Saez and Diamond explain taxes in the Journal of Economic Propaganda

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 τ * = 1/(1 + 1.5 × 0.57) = 54 percent, while the optimal top tax rate using a broader income base with no deductions would be τ * = 1/(1 + 1.5 × 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?


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49 Responses to “Saez and Diamond explain taxes in the Journal of Economic Propaganda”

  1. Gravatar of John Thacker John Thacker
    23. November 2011 at 08:53

    Also note that if people are paid exactly according to their marginal product, as Krugman and the Saez-Diamond analysis claims, then there’s absolutely no reason for the government to subsidize education.

    After all, to the extent that education is useful, it increases one’s marginal product, so if one is paid exactly according to that, then an individual will have all the right incentives to get more education, and there’s no public good.

  2. Gravatar of RS RS
    23. November 2011 at 09:01

    This is pretty ridiculous; do you really think Warren Buffet or Bill Gates will stuff cash under their mattress rather than invest it, if their tax burden increased dramatically? They would be idiots to do so, as there must be marginal gain for there to be a marginal tax burden.

    Most highly qualified people do not work primarily for monetary compensation; they work for social / status compensation. The would-be surgeon is not going to choose to be a homeless panhandler, irrespective of the taxation regime. Not only is there a question of what other choice a rational actor concerned only with pecuniary benefit would take, but there is the need for this would-be surgeon to gain and keep the regard of the people in his or her life, which would imperilled if they did not choose this—or some other high-achievement profession, leaving the social utility question a wash.

    Further, if a few would-be surgeons were deterred, it’s hard to say that they would have been among the best of their field, or that their replacements (positions in med school being oversubscribed) would be meaningfully less competent or qualified.

    Finally, almost any such tax regime would have the final brackets hit income far in the excess of what most surgeons earn. Most of the 10% high IQ people/productive people/creative people don’t earn over $1 million a year; .8% of households do. 9 of those 10% would be unaffected by a new tax bracket at that level. Most of the rest would be barely affected by it. It’s true 0.2% would have half or more of their income impacted by this new tax increase, but at that point, can you really say that someone with over a $2 million/yr household income actually makes life decisions based on MTRs, rather than social status?

    Even if they did, 90% of the 10% Ozimek is so concerned about would be unaffected. They’d have little to no reason to change their current course. That last 10% of 10% (the famed 1%) could opt out only to have some of the other top 10% replace them (and they themselves would only rationally opt out to the extent that they become part of the 10%-1%). Can you really draw a straight line between one high IQ, productive, creative person replacing another, and negative impacts to our society?

    Your point about pharma research is a bit glib. As the return seemed to be insufficient for the risk, the redirected investments would drive down the yield for safe investments, returning the risky ones to a attractiveness as having a return that still provided a substantial risk premium. Ultimately, the money has to be invested in something, and we can only build so many new houses.

    Meanwhile, think of the other side of the ledger; what development of human capital could this country engage in, with those increased resources? How much more talent would we liberate from underachievement due to environmental factors (crime, poor/overcrowded schools, lack of enrichment activities, etc etc) and how would those contributions weigh on the scales evaluating this policy shift?

    As for the capital/labour tax dichotomy, end it. We have a consumer demand shortfall, not a capital supply shortfall. We have people lining up to invest in this country. Tax all gains, labour or capital, at the same progressive set of rates. Most of those games you describe are pointless when that distinction is also pointless.

    I’m not sure I can countenance a MTR of 76% (!) but that a higher tax burden, simplified not through the end of tax brackets but rather of special treatment for dividends/capital gains/inheritance windfalls (treating all of it, rather, as “income”) has its benefits, and most of the harms you describe are illusory.

  3. Gravatar of acarraro acarraro
    23. November 2011 at 09:06

    But aren’t you confusing two different issues in your cross-sectional comparison? There is a difference between the total level of taxing/spending and how that spending falls between different income classes… Taxes in europe are higher for everybody especially given the large amount of generally regressive consumption taxes. So we don’t know which is which (average level or progressivity)…

    As far as the bio-tech industry example, it’s not as clear-cut. Innovation is a gamble: sometimes you win most times you lose. If you lose (and the winner pays more taxes) you’ll get somewhat compensated, so you might be more prone to risk as losing would be less expensive (we are generally risk-averse, aren’t we?)… If you consider that a large part of high-end goods are positional (so pecking order might motivate more than absolute value) it’s even less clear…

    I honestly don’t understand the loophole argument. Don’t they mean that since we have loopholes and only high income people use them, we should have higher marginal rates for high income? I read it that you could lower them if you did away the loopholes (which you can’t so they must be higher). But I likely misunderstand as I haven’t read the original…

    All I know is that in UK for example, capital and income tax is the same level but there are several ways to smooth consumption tax-free for most people (no main residency property/capital gain taxes, pension contributions, etc…). It seems to me a better way to solve the practical problem of people changing labor income in capital income (which applies to all small business not just hedge fund managers), while not screwing people that want to delay consumption…

  4. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    23. November 2011 at 09:20

    I just watched an old movie on TV about the relationship between Max Schmeling and Joe Louis. In the end Louis was broke, thanks to the IRS. Louis spent the war fighting exhibitions from which he donated all his purses to Army/Navy charities…and the IRS levied 90% tax on those.

    Schmeling, who fought as a paratrooper for Hitler, was given a Coca Cola distributorship after the war, and used some of his wealth to help out Louis. He even paid for his funeral. There’s some evidence that statistics doesn’t capture.

    I’m pretty sensitive to this issue right now, as I’d be blind today if it wasn’t for the state of modern opthamology. For which I thank Wall Street for providing the capital to train the doctor as well as produce the technology that restored my vision. I’d be a real jerk if I envied those who received the (high) incomes that made it possible.

  5. Gravatar of acarraro acarraro
    23. November 2011 at 09:34

    As far as the education arguement, I think it’s the same: basic education (which is heavily subsidized) raises average productivity rather than top productivity, so the progressivity has no bearing on the argument.

    The way I think about it is that luck pays a resonbly big role in life and that high marginal taxes balance that in part.

    Are you more outraged by the tax on capital or by the high marginal rate?

    In some ways 70% is not far from my current marginal rate in the UK, by the way (it’s “only” 65% right now). And I am ignoring VAT as well…

  6. Gravatar of K K
    23. November 2011 at 10:28

    OK, Scott. But what if you got rid of the other 90%. You think the income of top 10% would go up? Seriously the most ridiculous argument I’ve ever heard! There are rents to be had. Who do you think is more capable of seeking them out?

    “Consequently, he contributes a lot more to GDP than what he was able to earn.”

    Maybe. Or maybe someone else would have thought of it 12 months later and we end up paying 14 years of rents for nothing. You do understand that the fixed term of patents incentivizes the patenting of ideas with the lowest possible cost to develop and the maximum possible rent, right? And most biotech innovations and all of modern science originates in university labs funded with public money.

  7. Gravatar of John Thacker John Thacker
    23. November 2011 at 10:29

    “This is pretty ridiculous; do you really think Warren Buffet or Bill Gates will stuff cash under their mattress rather than invest it, if their tax burden increased dramatically?”

    No, he thinks that they’ll have less to invest, RS. That would be the main effect; substituting government investing for their investing. There might be some effect of them choosing to consume more instead of invest.

    Taxing the rich in a way that reduces their consumption switches goods from the rich to other people. Taxing their investment more does make them more likely to spend things on private planes or fancy food.

    I don’t understand your claim, RS, that the problem with the economy is that we need more rich people enjoying luxury goods instead of investing and letting other people consume.

    I also don’t understand your complaint that people are lining up to invest. If that were so, wouldn’t there be easily available credit, and a flow of money into stocks and other investments, instead of into low interest government bonds?

  8. Gravatar of John Thacker John Thacker
    23. November 2011 at 10:41

    K,


    And most biotech innovations and all of modern science originates in university labs funded with public money.

    And most all of what is taught in university originated in the work of scholars long dead and not at those universities. Therefore, we shouldn’t allow universities to charge such high tuitions and profit on the works of others.

    Or perhaps we should in both cases look at the marginal return.

  9. Gravatar of Mark Mark
    23. November 2011 at 10:50

    Why aren’t you tying this back into nGDP targeting?

  10. Gravatar of ssumner ssumner
    23. November 2011 at 11:01

    John Thacker, Very good point.

    RS, It’s always enjoyable to see someone come over here with an arrogant and insulting attitude, and then make a complete fool of themselves. You said:

    “This is pretty ridiculous; do you really think Warren Buffet or Bill Gates will stuff cash under their mattress rather than invest it, if their tax burden increased dramatically? They would be idiots to do so, as there must be marginal gain for there to be a marginal tax burden.
    Most highly qualified people do not work primarily for monetary compensation; they work for social / status compensation. The would-be surgeon is not going to choose to be a homeless panhandler, irrespective of the taxation regime.”

    No I don’t think they would put money under their mattress, nor did I so much as hint that they would do so. I claimed they wouldn’t cut back on consumption, as I’m sure even Saez and Diamond would agree.

    Nor did I suggest that surgeons would choose to become homeless. Next time read my post before commenting on it.

    And no, there is no shortage of consumption in the US, there is a shortage of demand.

    acarraro, Yes, which don’t know exactly which taxes are most important, but we do know that despite having a relatively efficient tax regime there are many fewer hours worked. that suggests that the disincentive effects of high MTRs might be rather important. Your point would carry more weight if the European tax system was relatively inefficient, but it isn’t.

    Patrick, Well said.

    Acarraro, You asked;

    “Are you more outraged by the tax on capital or by the high marginal rate?”

    Capital. I prefer a zero top rate on capital, and a relatively high top rate on wage income.

    Is the UK top rate 65%? I thought it was 50%.

    I don’t follow your education argument.

    K, I agree that there are problems with the patent system. But in areas like biotech it can be very important. What difference does 12 months make? Not much I guess, unless you are one of the 500,000 Americans who die from cancer ever 12 months. And do foreigners count too?

    Good point about the 90%. But the argument still applies for individuals. They often have MPs far above their compensation. On the other hand there is also lots of rent seeking, which should be addressed through deregulation, not taxation.

  11. Gravatar of ssumner ssumner
    23. November 2011 at 11:03

    Mark, Not everything relates to NGDP, although it may seem so.

  12. Gravatar of Mike Mike
    23. November 2011 at 11:43

    “Isn’t the obvious solution to make hedge fund managers treat their earnings as labor income?”

    I’m at a loss; how do you do construct such a policy?

  13. Gravatar of William William
    23. November 2011 at 12:07

    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.

    Off the top of my head, isn’t this wrong in any case with joint production of output? I always thought the significance of inputs being paid their marginal products was that the total wage bill + rents bill = total output, so there is no more “surplus” to give away. But as far as I can think, that doesn’t mean that workers would earn exactly as much if all the machines were destroyed tomorrow, or pulled out of use by their owners. Is the “no capital” thought experiment relevant or irrelevant?

  14. Gravatar of JStephen JStephen
    23. November 2011 at 12:11

    They used micro estimates for labor supply elasticity, ignoring macro ones. Pretty odd that they chose to completely ignore a large and growing body of research on the micro/macro gulf and research pointing towards possible reconciliation. Using macro estimates yields something like this:

    http://www.minneapolisfedDOTorg/research/QR/QR2811.pdf
    http://www.kansascityfedDOTorg/Publicat/Reswkpap/PDF/RWP06-16.pdf

    I don’t think they even REFERENCED the larger macro estimates. Here’s the recent Sargent and Rogerson papers on the gulf and why it may no longer be relevant:

    https://files.nyu.edu/ts43/public/research/AER_PP_LjungqvistSargent_7DOTpdf
    http://www.nberDOTorg/papers/w17430

    And some of the work leading up to that stuff:
    http://www2.dse.unibo.it/zanella/papers/elasticities-sept-2011DOTpdf
    http://www.ssc.upenn.edu/ier/Archive/02-015DOTpdf
    https://files.nyu.edu/cps272/public/ReadingGroup/ImaiKeaneDOTpdf
    http://people.bu.edu/fgourio/margworker1106DOTpdf
    http://www.cepr.org/meets/wkcn/1/1552/papers/flodenDOTpdf
    http://www.nber.org/papers/w13017DOTpdf

    Damn spam filter!

  15. Gravatar of JStephen JStephen
    23. November 2011 at 12:12

    (Replace “DOT” with a period where applicable)

  16. Gravatar of William William
    23. November 2011 at 12:20

    On further reflection, yes, I am correct in my comment above. Take a driver who works for a trucking company. Even though he can say to his employer, “Hey, there would be no output without my driving, so I deserve to get paid the entire amount we’re earning from this client.” Even though that’s true, he is not in a specially strong negotiation position because the owner can say, “Yes, but I can hire a different driver to do your job, so I’m just going to pay you the same as I could pay another guy to take your place.”

    But if the driver somehow acquires the legal right to fill his job, he can force the employer to give him the entire product of their joint output, minus the cost of gas, depreciation, and a penny to make it worth the owner’s while.

    The lesson is, it’s true that the decision of any individual doesn’t affect the earnings of anyone else, but that is irrelevant when you are contemplating large policy decisions. If you ban capital investment in the entire economy, it is going to wreak havok, not just hurt the income of rentiers.

  17. Gravatar of Daniel Daniel
    23. November 2011 at 13:36

    I see two strong arguments, one slightly confusing argument, and one weak argument. May I gently encourage you to clarify the confusing one and not make the weak one?

    The two strong arguments:

    1. We have excellent theoretical reasons to want the tax on capital to be zero.

    2. Empirically, we should be suspicious of any argument in favor of marginal tax rates even higher than those rejected by the Scandanavian countries.

    The somewhat confusing argument:

    3. Warren Buffett doesn’t spend his marginal income, he saves it, so what good is taxing it?

    The trouble here is that the point of taxing the rich is not to reduce their consumption but to increase everyone else’s for the same level of growth. To make this argument work you have to show not merely that you’d be taxing Buffet’s savings rather than his consumption, but that this would reduce others’ consumption or growth relative to some alternative policy – and if the alternative policy is “tax the middle class”, that’s hard to show.

    The weak argument:

    4. The earned income of the richest undercompensates them for their societal contribution if most of them are inventors.

    The trouble is, most studies of the top 1% (and especially the top 0.1%) indicate the representative member is a CEO or financial executive, and CEO and financial pay has exploded over the last 40 years in Anglophone countries without evidence of improved quality (e.g. no surge in growth in these countries versus the non-pay-exploding developed countries). So the “top 1% are inventors, not rent-seekers” is hard to find actual data in support of. Honestly the evidence makes it easier to argue that the dollar-for-dollar societal return of the top 1%’s earned income in the United States is *less* than average.

  18. Gravatar of StatsGuy StatsGuy
    23. November 2011 at 13:54

    “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.”

    And yet, German GDP per capita is comparable. Me wonders why? Mayhap they spend less time on rent-seeking activities. Or have fewer people in prison. Dunno.

  19. Gravatar of Dtoh Dtoh
    23. November 2011 at 13:58

    Scott
    Excellent point on expected after tax returns in bio-tech, but it’s not just biotech. Investments in most new ventures are characterized by a few winners and a lot of losers. In this environment, it does not take a very high capital tax rate to result in negative expected after tax returns. Additionally small changes in the tax rate are hugely amplified in the expected after tax return.

  20. Gravatar of Wonks Anonymous Wonks Anonymous
    23. November 2011 at 14:37

    Karl Smith one-ups his co-blogger (Adam Ozimek):
    http://modeledbehavior.com/2011/11/23/cross-marginal-product-of-labor-part-ii/

  21. Gravatar of ssumner ssumner
    23. November 2011 at 15:08

    Mike, I know people who got stock options at high tech companies. They had to treat it like labor income. Hedge fund managers should be required to do the same.

    William, I’m not certain but they seem to focus on labor income, so perhaps they are holding the capital stock constant. Or assuming that any capital taxes they impose don’t affect the size of the capital stock. But I didn’t take a close look and it’s not my area of expertise.

    Obviously I think capital taxation would reduce the capital stock, so I think your point is probably valid.

    JStephen, Thanks for all those papers.

    This isn’t my area, but I’ve always wondered about micro estimates. At the macro level what matters is income-compensated labor supply, as taxes are just re-injected back into the economy. Do micro elasticity estimates take that into account?

    Daniel, Glad you agree with part of my argument, but I have trouble following this:

    “The trouble here is that the point of taxing the rich is not to reduce their consumption but to increase everyone else’s for the same level of growth. To make this argument work you have to show not merely that you’d be taxing Buffet’s savings rather than his consumption, but that this would reduce others’ consumption or growth relative to some alternative policy – and if the alternative policy is “tax the middle class”, that’s hard to show.”

    If you don’t reduce the consumption of the rich and you do boost the consumption of the 99%, then total consumption rises. But if we assume that taxes on the rich don’t increase RGDP, then that means total investment falls, and growth slows. I think you probably know this, which means I probably misunderstood your point.

    I think you are 1/2 right on the top one percent not being inventors. Yes, they are more likely to be corporate execs. I don’t think we know whether execs are worth it, it’s really hard to tell. For instance, in another post I argued that decisions on allocating capital are far harder than in the 1960s, hence the CEOs job is much more important today. But let’s say I’m completely wrong. That doesn’t make my biotech problem go away. Lets say expected biotech paydays are only a small part of the super rich income, say 1%. But let’s also say a high MTR significantly reduces innovation in biotech. It’s very possible that the welfare cost could still be significant. Just to be clear, I was claiming massive external benefits. I’d find it very plausible if someone told me the external benefits of a cure for cancer, diabetes or heart disease is 100 times larger than the payday to the inventor. Slowing cures for those diseases by even a year or two would have massive welfare costs. I admit this is a bit hypothetical, but I think it’s something that we need to at least consider.

    I should add that I’m not opposed to fairly high MTRs on labor income (i.e. maybe 50% for CEOs) but I do oppose it for capital income. One solution to the problem I raised is to reverse current law–tax hedge fund earnings as labor income (as it should be), and stock options gains to biotech workers as cap gains. The hedge fund exemption is really an outrage.

    Statsguy, That’s wrong, which was the point of my example. The US raises about as much revenue as Germany with only 29% taxes, vs 40% taxes in Germany, because our GDP per capita (PPP) is much higher than in Germany.

    Dtoh, Good point.

    Wonks, Yeah, I probably need to correct that.

  22. Gravatar of ssumner ssumner
    23. November 2011 at 15:20

    Wonks, He’s defending Adam, isn’t he?

  23. Gravatar of FXKLM FXKLM
    23. November 2011 at 15:58

    I don’t see why giving flow-through tax treatment to carried interest is so outrageous.

    Suppose a $1 million fund is formed. The fund makes a non-recourse $200,000 loan to management to purchase an interest in the fund. Then the managers would participate in any gains from the fund the same as the other investors and would be taxed the same way. Economically, that’s really no different from carried interest so why shouldn’t the tax treatment be the same?

  24. Gravatar of Tommy Dorsett Tommy Dorsett
    23. November 2011 at 16:41

    If we are stupid enough as a country to impose S-D tax rates on capital, the affluent will stuff their after tax income into tax free munis and, if that exemption goes, they likely won’t earn a high per tax income in the first place. Oddly, some of E-Ss earlier work on MTRs showed that pre tax income in the US when MTRs were 70-90% may have been lower than otherwise would have been the case. Well, no sh1t. The income tax share of GDP was actually lower when we had 70-90 TMTRs than when TMTRs were 50% or less. As for Krugman, he seems to believe much of the income from the top, especially if earned in the financial industry, is income for activities that do more harm than good. So if those people withdraw their labor and allocate it elsewhere, the net impact may even be beneficial. Bring on those 90% TMTRs!

  25. Gravatar of TheNumeraire TheNumeraire
    23. November 2011 at 16:43

    “Mike, I know people who got stock options at high tech companies. They had to treat it like labor income. Hedge fund managers should be required to do the same.”

    Yes, the option is taxed as labor income but the employee retains the exercised shares and can later realize a capital gain if the market value of the capital stock rises. The employee stock option is also popular because management can deduct the value of the option grants as an expense as the tax fall upon the employee (I should say was popular because FASB has since changed the rules on expense treatment on stock options). The hedge fund manager is a different scenario in that the management fee is taxed as labor income but the profits accruing from the funds profits are taxed as capital gain . If the value of the capital stock within the fund has not appreciated there is no additional profit for the manager — the manager’s extra compensation stems from capital gains taken from the investor’s pool of gains. I don’t see why that is highly controversial. If the law changes to treat the fund profit as taxable labor income why couldn’t the fund managers/partners just issue new equity to compensate itself and dilute the investor stake of the fund’s profit?

    “Obviously I think capital taxation would reduce the capital stock, so I think your point is probably valid.”

    Especially true with the capital gains tax. Increasing the capital gains tax tends to both reduce the market value of the capital stock and also reduce the volume of realized taxable capital gains. In 1942 the CGT was reduced to a maximum 25 percent and the holding period for LT capital gains was reduced from 2yrs to 6mos. From 1969-1978 the CGT was raised twice. It was lowered twice from 1978-1986 and the raised in 1987 until being lowered twice since 1997. The equity market obviously performed better in terms of capital appreciation and higher price multiples (higher ratios of earnings and book value)during the lower tax years relative to the higher tax years. Realized capital gains were also larger and the venture capital/IPO market far more robust.

    “I think you are 1/2 right on the top one percent not being inventors. Yes, they are more likely to be corporate execs. I don’t think we know whether execs are worth it, it’s really hard to tell.”

    From an investor’s standpoint, the supposedly egregious CEO pay packages only arise because much of the compensation is stock-based and an appreciating stock price will expand the value of a stock-based pay package. Does the investor care much if the execs dilute the ownership of the capital stock by a small percent as the total value of the capital stock increases by a much larger percent?

    In truth, there is not such a huge difference in exec pay today vs. 40 years ago. In the 1950′s and 1960′s most forms of direct exec. compensation were limited because additional further increases would encounter the supposedly optimal range of MTR’s envisioned by Diamond-Saez (the historical studies of CEO pay put out by labour-union think-tanks carefully only measure direct compensation). In 1950 Congress introduced the “incentive” or qualified stock options which was subject only to LT capital gains tax subject to a multi-year holding period. It was therefore posibble for a higher-earning exec to increase his compensation without triggering MTR’s of 60-70 percent and beyond, provided the capital stock of the firm apreciated during the holding period after the option was exercised. (For proof of this, there is an article in the TIME magazine online archive from 1960 or 1961 that shows that the best-performing CEO’s of the 1950′s had cumulative incentive options valued between $1-$10 million on top of their annual salaries of $70-150,000. Household income in that era was closer to $5,000.)

  26. Gravatar of TheNumeraire TheNumeraire
    23. November 2011 at 17:00

    In reading the D-S paper, I’m left wondering how one can even offer an optimal MTR without estimating an income threshold at which the optimal rate is implied.

    In the OECD, there is not only a wide variation of MTR’s but also average income threshold at which the highest MTR’s are applied. In Denmark and Sweden, MTR’s are not only high, they apply to labor income at multiples of only 1.0 and 1.7 times the average wage (AW). This tend to compress the income distribution and reduce the number of high earners. In the U.S. the top MTR is lower and is not encountered until almost 9 times the average wage (in the 1960′s prior to the bracket creep resulting from the Great Inflation, the top rate of 70 percent was more than 30 times the AW).

    In my opinion, the income threshold is as important as the rate itself.

    Income taxes in Scandanavia, Western Europe, Australia and Canada raise higher amounts of income not by effectively soaking the rich, but rather by taxing more heavily at middle incomes. In Sweden personal income taxes bring in 20 percent of GDP, even with far fewer high earners. The U.S. system brings in only 8-10 percent and the number is far more volatile (cyclical) because the system relies so heavily on the incomes of high earners and on a cross-national comparison collects little from the steady wage earners.

  27. Gravatar of K K
    23. November 2011 at 20:09

    Scott: “I’d find it very plausible if someone told me the external benefits of a cure for
    cancer, diabetes or heart disease is 100 times larger than the payday to the inventor”

    Why is it that biotech execs are incapable of negotiating more than 1% of their marginal product? They are aligned with VCs for crying out loud! Personally I suspect we are being generous in assuming that the top 1% are earning no more than than their marginal product as predicted by standard economics. Like I said, there are an awful lot of rents being extracted. I don’t think it’s the fry cooks so my money is on the top 1%. Then we need nothing other than convex utility functions to justify taxing high earners at the revenue maximizing rate from the point of view of utility optimization. D-S say that’s around 70%. I have no reason to doubt them. (On the issue of whether utility optimization is a just tax policy that’s a separate matter. Personally, like you, I’d prefer to go after structural inefficiencies (rents) directly rather than just trying to relevel everything through taxation).

    John Thacker: “Or perhaps we should in both cases look at the marginal return.”

    My point was that science can’t be produced via private markets because the vast majority of the benefits of scientific discoveries are externalities that are impossible to internalize. The patent system allows the pharma industry to collect rents of property that is intrinsically public product. Your marginal analysis fails because the free market fails to obtain an efficient equilibrium.

  28. Gravatar of Dtoh Dtoh
    23. November 2011 at 22:37

    Another thing. A lot of income derived from labor is the result of time invested in developing skills and human capital. Doctors, lawyers, ball players, Ibankers, and fund managers immediately come to mind. These are just like investments in new ventures; if you’re not certain of success (I.e. Asymmetric return on the investment in human capital), high tax rates will make it uneconomical to make the huge investment of time needed to position oneself to have a shot at earning a high income in the future.

  29. Gravatar of acarraro acarraro
    23. November 2011 at 23:25

    Top UK tax rate works as follow 14% employer social security, 2% employee social security, 50% income tax. it’s a bit less since the 14% is on top (so employer pay 114 to give me 48). Assuming you save 100% that’s your tax.

    I would also make another point: let’s assume that I have other income: I can use losses from my investments to offset taxes. So actually all the high rate taxes do is unleverage my bet. I will get 30% of profits and losses… There is a drag from the risk free rate obviously… But it might induce me to invest more actually. I can leverage a bit more without really changing my risk profile.

    As far as the amount of investment capital, I would argue that the average tax rates matters more than the total tax rate.

    I would like someone to explain me way limiting the downside has no effect on incentives to invest in human capital. It seems very similar to increasing the upside in expectation…

  30. Gravatar of Adam Adam
    24. November 2011 at 05:30

    It’s an odd point to make that the a higher top MTR would substantially affect the extensive, not intensive margin. It’s probably exactly the reverse of that.

    A highly paid actor might conceivabley choose to take more leisure time and work less because his effective hourly wage is lower.

    On the other hand, if a CEO decides to move to France because his tax rate is too high, the firm will just replace him with another equally paid CEO. No difference at all to GDP. Same with an actor. Same with any other profession.

    Incidently – this fits very badly with your point in a different post that only relative incomes matter (and therefore NGDP that’s important).

  31. Gravatar of Kailer Kailer
    24. November 2011 at 07:23

    “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.”

    Great, I can’t wait until the FDA approves it in 2030. I just can’t wait for all those terrific drugs that were invented in the 90s to hit the market.

  32. Gravatar of Kailer Kailer
    24. November 2011 at 07:25

    “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.”

    Great, I can’t wait until the FDA approves it in 2030. I just love all the great drugs that were invented in the 90s and are just now hitting the market.

  33. Gravatar of Claron Claron
    24. November 2011 at 08:00

    We discussed this in comments before:

    http://www.themoneyillusion.com/?p=9417

    I am pretty sure PPP is useless for this comparison as it double counts direct consumption taxes (I know you consider income tax to be mostly consumption tax but in this case they show up in prices rather then reduced wages so they are counted differently in PPP terms).

    In calculating PPP for EU countries, the price at the point of purchase includes large consumption taxes which reduces PPP adjusted GDP. Using this as the denominator in %GDP of taxes then double counts the consumption tax. If the consumption tax is not double counted then the comparison is more valid. I attempted this in the comments section linked above. To me this makes the comparison somewhat less “compelling”.

    That said, I agree with almost everything you argue here and I think it is only a matter of time before most liberal minded progressives come around to the progressive consumption tax idea as the ideal. (like Matt Yglesias and Robert Frank)

    http://thinkprogress.org/yglesias/2010/08/07/198143/progressive-consumption-taxes/

  34. Gravatar of Floccina Floccina
    24. November 2011 at 20:09

    rs wrote

    This is pretty ridiculous; do you really think Warren Buffet or Bill Gates will stuff cash under their mattress rather than invest it, if their tax burden increased dramatically? They would be idiots to do so, as there must be marginal gain for there to be a marginal tax burden.

    They will have less money to invest.

  35. Gravatar of ssumner ssumner
    25. November 2011 at 09:16

    FXKLM, You know more about this than me, but aren’t the managers being rewarded for their labor in managing the fund? If so, why isn’t that labor income? Other investors don’t provide labor to the fund, so it’s all capital income for them. But perhaps I’m missing something. I’ll keep an open mind.

    Are you saying it’s being treated the same as stock incentives for CEOs?

    Tommy, Good point.

    Numeraire, As I said above, it’s not my area of expertise. But when you said:

    “If the law changes to treat the fund profit as taxable labor income why couldn’t the fund managers/partners just issue new equity to compensate itself and dilute the investor stake of the fund’s profit?

    I wondered whether the new equity given to fund managers would be treated as labor income.

    I agree on capital gains.

    K, You said;

    “D-S say that’s around 70%. I have no reason to doubt them.”

    Fine, but I gave you lots of reasons to doubt them, and you didn’t respond to most of them. So I have no reason to doubt my skepticism of their finding.

    On rents, we agree 100%.

    Dtoh, That’s a good point about human capital. Making education deductible only addresses a small part of this. We do subsidize education, which helps, but as you say the time cost is also large.

    One reason I like the Hong Kong and Singapore systems is that the rates are low (around 15%), so the efficiency costs of a non-optimal tax structure are also low.

    acarraro, So the UK has a payroll tax that’s not capped, as it is in the US? Wow, that’s a high top MTR.

    Adam, I agree that actors earn lots of rents, less sure about CEOs. But also recall that it’s hard to become an actor, and thus the ex ante expected return is low. So it’s possible we’d end up with less outstanding actors, as they would want to take the risk of entering the field, without the hope of big gains.

    I agree that this is inconsistent with my argument that relative income determines happiness. But I would add that I don’t think that can be fixed by redistributing income, because it’s more the ordinal ranking than the cardinal ranking that matters. If everyone makes $49,000, $50,000 or $51,000, there is lots of envy between those three groups.

    And once you bring in “real world” factors, you find they cut both ways. Bill Gates is redistributing tens of billions of dollars of wealth from middle class Americans and Europeans to poor children in Africa. I can live with that. I have a pragmatic view of income redistribution. Provide free education, health care for the poor, and wage subsidies for low wage adult workers. But don’t obsess with making things “equal,” the harm will outweigh the benefits once you get beyond meeting people’s basic needs.

    Kailer, We agree on the FDA.

    Claron, Fair point, I forgot about that. Here’s what I’d say:

    If someone claimed average European tax rates were about 25% higher than in America, and average European per capita income was about 25% lower (PPP) they’d be close enough to at least establish the presumption that Laffer curve effects need to be taken seriously at developed country levels of taxation. Not proof, but the cross-sectional studies are certainly suggestive.

  36. Gravatar of dtoh dtoh
    25. November 2011 at 14:36

    Scott,
    1. To reiterate, because you have asymmetric returns on investment of capital and labor, it makes absolutely no sense to discuss the impact of taxes and tax rates, unless you look at expected after tax returns. This totally changes any analysis.

    2. What is the the difference, between a) someone who quits a million dollar a year job at Goldman to start a fund, and then works for 3 years for minimal wages to find investors and get the fund started, and b) someone who invests 3 million dollars to hire people to get the fund started and find investors. Can’t see why there is any difference in tax treatment between the two.

    An alternative way to look at this is that it’s just like compensation in the form of options given to corporate executives. It is exactly the same thing, the fund manager has a call option on the value of the fund.

    3. On human capital, it’s not just education. It’s the time invested to get to the top of the pyramid. How many executives, do you think would have invested 20 years on the corporate ladder at relatively meager wages, time away from the family, 15 hour days, etc., if there wasn’t a shot for the big bucks made by the CEO and other officers. If the prize gets taxed away, everyone would chose to do something fun (e.g. econ professor) rather than going into the corporate meat grinder.

    4. The kind of income inequality we should be worried about is when it’s created by government intervention (e.g. free implicit government guarantees given to banks, anti-trust exemptions for sports teams, free broadcast spectrum given to TV networks, failure to enforce anti-trust laws against monopolistic software companies, etc.)

  37. Gravatar of The Unbroken Window » Blog Archive » Gee, Who Would Have Predicted That? The Unbroken Window » Blog Archive » Gee, Who Would Have Predicted That?
    28. November 2011 at 07:49

    [...] it is all couched in lovely economic theory. I have a zillion comments on the first paper, but Scott Sumner covers most of them here, I recommend that piece. Here is a highlight of the second: But top income share increases have not [...]

  38. Gravatar of jcb jcb
    30. November 2011 at 09:53

    “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?”

    If your wife will promise to prevent the next future pandemic the least the rest of us can do is cut her capital gains taxes now. Cut mine, and I promise to bring you world peace and prosperity.

    Marginal utility theory is a waste of time. It rests on a flawed understanding of human motivation as finely tuned calculation of the future. Do you really think that a potential brain surgeon decides not to go into brain surgery because the marginal tax rate is too high? And do what for a living? Choose leisure? Become a garbage man? Much of life consists of forced choices: there is an economic penalty for not choosing something.

    There is just as much logic in the alternative theory that people work harder when taxes are higher so that they can purchase what they want but can’t otherwise afford.

  39. Gravatar of Lee A. Arnold Lee A. Arnold
    1. December 2011 at 18:54

    Surely capital income should be taxed much higher than labor income, because it remains employed without continuous labor. The argument that higher capital taxes will reduce savings and investment (I will presume the conversation is to be kept within the bounds of the normal rates that have existed in the U.S.) is not credible on three counts, one that lower taxes obviously tends to cause sloppier and even crooked investments; two that, throughout the experimental literature, higher monetary rewards are only correlated with better performance of physical labor, and higher monetary rewards are NOT correlated with higher achievement in cognitive tasks, unless it is possible the common city rats have more brainpower than the average Wall Street executive; and three, the idea that less savings and investment IN THIS SENSE is harmful and bad, has not been cost-benefitted against the reduction of transaction costs by the gov’t institutions that are paid for by the taxation, i.e. it has not been balanced against the gains in productivity that are enabled by the social spending — of course these gains are not necessarily guaranteed by any particular gov’t institution any more than by a private business firm. “Countries with high taxes tend to see fewer hours worked” but that may not be the whole story.

  40. Gravatar of Scott Sumner Scott Sumner
    2. December 2011 at 18:51

    dtoh, I agree with most of what you say, and that’s why I oppose extremely high MTRs on even consumption. But I think reasonably high consumption taxes would not deter work effort all that much. Suppose corporate execs had to pay 50% tax rates on all consumption over $1,000,000 a year. (Consumption, not income–since most save a lot the tax rate would be a small share of income.) Does that really discourage ambition all that much? They still get to to boost living standards quite sharply if successful.

    I strongly agree with the rent seeking part.

    I don’t know enough about taxation of investment managers to comment intelligently.

    jcb, Comments like yours make me think the opposition lacks good arguments. There actually are jobs between brain surgeon and being a garbage man, like being an accountant or professor.

    Lee, Standard public finance models say that the tax rate on capital should be zero. I don’t see where your comment challenges that view at all.

  41. Gravatar of theCoach theCoach
    10. December 2011 at 12:07

    Would a brain surgeon be considered rich?

    My gues is not even close. Salaries appear to be under 600k a year for the most part.

    Where do S and D say the top rates kick in?

  42. Gravatar of Scott Sumner Scott Sumner
    11. December 2011 at 07:22

    theCoach, Certainly not top bracket, but a pretty high one.

  43. Gravatar of Will McBride Will McBride
    27. April 2012 at 09:27

    Scott, I promise I didn’t read this before I posted a blog responding to this week’s op-ed in the WSJ by D and S, but we agree on a lot, including our examples: http://taxfoundation.org/blog/show/28161.html

    Cheers and keep it up!

  44. Gravatar of TheMoneyIllusion » More nonsense on taxes TheMoneyIllusion » More nonsense on taxes
    1. May 2012 at 06:55

    [...] Saez and Picketty are really starting to annoy me now.   They’ve been going around suggesting that the optimal top rate on federal income taxes is about 70%.  Yet research recently published by Saez and Diamond makes the following points: [...]

  45. Gravatar of Good Assumptions, Bad Assumptions, and Economists « Unlearning Economics Good Assumptions, Bad Assumptions, and Economists « Unlearning Economics
    16. June 2012 at 06:46

    [...] here’s Scott Sumner on the Diamond and Saez ‘Marginal Tax rates’ paper:  And S-D also seem to lean toward [...]

  46. Gravatar of Why the Numbers Don’t Work | Empathy's Sword Why the Numbers Don’t Work | Empathy's Sword
    31. August 2012 at 09:11

    [...] as “not the mainstream view.” The Times goes on to say, “some economists really dislike them. And they are not absolutely airtight. The calculations rely on estimates about how higher tax [...]

  47. Gravatar of F.A.Z.-Community F.A.Z.-Community
    19. November 2012 at 03:35

    [...] Zusammenfassende Kritik von Arpit Gupta (hier und hier); ziemlich rüde Scott Sumner (hier). Gupta erwähnt mindestens einen wichtigen Punkt: Unter den einkommenstärksten [...]

  48. Gravatar of TheMoneyIllusion » Supply-side success in Britain TheMoneyIllusion » Supply-side success in Britain
    2. March 2013 at 11:24

    [...] an earlier post I criticized a paper by Emmanuel Saez and Peter Diamond.  Now Tyler Cowen links to an interview of [...]

  49. Gravatar of Sumner defeats Saez « J.uris D.ebtor Sumner defeats Saez « J.uris D.ebtor
    2. March 2013 at 16:51

    [...] an earlier post I criticized a paper by Emmanuel Saez and Peter Diamond.  Now Tyler Cowen links to an interview of [...]

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