Comment on Murphy and Thaler

Bob Murphy thinks he has an argument that blows away my critique of income:

A few weeks ago I promised to “eviscerate” Scott Sumner’s blog post, in which he claimed that income was a “meaningless, misleading and pernicious” concept. It is now ready for your inspection. Flowers and condolences can be sent to Scott Sumner’s widow, c/o Bentley University.

Not so fast there partner, I’m not dead yet.  Here’s a comment from his essay:

In the comments section of his first post, I asked Sumner if he had a problem with the standard definition of income. I reminded him that it is the amount of consumption that one could afford, without reducing the value of capital. Sumner replied, “I do not object to your definition. … I guess ‘meaningless’ was a bit strong, but what possible use is there for a concept that measures how much consumption one could do [without] impairing one’s wealth?”

This reply actually flummoxed me; it’s akin to asking what possible use there is for the concept of profit. Specifically, a household needs to calculate its income, in order to know if it is “living beyond its means.” We can make the analysis more esoteric if we wish. For example, one of the key issues in Austrian business-cycle theory is that people during the boom period enjoy a false prosperity — a high standard of living — because they are unwittingly consuming their capital. These crucial issues are dependent on the basic definition that Sumner finds useless.

I hate it when people quote my comments; often my brain is fried by the time I answer my 100th comment in a day.  But I’ll stick by this one.  Profit is useful because it tells firms whether to enter or exit an industry.  Positive economic profit suggests you should enter, and negative economic profit is a signal to exit.  But income is a signal for  . . .  what?  Surely not for consumption.  Yes, it tells you how much you can consume without digging into capital, but why would you want to consume that much?  I had negative income in 2008, but I didn’t decide to do negative consumption.  I dug into my capital—which Bob suggests is violating the recommendation of Austrian business cycle theory.  Entschuldigen sie bitte!  (That’s ‘sorry’ in Austrian.)

Bob also finds an inconsistency in my critique of income taxes.

By the same token, I could challenge Sumner’s own argument for a tax on consumption. Imagine two identical people who could each hold a $100,000-per-year job. Person A goes to work, and spends his entire income on goodies each year. Because the government imposes a Scott-Sumner-approved 11 percent tax on consumption, this man pays $10,000 to the government, and actually only consumes $90,000 worth of goodies.

On the other hand, person B decides to be a drifter. He only works occasionally at odd jobs; he spends most of his days hitchhiking, watching the sunset, and working on his great American novel. He doesn’t cheat on his taxes, though: out of the $10,000 in annual income that he earns, he saves none of it, sends $1,000 to the government, and consumes the remaining $9,000 in goodies.

I could very easily condemn this hypothetical consumption tax, and along Sumnerian lines. After all, the two men had equal abilities at the start of their adulthood. Person B could have chosen to work in the office and earn enough money to spend $90,000 each year on consumption. But instead, person B chose a different path. So why in the world should the government tax him far less than it is taxing the “equivalent” person A?

So far, so good. I am showing that the (immoral and inefficient) consumption tax cannot hold up to scrutiny; it isn’t really true that people who “consume” more are necessarily “richer” and therefore able to pay more, as Scott Sumner and other advocates of the consumption tax seem to think.

But what if I went further? Suppose I went on to argue, “Indeed, the very concept of labor income is meaningless, misleading, and pernicious. In our example, person A earned ten times as much ‘labor income’ as person B, but there is no reason to suppose that person A somehow has a better life, since person B could have made the same choices. Indeed, ‘labor income’ is really just forfeited leisure. The drifter could have devoted his hours to office work, but instead he chose to ‘purchase’ $90,000 worth of his time from himself. Therefore, to count ‘labor income’ as a form of freebie flow of wealth is to count the same hours twice.”

Now, regardless of how one feels about the validity of a consumption tax, does anyone want to go so far as to say that a paycheck isn’t really a form of income after all? I submit that Sumner made an analogous mistake in his own analysis. Just because we can imagine scenarios in which an income tax (that includes interest and capital gains) is patently unfair, does not mean that interest income therefore isn’t “really” income. Rather, it simply means that the conventional calls for progressive income taxes are misguided.

OK, whenever I lose an argument on logical grounds, I fall back on pragmatism.  I agree that consumption doesn’t really measure the theoretically relevant concept.  People get utility from goods, services, and leisure.  In practice it’s hard to tax leisure, or even measure leisure, so we tend to estimate living standards based on consumption, and we tend to tax consumption despite the fact that it distorts the labor/leisure choice.  We could avoid the distortion with a head tax, but that is probably too regressive.  On the other hand a land tax just might work. 

Of course Bob will say the tax discussion is off-topic (I always use sleight of hand when losing); he showed that my argument against income could just as easily apply to consumption on purely logical grounds.  And I admit that my critique was more about specific uses of income (taxes, Gini coefficients, etc) than the concept itself.  Consumption is also less than perfect, as a tax base and as a way of judging living standards.  But I still think it’s much better than income.  So income is truly evil, and consumption is just a little bit naughty. 

Oh, and my wife says she’d prefer red roses.

Part 2:  Richard Thaler tries to defend the indefensible

First, it is incorrect to say the estate tax amounts to double taxation. The wealth in many large estates has never been taxed because it is largely in the form of unrealized — therefore untaxed — capital gains. A 2000 study found that for estates worth more than $10 million, unrealized capital gains represented 56 percent of assets. For estates with active farms and businesses, the percentage is much higher. If no estate tax is imposed, capital gains taxes can be avoided indefinitely.

In fact, any tax on capital income is double taxation of labor income.  That’s why a consumption tax is best.  What Thaler should have said is that the estate tax is not necessarily triple taxation.  Triple taxation would occur if you earned some labor income, paid taxes, saved some of the remainder, earned capital gains on the saving, paid capital gains tax, and then was taxed when you died and left the remainder to your niece.  We need to abolish the estate tax and replace it with a progressive consumption tax (i.e. payroll tax.) 

Greg Mankiw replies to Thaler, and has much better arguments.


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37 Responses to “Comment on Murphy and Thaler”

  1. Gravatar of Mark A. Sadowski Mark A. Sadowski
    14. November 2010 at 13:31

    In my opinion the answer to Bob Murphy’s criticism is empiricism. Consumption taxes are positively correlated with growth, and are the only form of taxation to have this distinction. Nothing more needs to be said.

  2. Gravatar of Morgan Warstler Morgan Warstler
    14. November 2010 at 14:34

    We need to abolish the estate tax and replace it with a progressive consumption tax (i.e. payroll tax.)

    For the last time (actually knowing you, not likely), a payroll tax functions differently than a consumption tax:

    1, Payroll tax: paid on labor / wage of employees (regardless of who pays) – a disincentive to hire employees, and good reason to outsource, automate etc. A $10 employees costs you $15.

    2. Consumption tax: consumers look at a $10 item as something that costs $15… so they consumer less.

    #1 leads to first to productivity gains through headcount reductions. #2 encourages more people to be cheapskates and save.

    Why do you insist on confusing these two ideas as the same thing. What do you gain from egg heading this?

  3. Gravatar of Mark A. Sadowski Mark A. Sadowski
    14. November 2010 at 15:07

    Morgan,
    There is saving and consumption, and there is labor income and capital income. Elementary mathematics shows that a consumption tax is identical to a labor tax. Both exclude capital income. Even my cat understands this principle.

  4. Gravatar of Doc Merlin Doc Merlin
    14. November 2010 at 17:03

    @Mark
    ‘Elementary mathematics shows that a consumption tax is identical to a labor tax.’
    You are wrong.
    In terms of DWL its the same, but in terms of involuntary unemployment, it isn’t the same. because the Demand for labor has a much higher elasticity than supply of labor (which is extremely inelastic). Seriously, draw the supply and demand curves yourself and then look at them yourself.

    The DWL is the same in both cases, but Morgan’s suggestion moves reduces the consumer surplus less and the producer surplus more. Because the consumers of labor (businesses) have much, much higher elasticity than the suppliers we end up with less change in the equilibrium quantity of labor with a tax on wages (or consumption) than a tax on labor paid by the labor consumer. Give me a few minutes and I’ll draw up the curves for you.

  5. Gravatar of Mark A. Sadowski Mark A. Sadowski
    14. November 2010 at 17:13

    Doc Merlin,
    I’ll save you the time. If the demand for labor is perfectly elastic then the result is that a tax on labor is paid for entirely by labor. The result is entirely realistic.

  6. Gravatar of Doc Merlin Doc Merlin
    14. November 2010 at 17:18

    I should note, this only applies to involuntary unemployment, voluntary unemployment would be the same under both systems. Although Morgan’s system may be better lowering cyclical unemployment if wages are stickier than prices on goods.

  7. Gravatar of steve steve
    14. November 2010 at 17:21

    How about we only tax an estate when it becomes income for the person receiving that estate. In that case, why worry about prior taxation? Why should that income be treated differently than other income?

    Steve

  8. Gravatar of Mark A. Sadowski Mark A. Sadowski
    14. November 2010 at 17:22

    Doc Merlin,
    You’re kidding yourself if you think Morgan actually has a system.

  9. Gravatar of Rahul Deodhar Rahul Deodhar
    14. November 2010 at 17:37

    Fascinating post, I had missed the September one. Thanks for the response.

    I wish to draw your attention to a more fundamental issues.

    1) We set the tax rates and plan expenditures accordingly. Why can’t we do the reverse? I know the wording may not be clear so let me explain to the best of my abilities. Government sets tax rates, looks at collections, plans expenditure that (hopefully) results in more income and hence more taxes. This is a loop of sorts. However, I think we should go the reverse way, every year we should look at important, unavoidable, expenses and then deduce the tax rates from those.

    2) Taxes are less about being complicated right and more about being fair and easy. We have yet to discover a best first principles solution to tax calculation. Any mechanism we use ends up with unfair outcomes for certain portion of population. But if we stick to being fair, people should not have reason to complain. So I agree with you when you say that consumption is a better alternative.

    3) Taxes should not create distortions. Taxes are not means to guide the population and this, as such, should be considered as encroachment on civil liberties. Government has not business nudging people to have more babies, get more insurance, consume more, or invest in tax-havens etc. Alas, I am in a minority on this issue.

  10. Gravatar of Mark A. Sadowski Mark A. Sadowski
    14. November 2010 at 17:45

    Rahul Deodhar,
    You wrote:
    “3) Taxes should not create distortions. Taxes are not means to guide the population and this, as such, should be considered as encroachment on civil liberties. Government has not business nudging people to have more babies, get more insurance, consume more, or invest in tax-havens etc. Alas, I am in a minority on this issue.”

    Hardly. This is a raging issue on my part. We need to elliminate taxes as a distortionary issue. But look for much more from me on this in the future.

  11. Gravatar of scott sumner scott sumner
    14. November 2010 at 17:46

    Mark, I didn’t really see him as arguing consumption taxes were necessarily bad, rather he seemed to be showing that the logic I used against income could also be used against consumption. To me, it is a question of lesser of evils.

    Morgan, Eggheading has its advantages. I know the payroll and consumption tax seem different, but they are the same. In both cases they drive a tax wedge into the labor market. If either tax is 10%, a worker can consume 10% less than they produce at the margin.

    Mark and Doc, Mark is correct–he’s studied public finance, even I’d defer to his expertise.

    We are talking long run effects here. If nominal wages are sticky then the short run effect of a payroll tax also depends on it’s legal incidence.

    Steve, My whole point is that there should not be an income tax at all, only consumption should be taxed. That’s discussed in my post that Bob Murphy links to.

    Rahul, I agree with you that taxes generally should be very simple, and shouldn’t be used to tell people how to live. The only exception is that I support taxes on pollution.

  12. Gravatar of Doc Merlin Doc Merlin
    14. November 2010 at 17:56

    @Mark and Scott
    “Mark and Doc, Mark is correct–he’s studied public finance, even I’d defer to his expertise.

    “We are talking long run effects here. If nominal wages are sticky then the short run effect of a payroll tax also depends on it’s legal incidence.”

    I withdraw then. I thought we were talking about short run.
    In the long run, absolutely Mark is right. I thought we were talking about short run effects of payroll taxes. Also in the short run, the asymmetry of search costs (its harder to find a worker you would be willing to employ than a job you would be willing to do) have a similar effect on unemployment as sticky wages would.

  13. Gravatar of Doc Merlin Doc Merlin
    14. November 2010 at 17:59

    ” I had negative income in 2008, but I didn’t decide to do negative consumption. ”

    I forgot to ask. What do you mean you had negative income? Are you counting unrealized losses as income?

  14. Gravatar of Mark A. Sadowski Mark A. Sadowski
    14. November 2010 at 18:06

    “Mark is correct–he’s studied public finance, even I’d defer to his expertise.”

    I don’t want people to defer to my expertise. I want people to defer to my arguments.

    I generally think in the long run and if others find that confusing excuse me.

  15. Gravatar of Edwin A Edwin A
    14. November 2010 at 18:06

    Is it possible to have the same amount of tax revenue as we do today with a progressive consumption tax without hurting the lower-middle income brackets too much?

  16. Gravatar of Doc Merlin Doc Merlin
    14. November 2010 at 18:15

    @Edwin A.
    Possible… sure. The question is if its feasible without getting too much cheating. Brookings Institute says no, but they set rates high enough to balance the budget and then claim the consumption tax would need to be about 40%, then say that this is so high that tax cheating would be commonplace.

    The more right winged economics think tanks have different assumptions and thus reach different conclusions.

  17. Gravatar of Mark A. Sadowski Mark A. Sadowski
    14. November 2010 at 18:51

    Scott wrote:
    “Mark is correct–he’s studied public finance, even I’d defer to his expertise.”

    I started to think about this and it occured to me, how do you know this? Maybe my dissertation committee has talked me up? Maybe you hear about me from some other sources. Yes, I need a job right now but honestly how could you know about my expertise?

  18. Gravatar of scott sumner scott sumner
    14. November 2010 at 19:07

    Doc Merlin, Yes I am, because that’s the definition Bob Murphy told me is correct (and he’s right.)

    Edwin, Yes, because economics is not a zero sum game. An efficient tax system could in principle make everyone better off. In practice some would be worse off, but each quintile might be better off. It’s extremely hard to know who pays taxes anyway. Are corporate taxes paid by workers, consumers, or owners?

    Mark, You mentioned it once in a comment. And I remembered.

  19. Gravatar of Shane Shane
    14. November 2010 at 19:27

    Let me defend income taxes and the estate tax. Leisure is a non-renewable resource–they are making more of it all the time when they make new people, but it is always a diminishing quantity relative to each individual. Arguably work is an inefficient use of one’s precious time in the aggregate (most people don’t, I think, love their jobs), so one could argue that if one makes the foolish choice to work rather than say, sit around and read TheMoneyIllusion.com, you are making an economically unsound decision, especially in the U.S., where you will certainly not starve to death, even if you are without work (http://en.wikipedia.org/wiki/Dumpster_diving), and where you can read the TheMoneyIllusion.com at the public library for free. The only reason to work, then, is to increase the value of your leisure time. So we should tax income rather than consumption, because income without consumption is a way of wasting the most precious resource we have–our lives–and thus we should make sure that people think really hard before going out and getting a job.

    The same thing holds for the estate tax. Accumulation of resources represents a way of squandering your precious time by wasting all that work on your worthless heirs, when you should be enjoying that money. You can enjoy money in lots of ways, too, such as by giving it to charity or by spending it on trips to Monaco. But in any case, by not taxing estates, we subsidize an “unproductive” use of leisure time–those who work do not adequately enjoy the fruit of their labor, while those who inherit money are actually being robbed of the fruit of that labor as well, because in effect not working becomes their “job.” So they never know true leisure. If anything, eliminating income and estate tax would doubly tax potential heirs–first, by encouraging their parents to spend less on them, and, secondly, by giving them a bigger inheritance, which would devalue their leisure time in proportion, because they would spend more of their free time dealing with their inheritance.

    So a certain level of economic irrationality when considered from a very narrow point of view is actually highly efficient when considered from a somewhat broader economic point of view. Is it any wonder, then, that countries with very high income taxes and estate taxes tend to report some of the highest levels of happiness? Notice that all the Scandinavian countries are in the top 20 (http://en.wikipedia.org/wiki/Satisfaction_with_Life_Index). Sure Sweden abolished the estate tax, but with overall taxes already at around 51% of GDP, so what? The U.S. is also quite high, actually, probably in part because of its “inefficient” tendency to tax income and estates. I wonder if happiness will drop sharply in 2010, with so many rich people encouraging their relatives to die in order to save a few bucks.

  20. Gravatar of scott sumner scott sumner
    14. November 2010 at 19:39

    Shane, That’s the Robert Frank argument. I’m not convinced for all sorts of reasons.

    Here’s Will Wilkinson:

    http://www.willwilkinson.net/flybottle/2008/03/11/robert-frank-on-happiness-and-gdp/

    The happiness chart is comparing apples and orange. The Nordic countries are quite small–there are small areas in the US that are also very happy. Here’s what you should do. Make a list of all the dozens of countries around the world with more than 40 million people. There are probably at least 30 or 40 such countries, maybe more. At least 6 are European countries. Than rank them by happiness. See which country is number one. Then come back here and tell me that Americans work too much.

  21. Gravatar of Mark A. Sadowski Mark A. Sadowski
    14. November 2010 at 19:42

    Scott,
    Then you’re taking me at my word (and you’d be right).

    I’m on the job market this winter and you’ll be hearing from me bext year.

  22. Gravatar of Greg Ransom Greg Ransom
    14. November 2010 at 19:48

    “unrealized capital gains”

    How much is that simply a change in price due to inflation …

    Most of it?

  23. Gravatar of Greg Ransom Greg Ransom
    14. November 2010 at 19:55

    The aim of a government is to penalize people who are constantly improving their capital?

    And why not reward people for consuming their capital?

    (If you look closely at government housing and energy policy, you’ll discover that the government often does.)

    “wealth in many large estates has never been taxed because it is largely in the form of unrealized — therefore untaxed — capital gains.”

  24. Gravatar of Shane Shane
    14. November 2010 at 19:58

    I think Americans are quite happy, and the index agrees. My argument is that this in part is because of some of the “inefficient” policies of our government. It’s not a question of how much you work, but of how much you get out of it.

    Also, I’m totally being contrarian. I actually like the idea of a progressive income tax. And also, I’m totally out of my league here, as someone also on the job market in only a marginally related field to economics (18th c. studies). I think I was inspired/depressed by this article in The Chronicle to see how much I could fake it (http://chronicle.com/article/The-Shadow-Scholar/125329/).

    As Mark was noting, in the long run taxing payrolls=taxing labor. So taxing consumption means that, in the long run, you still have to think actively about how you live your life, balance work and play, etc. And that could happen with either an income tax or a consumption tax, with consumption taxes eliminating some of the harmful short-run effects of income taxes.

  25. Gravatar of Shane Shane
    14. November 2010 at 20:09

    By progressive income tax, I meant progressive consumption tax.

  26. Gravatar of Mark A. Sadowski Mark A. Sadowski
    14. November 2010 at 20:53

    Scott,
    I think you should revisit your mathematical argument in favor of the equivalence of a payroll tax versus a consumption tax. It would be well received at this moment.

  27. Gravatar of Shane Shane
    14. November 2010 at 21:04

    @Mark:

    In the long run, we’re all dead.

    In the short run, we’re all unemployed.

  28. Gravatar of Mark A. Sadowski Mark A. Sadowski
    14. November 2010 at 21:23

    Shane,
    So true.

  29. Gravatar of scott sumner scott sumner
    15. November 2010 at 06:03

    Mark, I look forward to it.

    Greg, The quotation Doc referred to had nothing to do with inflation. I lost larges amounts of capital in 2008 in both nominal and real terms.

    I agree with your criticism of Thaler.

    Shane, You said;

    I actually like the idea of a progressive income tax.”

    The problem isn’t the idea of a progressive income tax. That idea could be done in a few minutes. The problem is the reality of our progressive income tax, which takes endless hours to figure out. I spend no time at all on doing my payroll (FICA) tax each year–that’s why I prefer a progressive payroll tax.

    Oops, I should have read ahead before criticizing you.

    Mark and others, Bob Murphy links to my post in the quotation at the top of this blog post. So people can check out the argument.

  30. Gravatar of Shane Shane
    15. November 2010 at 07:36

    If avoiding wasted effort is the goal, why not just eliminate all but the simplest taxes, and ones that have beneficial effects like pollution taxes, and use money financing for the remaining government spending. The Fed could target inflation still, no? I’m sure someone out there has proposed such a thing. I’ve always wondered why we don’t hear more about it.

  31. Gravatar of Doc Merlin Doc Merlin
    15. November 2010 at 09:15

    @Shane:
    Because the point of government is to enable collection of economic rents to the politically connected. A simple tax system makes regulatory arbitrage in taxes much harder.

    Another way to see it is that good law is a public good and that bad law is a private good, so government itself is a sort of tragedy of the commons.

  32. Gravatar of Bababooey Bababooey
    15. November 2010 at 09:52

    There is saving and consumption, and there is labor income and capital income.

    When Mark Zuckerberg sells Facebook stock, does he realize labor income or capital income?

  33. Gravatar of Chris Chris
    15. November 2010 at 09:52

    I don’t get the Thaler criticism that a large portion of estates are unrealized capital gains. In order for the asset to be spent or consumed, the capital gain has to be realized which will result in the paying of the capital gains tax. How is taxing unrealized capital gains not double-taxation?

    Also Thaler says that if there is no estate tax, then the capital gains tax can be avoided indefinitely. That is true as long as the asset isn’t sold. But, if assets are never sold by their holders, what is the point of holding the assets in the first place? Are the stock certificates just nice to look at? If the assets are held to generate an income stream off of them, won’t the income be taxed even without an estate tax?

  34. Gravatar of Doc Merlin Doc Merlin
    15. November 2010 at 10:51

    @Chris:
    I agree!

  35. Gravatar of Chris Chris
    15. November 2010 at 11:11

    By Thaler’s reasoning, I can avoid the income tax indefinitely by not working!

  36. Gravatar of scott sumner scott sumner
    16. November 2010 at 05:58

    Shane, I agree.

    Bababooey, I’m not sure, but a few comments:

    1. I know that when employees earn stock options, the exercise of those options produces gains that are taxed as if they are wage income. This is appropriate.

    2. In principle, he should be taxed for any assets he built up as a result of his efforts in creating Facebook. But I don’t know the actual rules.

    Chris, I agree he is wrong. He is probably thinking of the fact that the tax basis of assets is stepped up to current market value when they are passe don to heirs.

  37. Gravatar of Scott Sumner’s Funeral: A Shovel-Ready Project Scott Sumner’s Funeral: A Shovel-Ready Project
    25. November 2010 at 20:46

    [...] me, I was just speaking in hyperbole because income taxes drive me bonkers.” But no, Scott doubled down. First he quoted me, when I wrote: In the comments section of his first post, I asked Sumner if he [...]

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