A lesson from California on the policy failure of “taxing the rich”

The Wall Street Journal editorial board calls it “the tax the rich boomerang.”

Stanford economists Joshua Rauh and Ryan Shyu analyzed how high earners responded to a 2012 referendum (Prop. 30) backed by Democrats that raised the top marginal rate on taxpayers with more than $1 million of income to 13.3% from 10.3%. The top rates on individuals earning more than $250,000 also rose between one and two percentage points.

The study abstract tells most of the story.

Drawing on the universe of California income tax filings and the variation imposed by a 2012 tax increase of up to 3 percentage points for high-income households, we present new findings about the effects of personal income taxation on household location choice and pre-tax income. First, over and above baseline rates of taxpayer departure from California, an additional 0.8% of the California residential tax filing base whose 2012 income would have been in the new top tax bracket moved out from full-year residency of California in 2013, mostly to states with zero income tax. Second, to identify the impact of the California tax policy shift on the pre-tax earnings of high-income California residents, we use as a control group high-earning out-of-state taxpayers who persistently file as California non-residents. Using a differences-in-differences strategy paired with propensity score matching, we estimate an intensive margin elasticity of 2013 income with respect to the marginal net-of-tax rate of 2.5 to 3.3. Among top-bracket California taxpayers, outward migration and behavioral responses by stayers together eroded 45.2% of the windfall tax revenues from the reform. (Emphasis added.)

The rich, surprise, are mobile. The authors state the implications simply in the conclusion to their 30-page paper (behind a pay wall).

Overall, we find strong behavioral responses to income taxation amongst high earners.

The WSJ sums it up:

This is especially relevant since liberal economists argue that the rich don’t care about marginal tax rates and raising the top income rate to 70% won’t affect revenue or incentives to work.

The study suggests Sacramento should think again. And watch out for the next recession when investment income and capital gains fall for the affluent.

The mobility of high-earners is one argument against steeply progressive state tax structures. Last February, we wrote that New York was facing the same problem.

 New York Gov. Andrew Cuomo explains,

Less than three weeks after he proposed his 2019 state budget, Gov. Andrew M. Cuomo on Monday raised red flags over slipping tax revenues and suggested that some popular items in the fiscal plan, including state aid to schools, could face cuts from what he offered in mid-January.

Calling the situation “as serious as a heart attack,” the Democratic governor said revenues are $2.3 billion below projections for the fiscal year that ends March 31.

Back to Cuomo:

“Tax the rich. Tax the rich. Tax the rich. We did that. God forbid the rich leave,” Cuomo said of a mobile group of people who can more easily switch residences to states with lower state and local tax levels.

As we’ve pointed out, the federal income tax is highly progressive. Under the principle of fiscal federalism, that makes more sense. It reduces the incentive to move from one state to another for tax relief. More:

A WRC report released last year lays out the concept (we discussed it here). An excerpt:

We also point to a key principle of fiscal federalism (a theory allocating responsibilities among the three levels of government), which holds that redistributive tax policies are best enacted at the national level. Adding this dimension to the analysis leads to our third finding:

3. All state and local tax structures are regressive. But when the steeply progressive federal income tax system is considered, the overall federal-state-local tax burden is progressive in Washington and every other state, and the differences among the states represent smaller proportions of households’ tax burdens.

 Things to keep in mind as the tax debate here continues.