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Optimal Taxation of Top Labor Incomes: A Tale of Three Elasticities

Thomas Piketty, Emmanuel Saez and Stefanie Stantcheva

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There are three major hypotheses about the articulation between growth in the highest incomes and changes to the highest tax rates. For some, the decline, in the United States, of the rate of taxation on the highest income brackets from the beginning of the 1980s stimulated business and job offers at the top of the income pyramid, where there has been an increase in very high salaries. For others, it is simply taxation minimisation behaviour that explains the strong rise in declared high incomes, without any real increase in income inequality. Thirdly, according to a recent hypothesis, rates of taxation imposed on the highest incomes function as regulators in the context of salary negotiations: a lowering of the highest rates leads to executives negotiating even higher salaries, to the detriment of other employees. Can we reconcile these three approaches and assess their impact, both theoretically and empirically?
In this article, Thomas Piketty, Emmanuel Saez and Stefanie Stantcheva first discuss the debates about high and very high incomes; several factors are offered as explanations for their strong growth in the past decade: those linked to market changes (globalisation, competition between executives, etc.) are distinguished from “institutional effects” (deregulation, tax policies, etc.). But their imbrication and the complexity of causalities prevent the identification of their respective importance. Next, the authors propose a theoretical model of optimal taxation on the higher income brackets covering the three initial hypotheses. Third, they attempt to assess the quantitative importance of these three tools using available data. Relying notably on the World Top Incomes Database, they establish a strong correlation between the decrease in top-income marginal tax rates and global economic growth – which suggests that the increase in the proportion of wealth owned by the highest incomes comes at the detriment of other individuals. The authors confirm this conclusion by also analysing the available data on the changes in remuneration of executives in other large firms, in the US since 1970 and in all rich countries since 2006. The central conclusion is that the strong increases seen in some countries – in particular, the United States and the United Kingdom – are explained not by the effects of size, sector or performance, but rather by executives’ capacity to negotiate their own salaries and by the changes to tax rates. These results suggest an important role for the third hypothesis, and imply that optimal top tax rates are slightly higher than those suggested by standard models.
Original title of the article: Optimal Taxation of Top Labor Incomes: A Tale of Three Elasticities
Published in : American Economic Journal, Economic Policy, 6(1): 230-71 - Février 2014
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