Taxing Top Incomes in a World of Ideas

Stanford's Charles Jones released a new paper showing that new ideas and innovation drive economic growth; and the reward for successful innovation and the associated risk-taking is a top income. His model suggests the optimal tax rate incorporating the role of innovation is 29%; if ideas are even more important than the model’s baseline it's possible for the optimal top income tax rate to turn negative as the growth related to higher innovation is greater than the social benefits of redistribution.

From Steve:

model of the optimum tax rate which a new constraint, ideas. 1) new ideas drive economic growth, 2) the reward for creating a successful innovation is a top income, and 3) innovation cannot be perfectly targeted by a separate research subsidy finds that, "...For example, consider raising the top marginal tax rate from 50% to 75%. As we discuss below, in the United States, the share of income that this top marginal rate applies to is around 10%, so the change raises about 2.5% of GDP in revenue before the behavioral response. In our baseline calibration, such an increase in the top marginal rate reduces innovation and lowers GDP per person in the long run by around 6 percent...."

Charles Jones, Taxing Top Incomes in a World of Ideas," National Bureau of Economic Research (Preliminary), September 6, 2018, https://www8.gsb.columbia.edu/faculty-research/sites/faculty-research/files/finance/Macro%20Workshop/toptax.pdf

"...The nonrivalry of ideas is key to this result and illustrates why incorporating physical capital or human capital into the top tax calculation is insufficient. If you add one unit of human capital or one unit of physical capital to an economy—think of adding a computer or an extra year of education for one person—youmake one workermore productive, because these goods are rival. But if you add a new idea — think of the computer code for the original spreadsheet or the blueprint for the electric generator —you can make any number of workers more productive. Because ideas are nonrival, each person’s wage is an increasing function of the entire stock of ideas. A distortion that reduces the production of new ideas therefore impacts everyone’s income, not just the income of the inventor herself.....The idea creation and implementation that occurs beyond formal R&D may be distorted by the tax system. In particular, high incomes are the prize that motivates entrepreneurs to turn a basic research insight that results from formal R&D into a product or process that ultimately benefits consumers. High marginal tax rates reduce this effort and therefore reduce innovation and the incomes of everyone in the economy....Taking this force into account is important quantitatively. For example, consider raising the top marginal tax rate from 50% to 75%. As we discuss below, in the United States, the share of income that this top marginal rate applies to is around 10%, so the change raises about 2.5% of GDP in revenue before the behavioral response. In our baseline calibration, such an increase in the top marginal rate reduces innovation and lowers GDP per person in the long run by around 6 percent. With a utilitarian welfare criterion, this obviously reduces welfare. But even redistributing the 2.5% of GDP to the bottom half of the population would leave them worse off on average: the 6% decline in their incomes is not offset by the 5% increase from redistribution. In other words, unless the social welfare function puts enormous weight on the poorest people in society, raising the top marginal rate from 50% to 75% reduces social welfare.....For example, in a baseline calculation, the revenue-maximizing top tax rate that ignores the innovation spillover is 92%. In contrast, the rate that incorporates innovation and maximizes a utilitarian social welfare function is just 29%. Moreover, if ideas play an even more important role than assumed in this baseline, it is possible for the optimal top income tax rate to turn negative: the increase in everyone’s income associated with subsidizing innovation exceeds the gains associated with redistribution.....This paper considers the taxation of top incomes when the following conditions apply: (i) new ideas drive economic growth, (ii) the reward for creating a successful innovation is a top income, and (iii) innovation cannot be perfectly targeted by a separate research subsidy — think about the business methods of Walmart, the creation of Uber, or the “idea” of Amazon.com. These conditions lead to a new term in the Saez (2001) formula for the optimal top tax rate: by slowing the creation of the new ideas that drive aggregate GDP, top income taxation reduces everyone’s income, not just the income at the top. When the creation of ideas is the ultimate source of economic growth, this force sharply constrains both revenue-maximizing and welfare-maximizing top tax rates. For example, for extreme parameter values, maximizing the welfare of the middle class requires a negative top tax rate: the higher income that results from the subsidy to innovation more than makes up for the lost redistribution. More generally, the calibrated model suggests that incorporating ideas and economic growth cuts the optimal top marginal tax rate substantially relative to the basic Saez calculation.... "