Optimal Taxation of Top Incomes: A Tale of Three Elasticities

Citation:

Piketty, Thomas, Emmanuel Saez, and Stefanie Stantcheva. 2014. “Optimal Taxation of Top Incomes: A Tale of Three Elasticities.” American Economic Journal: Economic Policy 6 (1): 230-271.
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Abstract:

This paper presents a model of optimal labor income taxation in which top incomes respond to marginal tax rates through three channels: (1) standard labor supply, (2) tax avoidance, (3) compensation bargaining. We derive the optimal top tax rate formula as a function of the three corresponding behavioral elasticities. The first elasticity (labor supply) is the sole real factor limiting optimal top tax rates. The optimal tax system should be designed to minimize the second elasticity (avoidance) through tax enforcement and tax neutrality across income forms. The optimal top tax rate increases with the third elasticity (bargaining) as bargaining efforts are zero-sum in aggregate. We provide evidence on this elasticity using cross-country times series macro-evidence and CEO pay micro-evidence. The macro-evidence from 18 OECD countries shows that there is a strong negative correlation between top tax rates and top 1% income shares since 1960, implying that the overall elasticity is large. However, top income share increases have not translated into higher economic growth. US CEO pay evidence shows that pay for luck is quantitatively more important when top tax rates are low. International CEO pay evidence shows that CEO pay is strongly negatively correlated with top tax rates even controlling for firm characteristics and performance, and this correlation is stronger in firms with poor governance. These results suggest that bargaining effects play a role in the link between top incomes and top tax rates, implying that optimal top tax rates could be higher than commonly assumed.

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Last updated on 12/22/2018