Saez and Piketty 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:
1. It’s very hard to close loopholes, so the optimal tax rate on capital should be calculated by taking those loopholes as a given.
2. If the income tax continues to have its current loopholes, the optimal top federal tax rate is 48%. BTW, under current law the top MTR is not 35%; it is considerably higher. However the tax code is so complex I can’t tell you the exact figure. I recall ObamaCare added another 3.8%, and there are some other quirks in the tax law that make the effective top MTR slightly higher. Certainly a top rate of 48% would be an increase, but less than many assume. (I could live with a 48% top MTR (or even more) if applied to consumption, not income.)
There is overwhelming theoretical and empirical evidence that higher MTRs sharply reduce work effort. Let’s review the evidence:
1. Theory. Because tax revenues are recycled back into the economy through various programs (mostly social spending in Europe) the income-compensated labor elasticity number is appropriate, which is unambiguously positive.
2. Evidence. Europe had tax rates close to US levels back in 1970, and a similar work effort. Then Europe decided to test the Prescott model by sharply raising taxes above US levels. A beautiful natural experiment, because we know that cultural differences would not explain any big differences in work effort. After all, the work effort was similar when the tax rates were similar.
3. More evidence. Then low and behold European work effort (in taxable market jobs) began falling sharply, so that before the current recession it was around 25% below US levels. This is what the Prescott theory would predict.
So you have both theory, cross-sectional, and time series evidence all strongly pointing to big government depressing work effort in Europe. And all competing explanations are rather ad hoc.
And how does Piketty respond to all this evidence:
High taxes have depressed the labor supply in European economies, according to economist Edward C. Prescott, a Nobel laureate, who argues that Americans generally work more hours because U.S. tax rates are lower. The result: U.S. inflation-adjusted GDP per capita in 2010 was about 40 percent higher than the average for the euro area, according to data from the Organization for Economic Cooperation and Development in Paris.
‘This is Nonsense’
“This is nonsense,” said the Picketty, 40, a visiting professor at MIT in 2000-2001. “When people in Europe have five weeks of vacation, this is not in response to high tax rates.”
Oh really? I kept reading to learn why “this is nonsense.” And there was nothing . . . no explanation was offered. In the past I’ve noticed that some people have trouble with this idea because they think of work effort as being in some sense socially determined, not responding to incentives at the individual level. But these social policy decisions are be very much influenced by the average preferences of the public. So yes, a 35 hour work week and 5 weeks vacation may be government-determined, but ask yourself why government responded to pressure for these changes in France, but not in America. Obviously growth in government may not be the only factor, but it’s nonsense to claim that this explanation is “nonsense.”