An argument for cutting taxes on the rich

Under the Reagan Presidency (1980-1988), income tax was cut across the board and the top rate of income tax reduced from 70% to 28%. The dramatic nature of the change in tax policy makes this a useful case study for debates on taxation.

Looking at the labour market trends that followed from the Reagan tax cuts, it is clear that the changes in tax policy had an asymmetric impact on the labour force. Whilst the proportion of high-income workers working long hours (>49 hours) rose noticeably in the period following the cuts, this measure remained relatively stable for the lowest quintile of the workforce. Furthermore, though average hours worked remained relatively constant from 1980 to 2000, this was largely attributed to the inertia of male labour supply. Female labour supply, on the other hand, increased markedly in this period. Such differing degrees of wage sensitivity were also observed among workers of different age groups, with elderly workers having a more responsive labour supply.

The observed trends can be explained by the heterogeneity of work preferences between different demographic groups. For example, there is evidence that the rich may be more responsive to tax cuts, with one study estimating the taxable income elasticity of workers earning over $100,000 at 0.57, compared with 0.18 for workers earning $10,000-$50,000. One possible explanation is that high-income earners have the alternative of substituting wage income with stock options, capital gains or non-taxable perks, whereas low-income earners are much more dependent on their wage income. Thus when income tax rises, high earners have greater flexibility to limit the proportion of their income coming from their salary.

These asymmetric impacts of tax policy suggest that the economic benefits from tax cuts depend partly upon how they are targeted. Tax cuts are more effective when targeted towards the most responsive workers, which may well include high earners.