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Taxation at the Top

Published on October 15, 2014 by Makeda Easter

Researcher, economist use Stampede supercomputer to assess consequences of increasing tax rate on top earners


Alejandro Badel, economist at the Federal Reserve Bank of St. Louis
Life for the top one percent of income earners can be taxing…literally. In 2010, the top 1 percent of income earners in the U.S. consisted of households making $365,000 per year or more. Adding up federal income taxes, state income taxes, medicare taxes and sales taxes, these households paid, approximately, a marginal tax rate of 42.5%.

Recent research released by prominent economists Peter Diamond and Emmanuel Saez argued that taxing top earners at an even higher rate of 73% produces the maximum government revenue. The study ignited debates among economists and policymakers alike.

However, economists Alejandro Badel and Mark Huggett wanted to take a deeper look at taxation by using numerical methods to simulate a complex economy, which led to their collaborative research and subsequent working paper, Taxing Top Earners: A Human Capital Perspective.

The economists' initial findings yielded vastly different results than those of Diamond and Saez, including a lower optimal tax rate and the added consideration of human capital accumulation.

A Model Economy

Creating a model economy was the first step in evaluating the consequences of increasing the tax rates on top earners. The artificial economy is calibrated to match the U.S. earnings distribution, where earnings and wealth differ vastly across the population.

"When one builds an economic model, a typical assumption is that agents make best choices to maximize their welfare," said Huggett an economics researcher at Georgetown University. "Solving a maximization problem by computer can take a particularly long time if the number of possible states of individuals are very large."

"We need resources like Stampede to efficiently compute optimal individual decision rules about working, learning and saving, and then simulate the behavior of millions of model households, using these rules, in order to determine economic aggregates and equilibrium behavior," Badel said.
Alejandro Badel, economist at the Federal Reserve Bank of St. Louis
To address this computational challenge, Badel and Huggett turned to XSEDE, the Extreme Science and Engineering Discovery Environment, which provides researchers access to shared computing resources, data, and expertise. Through XSEDE, the researchers ran simulations of their model economy on Stampede, one of the world's most powerful supercomputers, at the Texas Advanced Computing Center (TACC).

"We need resources like Stampede to efficiently compute optimal individual decision rules about working, learning and saving, and then simulate the behavior of millions of model households, using these rules, in order to determine economic aggregates and equilibrium behavior," Badel said.

Initial simulations of the model economy revealed 53% as the optimal tax rate for top earners, much lower than the 73% rate Diamond and Saez proposed.

Mark Huggett, Economics researcher and professor, Georgetown University
"The Laffer curve is a concept economists use to represent the relationship between a tax rate and the total revenue obtained by implementing it," Huggett said. "The curve's hump shape captures the idea that eventually the tax rate will increase so much that the revenue will fall. In our model, we found the highest point of the Laffer curve occurred around 53%."

Human capital accumulation also plays a large role in the economists' model economy, affecting both the shape of the Laffer curve and optimal tax rate. In the model, top earners have a combination of good initial conditions, which include a high skill level and high learning ability by age 23. They also invest heavily in acquiring new skills, even if that means accepting reduced earnings.

But the researchers argue that an increase in the tax rate would have adverse affects on these potential high earners.

"Suppose you're a 25-year old in medical school, and considering taking on a medical specialty that might involve many years of hard work and lower earnings. Yet, you also know that once you become a great doctor, you will be compensated very well," Huggett said. "If you learn that the top tax rate increased from 42.5% to 73%, you may decide taking on that medical specialty is not a good decision."

Badel and Huggett found that a spike in the tax rate would have adverse affects on potential high earners.
Badel and Huggett argue that these potential high earners would be most strongly impacted by increasing the marginal tax rate. Higher taxes would lead to a change in skill-related investments for this group, resulting in a reduction in human capital accumulation and eventually reduced government revenue.

A New Perspective

Even though Badel and Huggett are still running simulations of their model economy to better determine the optimal tax rate for top earners, their research has already garnered attention in economic circles.

Badel and Huggett found that the tax revenue and some welfare measures increase until the top tax rate reaches 53%. Revenue declines for top tax rates exceeding 53%.
"So far the paper has been pretty influential," Badel said. "Other economists are starting projects in the same vein by creating their own models and literature on the issue."

The two economists have also been disseminating their initial research in the U.S. and abroad at conferences including, the Princeton University Economics Department, the annual meeting of the Society for Economic Dynamics, the National Bureau of Economic Research Summer Institute, and the meetings of the Midwest Macroeconomics Association, among several other venues.

Importantly, the research is informing much-needed conversations over whether economists and policymakers should favor complex quantitative models or simple but elegant methods to identify the best way to tax the wealthiest in our society.


Story Highlights

Two prominent economists recently proposed raising the marginal tax rate on the top 1 percent of earners from 42.5% to 73%.

To take a deeper look at this issue, researchers Badel and Huggett developed their own model economy to assess the consequences of increasing the tax rates on top earners in the U.S.

Using Stampede through an XSEDE allocation, the researchers initially found that the optimal tax rate is actually much lower than proposed and that increasing tax rates would negatively impact potential top earners.

The research is informing conversations among economists and policymakers on the best way to tax the wealthiest in our society.

Stampede is funded by the National Science Foundation (NSF) through award ACI-1134872. XSEDE is funded by the National Science Foundation (NSF) through award ACI-1053575.


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