A follow up to the November 3, 2021, REDW Wealth Management Update webinar series
Now that the Build Back Better Act has passed the House and is being actively negotiated in the U.S. Senate, taxpayers in the highest level tax brackets are understandably wary of what’s coming. It’s important to keep in mind that even the bill is far from final. Consider a little bit of tax bracket history.
History of top tax bracket rates vary from 25% to 94% over last century, but fairly stable over last ~35 Years
Starting in 1919, the highest tax bracket topped 73 percent, followed by a period of variability where the highest end ranged from 46 percent in 1924 to up to 94 percent in 1945. After 1945, the highest tax rate stayed in the low 90th percentiles until the Kennedy tax cuts in 1964 lowered it back down to 77 percent. The highest tax rate continued to fall until it hit 70 percent, where it remained stable all the way through 1981 when the Reagan tax reform act in 1986 lowered the top rate to 50 percent. Since the 1980s, the trend has been to lower the top tax bracket rate to just under 40 percent, where it’s remained for just under 35 years.
So how would the Build Back Better Act change that? Despite the public discussion regarding raising taxes on high earners, the House version of the Act leaves the top rate at 37 percent, where it landed following the 2017 Tax Cuts and Jobs Act (TCJA).
An earlier version of the Build Back Better Act proposed raising the top income tax rate from 37 to 39.6 percent. However, this increase will automatically kick in when the TCJA sunsets at the end of 2025.
Higher Tax Bracket Rates Don’t Lead to Higher Tax Revenue
While it may seem that historically there would be a big variance in tax revenue to accompany the changes in the top tax bracket rate, that expectation is not borne out by the historical record. If you consider historic tax revenue as a percentage of GDP (see graph below), you will see that no matter what the top tax rate is, from about World War II forward, tax revenue stays between 15 and 19 percent.
Historic Tax Revenue as % of GDP – “Federal Receipts as Percent of Gross Domestic Product” | Sources: OMB, St. Louis Fed, fred.stlouisfed.org
The gray bars indicate recessions. And the pattern is pretty clear that tax revenue declines with a recession. Intuitively, this makes sense. Then tax revenue goes back up when as the economy expands.
As Taxes Go Up, High Earners Work Less and Play More
Regardless of who’s in office and the tax regime they may support, tax revenue as percentage of GDP mostly stays the same. Planned tax rate increases are typically subject to static scoring by the Congressional Budget Office (CBO), meaning if the top tax rate goes up 5 percent, it’s assumed that the revenue collected will increase 5 percent. Instead, top earners tend to modify their behavior and work less when they have to pay more in taxes. Since the CBO doesn’t use dynamic scoring in evaluating proposed plans, they fail to take into account how taxpayers may change their behavior if rates increase. Static scoring assumes that taxpayers are just going to go ahead and write a bigger check, but that’s not what typically happens.
In a recent podcast from Dimension Fund Advisors, (one of the fund companies used by REDW Wealth,) founder Ken French speculated that if the government raises taxes, the result is always the same. In relative terms, French explained, the price of leisure has just been reduced because the price of working went up, so high earners (like him) will simply consume more leisure, leaving tax revenues fairly flat.
Key takeaway: It’s nice to have a little perspective on the highest tax rates and know that they will likely continue to stay under 40 percent, no matter which party is in power.
We welcome your questions. Please contact Ross Nettles or one of our trusted REDW Wealth advisors to discuss developing updates in the Build Back Better Act, or to discuss your wealth management concerns.
