Oops, I meant the Journal of Economic Perspectives, a prestigious publication that is supposed to provide survey articles about what is going on in various specialized fields, for those of us outside of those fields.
In a recent article Peter Diamond and Emmanuel Saez argue that we should impose much higher taxes on high incomes. Note that I don’t say much higher taxes on “the rich.” It would not put higher taxes on Warren Buffett, as the tax won’t come out of his consumption, it will come out of the investments that he no longer makes, and the charities to which he no longer contributes. Ditto for Bill Gates. A point Saez and Diamond somehow overlooked.
Their entire article skillfully toggles back and forth between pragmatic real world arguments and pie-in-the-sky theoretical arguments. The only common thread is that the approach used to make each point is the one that just happens to favor higher MTRs on high incomes. For instance, consider the argument they make for taxes on capital. The traditional view is that the tax on capital should be zero, because a higher rate would impose higher taxes on future consumption than current consumption, and hence lead to a sub-optimal level of savings and investment. In response, they point out that our current tax system often allows people to take advantage of gimmicks that result in labor income being falsely reported as capital income:
The existence of tax differentials between labor and capital also creates pressure to extend the most favorable tax treatment to a wider set of incomes. For example, in the United States, compensation of private equity and hedge fund managers in the form of a share of profits generated on behalf of clients is considered realized capital gains, although it is conceptually labor income.
Isn’t the obvious solution to make hedge fund managers treat their earnings as labor income? Obviously yes. I presume S-D would say that’s unrealistic, that the political process inevitably results in these sorts of loopholes. Fair enough, but then let’s see what happens when those pragmatic arguments cut the other way. Paul Krugman recently trumpeted the S-D conclusion that the optimal tax rate on high incomes is over 70%:
Using parameters based on the literature, D&S suggest that the optimal tax rate on the highest earners is in the vicinity of 70%.
That presumably comes from this statement by S-D:
As an illustration using the different elasticity estimates of Gruber and Saez (2002) for high-income earners mentioned above, the optimal top tax rate using the current taxable income base (and ignoring tax externalities) would be Ï„ * = 1/(1 + 1.5 Ã— 0.57) = 54 percent, while the optimal top tax rate using a broader income base with no deductions would be Ï„ * = 1/(1 + 1.5 Ã— 0.17) = 80 percent. Taking as fixed state and payroll tax rates, such rates correspond to top federal income tax rates equal to 48 and 76 percent, respectively.
I believe Krugman was referring to the 76% rate, which assumes a theoretically ideal tax system with no loopholes. And S-D also seem to lean toward the “assume a can opener” school of policy analysis:
In the current tax system with many tax avoidance opportunities at the higher end, as discussed above, the elasticity e is likely to be higher for top earners than for middle incomes, possibly leading to decreasing marginal tax rates at the top (Gruber and Saez, 2002). However, the natural policy response should be to close tax avoidance opportunities, in which case the assumption of constant elasticities might be a reasonable benchmark.
So there you are. It’s just too much to ask of our policymakers to actually make hedge fund managers pay labor taxes on their labor income, but S-D have no problem waving a magic wand and assuming away all tax loopholes. Notice how both assumptions favor higher MTRs on higher incomes.
If the gap between labor and capital taxes was a potential source of cheating, I wonder why we wouldn’t want to shrink the gap with lower top rates on labor income, rather than higher top rates on capital income (which discourage saving and investment.) To be fair, S-D mention that possibility, but merely as a throwaway observation that 99% or readers would skim right over:
Does the presence of capital income mean that earnings should be taxed significantly differently? When we discuss taxation of capital income in a later section, we note that the ability to convert some labor income into capital income is a reason for limiting the difference between tax rates on the two types of income””that is, an argument for taxing capital income. Plausibly, it is also an argument for a somewhat lower labor income tax, assuming that labor income should be taxed more heavily than capital income.
This is mentioned before the long discussion of capital income, which is entirely focused on (pragmatic) arguments in favor of taxes on capital—against the usual presumption of a zero optimal MTR. Thus readers would have forgotten this point long before they finished the paper. It might be important to actually investigate the implications of this alternative approach before we rush back into top MTRs that even the Scandinavian countries have found to be counterproductive (and which they abandoned many years ago.)
The S-D results rely on short run estimates of labor elasticities, and they admit that these ignore possible long run effects:
It is conceivable that a more progressive tax system could reduce incentives to accumulate human capital in the first place. The logic of the equity-efficiency tradeoff would still carry through, but the elasticity e should reflect not only short-run labor supply responses but also long-run responses through education and career choices. While there is a sizable multiperiod optimal tax literature using life-cycle models and generating insights, we unfortunately have little compelling empirical evidence to assess whether taxes affect earnings through those long-run channels.
Little compelling evidence? That might be technically true, but it’s highly misleading. Both common sense and the empirical evidence we do have suggests that high MTRs have much bigger incentive effects in the long run. First consider the intuition. Suppose you have 76% tax rates on the rich. Now consider how that would affect hours worked in brain surgery of the following two groups:
1. People who have already become brain surgeons.
2. People considering becoming a brain surgeon.
For the first group, I doubt the effect would be all that large. Their education is a sunk cost, and even after-taxes their income from brain surgery will exceed any likely alternative. On the other hand the person considering undertaking the long and arduous process of becoming a brain surgeon might be deterred by the smaller expected after-tax income. This would reduce surgeon supply until after-tax wages rose high enough to make medical school just worthwhile for the marginal student.
The best empirical evidence for long run effects comes from cross-sectional studies. Those may not be “compelling” because it’s hard to hold everything constant. But the evidence we do have (from Prescott and others) suggests that countries with high taxes tend to see fewer hours worked. As a result (back in 2007) the Germans only collected about as much tax revenue per capita as the US, despite the fact that taxes are 40% of GDP in Germany vs. 29% in the US. I pick Germany because it would be pretty hard to argue that German workers are in any sense “inferior” to American workers. They just work a lot less, presumably because they have much less incentive to work.
S-D might argue that this evidence isn’t compelling. But would we really want to make a great leap into the unknown on the assumption that both common sense and the empirical evidence that we do have is wrong? What’s their model of European hours worked? In addition, back when we did have 90% top MTRs, the wives of high paid men tended not to work. Do S-D want us to go back to the 1950s, when women stayed home?
Krugman also points out that S-D analysis relies on the assumption that workers are paid their marginal product:
Yet textbook economics says that in a competitive economy, the contribution any individual (or for that matter any factor of production) makes to the economy at the margin is what that individual earns “” period. What a worker contributes to GDP with an additional hour of work is that worker’s hourly wage, whether that hourly wage is $6 or $60,000 an hour. This in turn means that the effect on everyone else’s income if a worker chooses to work one hour less is precisely zero. If a hedge fund manager gets $60,000 an hour, and he works one hour less, he reduces GDP by $60,000 “” but he also reduces his pay by $60,000, so the net effect on other peoples’ incomes is zip.
Conservatives do often assume that workers are paid their MPs. But I think it’s also fair to say that those at the top may well contribute more than their marginal product. Here’s Adam Ozimek:
Consider, for instance, that if we suddenly kicked out the top 10% of high IQ people (or 10% most productive people, or 10% most creative people, or whatever) in the U.S.. It strikes me as fairly likely that the total output of the remaining 90% would go down. Krugman seems to argue that this would not be the case. But even if you disagree with me in the short run, in the long-run the productivity increasing innovations these people would have made won’t show up, and the rest of us would have lower productivity as a result.
Travis Allison emailed me the Krugman post, and made this comment:
Suppose that an inventor creates new product X and patents it. He reaps the benefits from the patent for 15 years or whatever the time period is and then it goes into the public domain. Consequently, he contributes a lot more to GDP than what he was able to earn.
Let’s consider the biotech industry, which many believe will be the most important industry of the 21st century. Investments in biotech tend to be all or nothing. So your decision to invest in a biotech company will be very sensitive to the after-tax expected gain in the state-of-the-world where your company invents a cure for cancer. Obviously a very high tax rate on the rich will tend to reduce that gain much more sharply than say the return from investing in MBSs (on which you’d pay a lower tax rate.) So very high taxes on the super rich will tend to shift capital away from companies trying to find cures for cancer, and toward home construction. That could easily delay a cure for cancer by 5 or 10 years. (Just imagine where the world would be today without US high tech firms.) Now maybe that’s a trade-off that S-D are comfortable making. After all, we don’t know for sure whether the biotech industry will be able to cure cancer, heart disease, or diabetes, nor do we know the degree to which the speed and likelihood of a cure is sensitive to different rates of investment in biotech. But at a minimum, I’d think we’d want to think long and hard before taking that gamble.
PS. I can assure you that people in biotech are highly motivated by possible capital gains. My wife works in a small biotech firm that is working on a vaccine that would prevent all types of flu. How nice would that be next time there’s a pandemic like 1919?