The relationship between tax rates and government revenue has long been a central debate among economists and policymakers. A foundational principle of public finance is that not all tax hikes bring in more revenue. Setting a tax rate too high can actually yield less money than a lower rate because high levies influence human behavior—specifically, how much people choose to work and how much businesses decide to invest. Both of these economic activities directly affect the broader income tax base.
Because of this complex dynamic, economists and policymakers have continually sought to determine the elusive "Goldilocks rate"—the precise tax level that maximizes government revenue without triggering counterproductive economic contraction. Now, a new research paper sheds significant fresh light on this fundamental question, concluding that the income tax rate that maximizes government revenue may actually be lower than many previous estimates suggested.
The inquiry into optimal tax policy often revolves around the concept of the Laffer curve, which illustrates the theoretical relationship between rates of taxation and the resulting levels of government revenue. An exceptionally influential policy paper in the "optimal tax theory" literature was published by economists Peter Diamond and Emmanuel Saez in 2011, titled "The Case for a Progressive Tax." That work sought to identify the absolute "peak" of the Laffer curve, defined as the marginal tax rate at which tax revenue reaches its maximum possible level.
Building directly upon earlier theoretical work published by Saez, the 2011 paper estimated a top revenue-maximizing tax rate of 73 percent in the United States. However, the complex findings of that study were frequently misunderstood by policymakers, political commentators, and the general public. Some observers erroneously assumed that the paper’s findings implied the top income tax rate should be set at that dramatic level, misinterpreting a theoretical peak for a prescriptive policy recommendation.
To understand the 2011 paper accurately, it is essential to look at how that 73 percent figure was constructed. First, the top revenue-maximizing rate estimated by Diamond and Saez was fully inclusive of all taxes levied at the federal, state, and local levels. This comprehensive figure accounted for all payroll taxes and sales taxes, meaning the paper did not estimate that revenue would be maximized if the top individual income tax rate—which stood at 35 percent at the time of publication—was abruptly hiked to 73 percent.
A second, and critically overlooked, contributor to the 73 percent figure was the assumption of a tax base that was significantly broader than the actual American tax system was at the time, or remains today. The authors estimated that if they utilized the existing, narrower tax base characterized by numerous deductions, exemptions, and credits, the top revenue-maximizing rate would drop to 54 percent. Furthermore, looking strictly at the top federal income tax rate under those real-world conditions, the revenue-maximizing rate was estimated at 48 percent. For historical context, that 48 percent threshold is not substantially higher than the combined federal and state income tax rates already faced by high-income earners residing in high-tax jurisdictions such as New York and California.
Despite its enormous influence, the 2011 paper by Diamond and Saez was certainly not the final word on the topic of optimal taxation. In the years since its publication, numerous academic papers have approached the problem using different methodologies, econometric models, and datasets. This subsequent body of research has produced a wide range of total government revenue-maximizing tax rates from all sources, generally spanning between 46 percent and 73 percent.
In a new research paper building on this extensive body of work, economists Rachel Moore, Brandon Pecoraro, and David Splinter argue that many previous papers utilized tax bases that were either unrealistically broad or overly narrow. Crucially, those earlier models often failed to account for important behavioral adjustments made by taxpayers in response to shifting policy. Given the realities of the modern tax code, the authors find that actual Laffer curves are significantly flatter than Saez and other researchers previously estimated. This flatness implies that the potential revenue gains from increasing top marginal tax rates are substantially smaller than what older estimates have indicated.
When evaluating tax policy, lawmakers are typically most interested in understanding how a change in the top ordinary income tax rate would directly impact government coffers. However, a remarkably large share of income earned at the very top of the distribution actually falls outside of the ordinary income tax base entirely. For instance, while the ordinary income tax base does capture some forms of capital income—such as short-term capital gains and the profits generated by pass-through businesses—other major categories of capital income are treated differently. Long-term capital gains and qualified dividend income, for example, are taxed at preferential, lower rates. Moreover, the ordinary income tax base is systematically eroded by a wide variety of deductions and credits designed to encourage specific types of investment and economic behavior.
To address these complexities, the authors of the new paper improve significantly upon previous studies by constructing multiple distinct tax bases. They utilize detailed, high-quality administrative data covering high-income taxpayers to estimate real-world behavioral responses along the Laffer curve. This sophisticated modeling approach allows them to capture various margins of adjustment that occur when tax rates change.
For instance, corporations and business owners may alter their organizational structures, shifting away from corporate entities and toward noncorporate structures if tax rates on pass-through business income decline, or vice versa. Similarly, individual income taxpayers have the flexibility to increase tax-deductible activities, such as charitable donations or targeted investments, when their statutory tax rates rise, thereby shielding a portion of their wealth from higher taxation.
By carefully accounting for these additional margins of economic adjustment, the researchers discover that the revenue losses resulting from federal rate increases roughly double when compared to previous estimates that relied on analyzing only a single, monolithic tax base. When the authors run their model using a single broad tax base, they find a revenue-maximizing federal income tax rate of 55 percent. Yet, when they switch to utilizing multiple bases and fully account for all possible behavioral responses—representing what they term the "true" tax base—that revenue-maximizing federal rate drops significantly to 48 percent. At that specific rate, the model yields an additional $43 billion in revenue, representing approximately 0.2 percent of the nation’s Gross Domestic Product.
The picture shifts even further when the researchers factor in all taxes collected across federal, state, and local levels of government. Taking this comprehensive view into account, the top federal income tax rate that maximizes total government revenue from all sources falls even lower, settling at 39 percent.
According to their calculations, an increase to that 39 percent level would yield a mere $1 billion in additional total tax revenue nationwide. At that rate, the secondary revenue losses experienced by state and local governments—driven by shifts in taxpayer behavior—almost fully offset the nominal gains achieved at the federal level. Notably, a rate of 39 percent is also exceptionally close to the current top federal individual income tax rate of 37 percent, suggesting that the U.S. federal government is already operating very near the peak of its revenue-maximizing potential under the existing tax structure.
Taken as a whole, this new economic research demonstrates that aggressively raising top income tax rates on the current, highly porous tax base may generate considerably less revenue than policymakers have historically assumed. This shortfall is largely driven by the inherent flexibility of high-income taxpayers, who can easily shift income to different tax bases or alter their financial behavior within the existing tax code to minimize their liabilities.
As lawmakers continue to debate federal fiscal policy, economic growth, and deficit reduction, this study underscores the importance of looking beyond simple statutory rate hikes. Policymakers would be wise to keep these dynamics in mind when considering proposals to increase tax rates on high-income earners, particularly if those proposals are advanced without accompanying structural reforms to broaden the tax base and limit avoidance opportunities.
