Income tax revenues and the top marginal tax rate in the United States

In this post, I present a very crude analysis of the relationship between the top marginal tax rate on income and income tax revenues in the United States. I do not consider the level of income at which the top marginal tax rate applies; nor do I consider the lower income tax rates, or the levels of income at which they apply. Data are from the White House and the Tax Foundation.

The chart below depicts income tax revenues as a percentage of GDP and the top marginal tax rate since 1934--the earliest year for which I could find data. After rising from a very low level prior to 1944, income tax revenues have been remarkably stable over the 20th and early 21st centuries. Prima facie, revenues from income tax do not appear to bear much relationship to the top marginal tax rate.

The chart below shows the same information as the one above, but with income tax revenues on a separate axis. It confirms that--superficially at least--the two variables do not bear much relation to one another. For example, as the top marginal tax rate decreased from 91% in the early 1960s to 28% in the late 1980s, the medium-term trend in income tax revenues was more-or-less flat. In fact, there was a very slight upward trend from the early 1950s to the mid 1980s.

Under plausible assumptions about human behaviour, one should not expect to collect any income tax revenues (over and above those provided by lower income tax rates) when the top marginal rate is 0% and when it is 100%. At a top marginal rate of 0%, any additional tax revenue would have to come from people willing to pay income tax voluntarily. And at a top marginal rate of 100%, any additional tax revenue would come from people willing to work voluntarily. Therefore, one should expect to observe what is known as the Laffer-curve: an inverse-U-shaped relationship between income tax revenues and the top marginal rate, with two minima at top marginal rates of 0% and 100%, respectively.

The chart below shows the bivariate relationship between income tax revenues and the top marginal rate, with a quadratic (i.e., U-shaped) function fit to the data. Contrary to theoretical expectation, the peaks of the function are at the lowest and highest top marginal rates! But this is almost certainly attributable to the pre-1944 outliers: years in which very little income tax revenue was collected, despite high top marginal rates.

Incidentally, I do not understand why so little income tax revenue was collected prior to 1944. There must be a good legal or economic reason. Nevertheless, as the chart below indicates, once the pre-1944 values are excluded, the quadratic function takes the expected form.

How much have homicide, theft and robbery fallen in the last two decades?

The Economist recently ran an story entitled The Curious Case of the Fall in Crime, which discusses some of the reasons why crime has fallen in the West over the last couple of decades. The BBC featured a similar article specifically about the British case. But by how much has crime actually decreased? Here, I present three charts which depict, respectively, the change in the homicide rate, the theft rate, and the robbery rate in a number of Western countries since 1995. Data are from the United Nations Office of Drugs and Crime.

Looking just at these three metrics, the drop in crime is quite impressive. Homicide has fallen by 20-50%, theft by 10-50%, and robbery by a similar amount. The only outlier here is Italy, which appears to have experienced a considerable increase in robbery, beginning in the early 2000s. (Part of this increase may be due to a some kind of change in the definition of 'robbery' under Italian law.)

Evaluating "too big to fail"

Many commentators have argued that one of the key factors contributing to the financial crisis of 2008 was "too big to fail"--policy-makers' belief that certain institutions could not be allowed to fail because the consequences of their failure would be too disastrous. Here, the argument is simply that there is less incentive to avoid excessive risk-taking when someone else is picking up the bill. Ex post, of course, many financial institutions did get bailed out; not just in the US but in other countries as well. However, although the foregoing argument seems highly plausible (to me at least), one cannot be sure that financial institutions believed ex ante that they would in fact be bailed out. Here I want to review some of the evidence that they did.

The first kind of evidence is that people favourable to the banks were in Washington during the lead-up to the crisis. The two most prominent examples are Hank Paulson, who was Treasury Secretary between 2006 and 2009, and Tim Geithner, who was president of the New York Fed between 2003 and 2009. Paulson had been the CEO of Goldman Sachs between 1999 and 2006. Of course, by itself this fact is very weak evidence that he put his old institution's interests before the tax-payer's. However, there are a couple of additional reasons to suspect he might have done. First, Lehman Brothers--Goldman's biggest rival--was allowed to fail, yet AIG, which owed money to Goldman at the time, was bailed out. Second, on September 18th, 2008 (the day of the run on US money market funds) Paulson corresponded with Lloyd Blankfein, who succeeded Paulson as CEO of Goldman Sachs, more than with any other person in Washington except Ben Bernanke. Geithner has been accused by Sheila Bair, the ex-head of the FDIC, of putting the interests of bailed-out institutions' creditors before those of the US tax-payer. Similar accusations have been made against him by Neil Barofsky, the special inspector general of TARP and author of Bailout. Indeed, Geithner was ostensibly described by one Wall Street banker as "our man in Washington."

The second kind of evidence is that the largest Wall Street banks seem to enjoy a "too big to fail" subsidy. In particular, they face lower borrowing costs than their rivals because of the implicit government guarantee on their debts. According to a report by the Independent Community Bankers of America, of 15 studies that investigated the existence of the "too big to fail" subsidy, 14 found evidence that it existed, whereas only 1 did not, and that study was carried out by JP Morgan Chase. More recently, a study by Goldman Sachs found that the "too big to fail" subsidy has generally been small in magnitude, was largest during the financial crisis, but has since become negative. However, as the Bloomberg article reports, the economist Simon Johnson "said that Goldman Sachs' report proves the value of the too-big-to-fail subsidy because it shows the biggest banks enjoyed a large advantage during the financial crisis".

The third kind of evidence is simply the long list of bailouts that preceded those of 2008. Franklin National Bank was bailed out in 1974; Continental Illinois was bailed out in 1984; a large number of financial institutions were bailed out in 1989 following the S&L crisis; and several Wall Street banks were indirectly bailed out in 1994 when the Mexican government was loaned $50 billion to pay off its creditors after the peso crisis. In addition, LTCM's bailout in 1998 was organised by the New York Fed and was helped-along by easy monetary policy on the part of the Federal Reserve (though it was not taxpayer funded). Finally, a number of large non-financial institutions have been bailed out by the US government over the years. These include: the Penn Central Railroad in 1970, Lockheed in 1971, New York City in 1975, Chrysler in 1980, and the airline industry in 2001.