Ocasio-Cortez’s tax on the super rich won’t happen. Here’s a better way to do it

Editor’s Note: William G. Gale is senior fellow at the Brookings Institution and author of Fiscal Therapy: Curing America’s Debt Addiction and Investing in the Future (Oxford 2019). The opinions expressed in this commentary are his own.

Alexandria Ocasio-Cortez’s recent proposal to create a 70% tax bracket on income over $10 million will not become law anytime soon. But the proposal, which would only affect fewer than one in every 1,000 households, has sparked a long overdue discussion about taxing the wealthy. Raising taxes on the rich is the right idea at the right time, but some ways to do so are better than others.

Why should the rich pay more than they already do? First, we need the money, and higher taxes are the only way to get wealthy Americans to bear non-trivial amounts of the fiscal burden. Currently, the economy is at full employment, but the government is running substantial deficits. Low revenues are a big part of the problem; they do not come close to funding current spending. As an aging population pushes up Social Security and Medicare spending in the future, both projected deficits and the need for higher revenues will increase, even if policymakers cut spending somewhat.

Second, high-income households have enjoyed skyrocketing incomes over the past 40 years, but their average tax rates have remained relatively constant. From 1979 to 2015, average market income for those in the top 1% rose by 233%, from $552,000 to $1.84 million (in 2015 dollars). But federal taxes as a share of their income have fallen — from 35% in 1979 to 33% in 2015 — and the 2017 tax cuts reduced them further. In a progressive system like ours, the tax share of income should rise as income rises. High-income households are due for a significant increase in tax burdens.

Third, higher tax burdens on the wealthy would reduce (what economists call) rent seeking, the appropriation of wealth from others without creating new wealth. Studies have shown that countries with lower top marginal tax rates have higher pre-tax income inequality. The logic is that, while lower tax rates on high-income households — introduced in the Reagan, Bush and Trump tax cuts — may have stimulated labor supply and saving, they also raised the return to rent seeking, encouraging, for example, executives to capture a larger share of profits, at the expense of wage earners. Thus, some of the top 1%’s impressive gains may well have come at the expense of, rather than benefit to, the rest of the population.

How to raise taxes on the rich is just as important as why. Simply raising the top rate to 70% would in essence be a full-employment act for tax planners and would create massive sheltering activity. Yes, the top rate was 70% or higher in the 1950s, 60s and 70s, but tax avoidance also thrived.

That’s why increasing the top rate should be done in tandem with closing loopholes — that is, “broadening the base” — to include more income in the definition of taxable income. This would reduce high-income earners’ ability to avoid taxes, and it could include taxing capital gains at death and raising tax rates on realized capital gains and dividends to be more in line with taxes on wages. Repealing the deduction for pass-through (non-corporate) businesses enacted in 2017 would also be a step in the right direction. The deduction is complicated, makes capricious distinctions and provides an overwhelming share of its benefits to households with incomes above $1 million.

The estate tax, which the Bush and Trump tax cuts eviscerated, should be modified as well. We should reduce the exemption (currently $22 million for married couples) or convert the tax to a levy on those who inherit wealth.

Raising the corporate tax rate from 21% to 25% — still far below the 2017 rate of 35% — would also help; it would mitigate the use of corporations as tax shelters, and high-income households would bear most of the burden. Any adverse effect on businesses could be offset by allowing them to expense all capital investments.

Finally, the rich should pay the taxes that they owe. Cuts in IRS funding over the last 20 years have reduced audit rates of high-income households and corporations. Evasion rates are high for the types of income that disproportionately go to high-income households. The evasion rates range from 13% to 16% for realized capital gains and income from partnerships and S-corporations, up to 64% for sole proprietor income. In contrast, evasion rates on wages, which disproportionately go to middle- and low-income households, are only 1%. Let’s give the IRS the money and tools to do its job.

With a broader base and better enforcement, it would make sense to raise the top rate. Higher rates raise more revenue with a broader base, and vice versa. Certainly, the economy was doing well in 2017 before the top rate was cut from 39.6% to 37%. Increases above that rate would be sensible too. Research shows little correlation between how countries change their top income tax rate and how much their economies grow.

Ultimately, if we want more revenue from the rich, we should broaden the base and boost rates. Raising taxes on the rich is an idea whose time has come, receiving consistent support in polls over the last few decades. Doing it the right way — comprehensively — could fund new spending and reduce the debt, while making the tax system fairer at little economic cost.