Why A 39.6% Top Bracket Might Be The Key To Tax Reform

Nothing is sure to be more eyebrow raising in tax reform than the "millionaire bracket" that reform will likely create. Rumors are the plan is for the current top tax rate of 39.6% to start kicking in at $1 million of taxable income, as opposed to the $480,000 and change that it does for married couples today.

That's notable, because it means a Republican tax reform plan will not feature a reduction in the top marginal tax rate. That hasn't happened since, well, ever. Is it a good idea, or a "million dollar mistake"(to quote the Wall Street Journal editorial page)? I would argue it is not only a good idea, but a necessary one for tax reform to succeed. Below is a succinct summation of why this is:

Cutting the highest rate is no longer the top tax reform priority. Back when President Kennedy proposed a tax cut, the top rate was 91%. When Ronald Reagan did, it was 70%. Today, at 39.6%, the top rate is just over half the level President Reagan inherited in 1981. If you believe in the Laffer Curve, you believe in diminishing returns from cutting a tax rate below its growth maximizing level. I would argue on this top rate, for reasons which will become clear below, we are on the diminishing returns side of the Laffer Curve.

The top tax rate post-reform will be a labor tax rate only. Our tax system already removes capital income--in the form of capital gains and dividends--from the top rate's buckets of income. We have a separate tax on long-term capital gains and qualified dividends. Tax reform is likely to also siphon off bona fide business income from the top rate's income categories. All that leaves is labor, and maybe a little interest and rent. The top bracket under tax reform is basically confined to uber-successful doctors and lawyers, media and entertainment celebrities, and athletes. The IRS breaks down the figures below:

Once capital income (already removed) and business income (removed under tax reform) is accomplished, wages will be more than three-fourths of the income left in the top bracket which is taxed at a 39.6% rate.

Cutting the top rate on labor income yields no economic growth. According to the Tax Foundation, lowering the top tax rate on labor has little to no impact on net jobs created, business fixed investment, economic growth, or after-tax incomes (except obviously for those directly affected).

Cutting the top rate on labor income is tremendously expensive. Also according to the Tax Foundation, we could expect a cut in the top tax rate on labor alone to equal about $60 billion per percentage point over 10 years. Want to cut the rate by 5%, to the Bush-era 35% level? That will run you about $300 billion over a decade. And remember, you're blowing $300 billion of tax reform efforts on something that gets no growth.

The public is against cutting the top tax rate on wealthy wage earners. According to decades of Gallup polling, the public is not keen on reducing tax rates for people in this income band. When asked just this past April if "upper income people" were "paying their fair share in federal taxes," only 24 responded "yes" while 63% responded "no." Class warfare is no way to conduct tax policy, but it's also not a reason to beat one's head into the wall for no reason. Cutting the top rate is a political headache which drains resources from tax reform and doesn't even provide economic growth to make up for any of that.

Tax reform can only cut taxes by $1.5 trillion. According to the budget resolution, tax reform can only result in a net tax cut of $1.5 trillion in the first decade. We just found that the most common rate reduction called for--from 39.6% to 35%--would eat up $300 billion of that, or $1 out of $5 in tax reform efforts. Again, for no growth. It simply isn't worth it.

What else can you do for $300 billion? Well, that happens to be the exact size of repealing the death tax, for one thing. That's something that would create over 150,000 jobs and grow the economy a full percent higher permanently. Another option would be a repeal of the 3.8% capital gains and dividends tax hike in Obamacare (the "NIIT"). These are but two examples of tax relief which would be far more pro-growth than cutting the top rate on labor income.

Top bracket wage earning taxpayers are no longer part of the Republican coalition. Republican/Trump voters tend to be those who live in households that make more than $50,000 per year, but less than $250,000 per year, according to exit polls. Above and below those numbers, exit polls from the 2016 race showed Hillary Clinton voters. On the upper end, this is less pronounced. But there are lots of empirical reasons to believe that very high income wage earners are not part of a Republican governing coalition anymore. For example, Clinton trounced Trump in cities of 50,000 or more, where incomes tend to be higher. The reverse is true in rural areas, with suburbs leaning only sightly Republicans.

It's a safe bet that modern Republicans voters range from the working class up to the comfortable mass-affluent. And that means well under $1 million per year wage earners.

Wealthy but non-rich taxpayers will still be getting tax relief. Taxpayers earning between $480,000 and $1 million will get tax rate relief under this plan. That's a lot of people. According to the same IRS data as above, 834,000 households make between a half-million and a million dollars annually. These families will receive tax relief of up to $26,000 under tax reform from the bracket widening alone.

The Tax Policy Center is wrong--again--and should not be trusted. In a recent "analysis" of the upcoming tax plan, the Tax Policy Center incorporated a laughable data point into the debate. In addition to saying large tax relief on businesses and households won't materially change economic outputs (something no credible economist would say), they failed to incorporate the effects of this 39.6% rate. I can't blame them for not knowing what's in a plan which hasn't been released yet. I can blame them for doing an analysis of such a plan, as it shows a remarkable lack of judgment and objectivity.