The late Mitch Hedberg was one of the best one-liner comics who has ever lived. In this clip, he explains the concept of marginal utility more concisely than anyone I've ever heard attempt it. The first pancake is great, the second pancake is good, but the fifth pancake brings you almost no benefit whatsoever.
What does this have to do with tax rates? Think of dollars instead of pancakes. For someone who doesn't have much in the way of assets or income, each additional dollar that person acquires is of more value to him or her than someone who has lots of assets and income.
Consider Herman Cain's cartoonish 9-9-9 plan. Under it, everyone would pay 9% income tax. Someone making $20,000 per year would pay $1,800 to the federal government, leaving $18,200 left over for everything else. That could be the difference between having a car or not, or having an important medical procedure done or not.
Now think about someone making $200,000 a year. That person would pay $18,000 per year to the federal government, leaving $182,000 left over for everything else. This person may or may not even miss the income tax given the abundance left over depending on how closely that person manages his or her finances. The tax rate for both people is the same, but the amount paid is more precious to the first person than the second.
That's one reason why we have a progressive tax system where the rich pay more than the poor. It goes beyond non-quantifiable things like "fairness". It's better for the rich to pay more because the amount of marginal value they lose with each additional dollar assessed in taxes is much lower than that of people who have much less.
tl;dr crowd, thanks for coming. You're dismissed.
This insight doesn't just apply to deciding where to set tax rates in normal times. It also applies to times like what we have now where the government is faced with two opposing dilemmas: how to get the economy going again while also reducing long term deficits.
In any Econ 101 class, you learn that Y = C + I + G + NX. Y is GDP, C is consumption, I is investment, G is government spending, and NX is net exports. Consumption is what you and I do every day when we buy goods and services. Investment here doesn't refer to things like buying stocks and bonds, but rather it's business investment like building new facilities and upgrading equipment.
When people talk about getting the economy going again, they mean making GDP increase. To do that, you have to increase some or all of its components on the right side of the equation. In a recession like we're in now, C and I drop. NX is not something the government can directly control easily or entirely. That leaves the G component, something the government does have complete control over. Additional government spending can sometimes cause crowding out, or a subsequent drop in I due to higher interest rates. Right now though, we're probably in a liquidity trap where the effect of crowding out is at a minimum. Raising G will cause GDP to rise right now.
So where should the government spend that money to achieve the best bang for its buck? It should spend it on those who would get the most marginal utility from it, which is to say, not on the rich.
In addition to the marginal utility argument, the rich have a higher savings rate than the non-rich. Therefore, $1 billion spent on the poor and middle class will raise the C component a lot more than $1 billion spent on the rich. In particular, targeting those with the largest debt like underwater homeowners would be best given the balance sheet recession we're in. The poor and middle class will save some of it, meaning each additional dollar of government spending will result in less than a dollar increase of C, but that saving effect will be much less with them than with the rich.
One form of government spending is tax cuts. Whether the government gives money away to individuals or chooses not to collect it from them in the first place, it has basically the same effect in practice. If you've been following along, it means that cutting taxes on the rich is not a good way to get the economy moving again.
It's true that the rich can sometimes be job creators as small business owners, but right now, small business owners' biggest worries are related to not having enough customers:
A business doesn't need to hire more people (or raise I through investing, for that matter) if it isn't gaining new customers or increased business from its existing customers. Raising C will help businesses get more customers and business, giving them reason to hire more people and invest, and start a virtuous circle.
As far as reducing long term deficits goes, the only way to accomplish that via spending cuts alone is to gut nearly all government programs as we currently know them. Voters won't go for that, so raising taxes will have to be a part of the equation.
Because of marginal utility (among other things, like the savings rate), it makes the most sense to raise taxes the most on the rich. You can't just soak the rich for everything they've got; at some point some of them will do things to avoid an overly heavy burden (things that can be cancelled out by others' actions at lower-than-maximum rates). That point is a lot higher than current marginal tax rates on the highest tax brackets, which means there's plenty of room for the rates on the highest income levels to rise. Letting the Bush tax cuts on those making over $250,000 annually expire as the president has proposed is a good start, but it's not all that can be done.
When times get better, everyone except the most poor will need to share more of the tax burden. The long term deficits can't be wiped away merely by taking a vacuum cleaner to the wallets of the rich any more than they'll be solved by gutting popular and vital government programs. For right now in the short term though, raising taxes on the rich while not cutting programs for the poor and middle class is the right call.
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