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Tax hikes on the wealthy: Good or bad for growth?

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Conservatives have argued for decades that tax cuts are the key to economic prosperity. And the tax plan presumptive GOP nominee Donald Trump is pushing would cut taxes for the top 0.1 percent of earners by an average of approximately $1.3 million per year, embracing that conservative point of view.

On the other hand, Democrats such as front-runner Hillary Clinton take another approach. Clinton says she'll reform the U.S. tax code so that the wealthiest pay their fair share. The response from Republicans has been predictable: They argue that such a tax plan will lower growth and harm the economy.

Do the conservative arguments against tax increases have any merit? Or are they, as Democrats claim, a way to serve an ideological goal of smaller government and reward wealthy Republican donors? Let's take a closer look.

Increasing taxes on the wealthy will harm economic growth: This argument is made frequently, along with the claim that increasing growth will lift all boats, but the evidence doesn't support either claim. As Nobel Prize-winning economist Peter Diamond and John Bates Clark medalist Emmanuel Saez have noted, since the 1970s no clear correlation exists between economic growth and top tax-rate cuts across Organization for Economic Cooperation and Development countries.

As for the trickle-down argument, this claim falls apart when you examine what happened to the distribution of income after tax cuts for the wealthy enacted during the Bush administration. Income of those at the top went up substantially, with no corresponding gain for those lower in the income distribution.

Increasing taxes on the wealthy won't solve the income inequality problem: Higher taxes for the highest earners may not solve the problem, but it would help. Again, consider the tax cuts on the wealthy enacted during the Bush years. In addition to not generating a positive trickle-down economic growth effect, those cuts contributed to the stunning increase in income inequality in recent decades. Raising taxes would have the opposite effect.

Tax increases will blunt the incentive to invest in new businesses: Decreasing taxes did not increase economic growth, so why would increasing taxes to levels they've been at in the past be harmful? In addition, it's hard to believe that a reduction in expected aftertax income of, say, 10 percent from $10 million to $9 million, or even from $300,000 to $270,000, would cause someone to pass on the investment opportunity.

The wealthy will move to other countries to avoid the tax increase: A recent study examined the propensity of the rich to move between U.S. states in response to state tax increases. The lead author of the study, Cristobal Young of Stanford University, summarized the results by saying, "The most striking finding in our study is how little elites seem willing to move to exploit tax advantages across state lines."

If the wealthy aren't willing to move between states in response to tax differences, it seems even more unlikely that would undertake the far more difficult task of moving to another country.

Increasing taxes on the wealthy won't increase tax revenue: The Laffer curve argument that increasing taxes will cause the wealthy to pursue tax-avoidance strategies or forego profitable opportunities to the extent that tax revenues actually fall has been examined again and again, and the message is clear. Tax avoidance may increase somewhat, but nowhere near enough to cause tax revenues to fall.

Diamond and Saez have looked at this closely, and they found that the revenue-maximizing top federal marginal income tax rate would be in or near the range of 50 percent to 70 percent (taking into account that individuals face additional taxes from Medicare and state and local taxes).

Less will be donated to private charities: Would tax increases cause the wealthy to reduce their charitable giving? Research on this question suggests it's the other way around. Back in the 1970s, when the top rate of federal income tax was 70 percent, wealthier Americans (those with incomes of over $500,000 in 2007 dollars) gave around twice as much of their money to charity than they did in 2007, when the top rate had fallen to 35 percent.

Why does this happen? When taxes are higher, the benefit of the tax deduction for charitable giving is also higher, so people tend to increase the amount they give. In addition, the wealthy give their biggest donations almost exclusively to universities and colleges, hospitals and medical centers, and arts institutions. They rarely make large gifts to social-service groups, grass-roots organizations or nonprofit groups that focus on the poor or minorities.

So to the extent that the increased tax revenue is used to support these groups, social welfare could benefit.

The wealthy deserve what they earn: This argument assumes that they're paid according to their contribution to society. But in a world of monopoly power, regulatory capture and asymmetric power relationships in bargaining over the wage and profit shares of business earnings, the presumption that those at the top of the income distribution earned their income flies out the window.

If we assume that fairness is defined as keeping what you contribute to the social good (what economists would call the value of their marginal product), and no more than that, such fairness would compel us to take the income the wealthy earn in excess of their contribution to the social good.

Where should that income go? Substantial evidence shows that wage earners have earned less than their marginal products in recent decades. So under the principle that people should have an income equal to what they contribute, fairness would suggest that we redistribute to underpaid wage earners some of the income the wealthy earn in excess of their contribution, either through direct payments, tax adjustments or spending on social programs that benefit lower-income households.

It's a tax on small businesses: The number of small-business owners that would be affected by a tax increase on incomes over $250,000 is fairly small. For example, an analysis of President Obama's proposal in 2009 to increase the rates for those in the top two tax brackets would affect only 1.9 percent of small businesses.

Many of those who would be affected are investors in the businesses who play no role at all in day-to-day management. And they could always escape the tax completely by filing as corporations. You also have to wonder how many people would choose to give up their businesses if their incomes were only, say, $350,000 due to a tax increase.

Arguments about the size of government and the taxes needed to support the many things that government does are certainly fair game for politicians. But the argument that tax increases on the wealthy will cause substantial harm to the economy does not withstand a close look at the evidence.

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