some hair-raising responses:

  • Emmanuel Saez ,University of California at Berkeley: Revenue maximizing rate “means a top federal income tax rate of 69% (when taking into account the extra tax rates created by Medicare payroll taxes, state income tax rates, and sales taxes) much higher than the current 35% or 39.6% currently discussed.”
  • Brad DeLong, University of California at Berkeley: “At 70%.”
  • Dean Baker, Center for Economic and Policy Research: “It would be somewhere around 70 percent and possibly a bit higher.

These responses would be “fall out of your chair” funny if they weren’t being taken so seriously in Congress. Which makes the Alan Reynolds piece in today’s Wall Street Journal so important. Reynolds takes an in-depth look at a couple of recent papers, the first by Peter Diamond from MIT and Emmanuel Saez from Berkeley, and the second by Saez and Thomas Piketty of the Paris School of Economics, that form the intellectual foundation for these claims. Here’s Reynolds:

The authors arrive at their conclusion through an unusual calculation of the “elasticity” (responsiveness) of taxable income to changes in marginal tax rates. According to a formula devised by Mr. Saez, if the elasticity is 1.0, the revenue-maximizing top tax rate would be 40% including state and Medicare taxes. That means the elasticity of taxable income (ETI) would have to be an unbelievably low 0.2 to 0.25 if the revenue-maximizing top tax rates were 73%-83% for the top 1%. The authors of both papers reach this conclusion with creative, if wholly unpersuasive, statistical arguments.

But the ETI for all taxpayers is going to be lower than for higher-income earners, simply because people with modest incomes and modest taxes are not willing or able to vary their income much in response to small tax changes. So the real question is the ETI of the top 1%.

So what is the real tax responsiveness of this top 1%?

A 2010 study by Anthony Atkinson (Oxford) and Andrew Leigh (Australian National University) about changes in tax rates on the top 1% in five Anglo-Saxon countries came up with an ETI of 1.2 to 1.6. In a 2000 book edited by University of Michigan economist Joel Slemrod (“Does Atlas Shrug?”), Robert A. Moffitt (Johns Hopkins) and Mark Wilhelm (Indiana) estimated an elasticity of 1.76 to 1.99 for gross income. And at the bottom of the range, Mr. Saez in 2004 estimated an elasticity of 0.62 for gross income for the top 1%.

A midpoint between the estimates would be an elasticity for gross income of 1.3 for the top 1%, and presumably an even higher elasticity for taxable income (since taxpayers can claim larger deductions if tax rates go up.)

But let’s stick with an ETI of 1.3 for the top 1%. This implies that the revenue-maximizing top marginal rate would be 33.9% for all taxes, and below 27% for the federal income tax.

Just as a reminder folks, we’re at a top rate of 35% now, and scheduled to hit almost 45% at the end of the year, so this has direct consequences to the pass-through community and S corporations. Congress will be debating rates as early as this fall, and unlike the corporate rate debate, where there seems to be some consensus over what the rate should be in the future, the debate over the top individual rates is all over the map. For that debate, papers like the Diamond/Saez paper have their audience. That’s what makes the Reynolds response so important.