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?

Christina Romer on fiscal policy

Marcus Nunes sent me a new Christina Romer paper, which claims that fiscal stimulus is effective.  I’ll argue that she has some good evidence, but also that there are weaknesses in her argument.

Her best evidence is a study that she did with David Romer, which examined two types of tax cuts; those done to boost the economy, and those done for other reasons, which can be viewed as “exogenous.”

What David and I did was to bring in information on the motivation for tax changes. For every legislative tax change, up or down, there is a huge narrative record about why it was passed. This narrative record is contained in Congressional reports, presidential speeches, the Economic Report of the President put out by the Council of Economic Advisers each year, and other documents.

We read all of those documents and classified tax changes into those taken in response to other factors affecting output and those taken for more independent reasons. We identified a number of tax cuts taken because the economy was slipping into a recession. We also found a number of tax increases taken because government spending was rising; for example, policymakers raised taxes dramatically during the Korean War. This is important because spending increases will tend to increase output, while tax increases will tend to reduce it. So in cases where the tax increase is caused by the spending increase, there are systematically factors going in opposite directions.

At the same time, we also found a number of tax changes taken not in response to current or forecasted economic conditions, but for more ideological or long-term reasons. For example, Ronald Reagan cut taxes in the early 1980s because he believed lower tax rates were good for long-term growth. Bill Clinton raised taxes in 1993 because he thought dealing with the deficit would be good for the long-term health of the economy.

We argued that to estimate the impact of tax changes, we should look at the behavior of output following these tax changes made for more ideological reasons. In other words, we dealt with some of the omitted variable bias problem by excluding from the empirical analysis the tax changes taken in response to economic conditions.

They found that the endogenous tax changes had a modest (but positive) effect on output, while the exogenous changes had a large impact on output.

I favor a pragmatic approach to research, so I applaud the Romers for using the narrative approach.  However what’s being tested here isn’t really “stimulus,” it’s tax cuts.  The traditional Keynesian model says fiscal stimulus will boost NGDP, and will also boost RGDP if there is slack in the economy.  Otherwise you get higher prices.  So there are actually two interesting questions worth testing; does Keynesian stimulus boost NGDP (i.e. spending) and does the higher spending lead to more real output.

To make things even more complicated, supply-siders have suggested an alternative channel through which tax cuts might boost RGDP; increasing the incentive to work, save and invest.  The basic supply-side model doesn’t predict claim any impact of tax cuts on NGDP, indeed it was sold in the late 1970s as a tool for boosting output without boosting inflation.  Even so, if the central bank is targeting interest rates, then supply-side effects could easily lead to more NGDP as well.

So let’s accept Romer’s argument that tax cuts boost RGDP.  Is it a problem that we don’t know exactly how or why?  It could be, because if it is due to supply-side effects then lump sum tax rebates and government spending increases wouldn’t necessarily work.

Romer discusses one such event that occurred in the spring of 2008, when the Bush administration issued tax rebates to boost consumption.  John Taylor later pointed out that consumption did not seem to respond to these tax rebates, despite the temporary spike in disposable income.  Romer replied:

The trouble with this analysis is, Professor Taylor wasn’t thinking about what else was going on at the time. Democrats and Republicans didn’t come together to pass the tax rebate for no reason. This was the heart of the subprime mortgage crisis. House prices were tumbling. Mortgage lenders like Countrywide Financial were in deep trouble.

Economists were worried that consumption was about to plummet. For most families, their home is their main asset. When house prices fall, people are poorer, and so tend to cut back on their spending.

Against that background, the fact that consumption held steady around the time of the tax rebate may in fact be a sign of just how well it was working. It kept consumption up for a while, despite the strong downdraft of falling house prices.

Romer’s right that without the rebates aggregate spending and output might have been somewhat lower during mid-2008.  But Romer doesn’t consider whether that might have led the Fed to move much more aggressively in September 2008.  As it is the Fed met two days after Lehman failed and did nothing (which effectively tightened policy sharply as the Wicksellian natural rate was plunging rapidly during this period.)

The Fed cited an equal risk of recession and inflation (i.e. economic overheating) when it left interest rates unchanged at 2% in September.  It seems highly unlikely that the Fed would have been so passive if Romer’s counterfactual had come to pass.  If so, then John Taylor might be right, but for the wrong reason.  The real problem is that the Fed sabotaged Bush’s tax rebate.  The real problem is that in new Keynesian models the fiscal multiplier is precisely zero if the central bank targets either inflation or NGDP.

This is the biggest weakness in Romer’s paper.  When discussing Taylor’s critique she rightfully talks about the omitted variable problem.  But then she basically ignores the problem of monetary policy counterfactuals when considering what would have happened without the Obama stimulus.  The basic problem here is that she seems to hold three contradictory views:

1.  She agrees with Bernanke that the Fed is not out of ammunition.

2.  Elsewhere she praises Bernanke for acting aggressively in 2008-09, making the recession less severe.

3.  Her three million “jobs created or saved” estimate for the Obama stimulus implicitly assumes that if Obama’s stimulus had not passed, then the Fed would have responded to the deeper downturn with almost criminal negligence.

Now I’m perfectly willing to concede that it’s unlikely a counterfactual monetary policy would have exactly offset any fiscal stimulus reductions.  But I would also insist that monetary policy counterfactuals must be addressed in any multiplier estimates.  And I see one Keynesian study after another completely ignoring this problem.

She also cites the study by Nakamura and Steinsson that looked at the cross-sectional effects of defense spending in various regions.  But as I’ve pointed out many times, these multiplier estimates are completely consistent with the national multiplier being zero.  In other words, models that assume no aggregate multiplier effect (such as the monetary policy offset model) would nonetheless predict that regional defense expenditures would impact regional GDP.

She also cites a study of how individual reactions to rebate checks depend on the date they were received (Jonathan Parker, et al.)   This approach is somewhat better, but still fails to fully address the monetary offset problem.  Stimulus might boost NGDP in Q2, and the Fed might take it all back in Q3.

On a more positive note let me acknowledge that the Romers’ tax cut study is very important.  It suggests that we do know, at a minimum, that cuts in marginal tax rates boost RGDP.  I’m willing to support that sort of fiscal stimulus.  But at this point I’d have to say that’s all we know.  In a world where central banks are targeting inflation (and by implication AD), then all multiplier estimates for demand-side stimulus will be highly uncertain, little more that estimates of monetary policy incompetence in the specific period being examined.

Tax rates on all T-securities now exceed 100%

For the first time I can recall the tax rate on all T-securities (for someone in a 33% income tax bracket) exceeds 100%.  Even for the 30 year bond.  For 10 year T-bonds the tax rate is now nearly 1000%!  For 5 year T-notes the tax rate is now infinite—because the real yield of 5 year notes is now negative.

For those who don’t know how to compute tax rates, here’s an example:

The 10 year bond yields 2.05%.  Someone in the 33% bracket would pay 0.6765% of that in taxes.  But the real yield on the 10 year TIPS is only .07%.  So the tax is nearly 10 times the real yield.  Hence the tax rate is nearly 1000% (actually 966%.)

Tax rates are also extraordinarily high on corporate and muni bonds.  Even the tax on equities is far higher than the advertised rate.  And these calculations ignore the fact that (under an income tax) savings are double taxed.  The actual tax rates (relative to consumption) are still higher.

Of course you’d never find any of this out reading progressive blogs.  They still prattle on about how Buffett pays lower taxes than his secretary.  About how we can solve our problems by piling ever higher taxes on capitalists.  Liberal discourse on taxes is about as reality-based as conservative discussion of global warming.

We really need to switch to a progressive consumption tax.

Thinking like an economist

A few months back one of my colleagues sent me the following email:

Dear dismal scientists (all you econ prof’s too)

I am happy to report that after going to my tax accountant Wed night, this dismal scientist reduced his tax burden by $12,000 by divorcing the love of my life  (I was expecting as high as 15K)
As a result, we will be sending you postcards from Hawaii, Fl or where ever.  The only downside is that when we get re-married, Leslie wants a destination wedding.  I told her that Lawrence is a destination.  She had no sense of humor.


And here’s Justin Wolfers:

Because Betsey and I earn similar incomes, we would pay a marriage penalty.  The U.S. has a household-based taxation system which subsidizes married families when one person stays home and taxes most people extra if they choose to marry and both work full-time.  The average tax cost of marriage for a dual-income couple is $1,500 annually.  When our accountant ran the numbers for us a few years back we discovered marriage would cost us substantially more.  I love Betsey and all, but is the marriage certificate worth thousands of dollars annually?  I can love her plenty without the certificate.  But this isn’t just about a bean-counter saving his beans.  Truth is, I find it offensive that the tax man treats me differently according to a  very private decision””whether I marry or not.  And so I prefer to remain unmarried, at least in the eyes of the tax man.

I agree with Wolfers, and yet I am married.  Can you guess why?

By the way, both the Dems and GOP support me and my wife having to pay far more in taxes than Wolfers and his partner–even with identical incomes.  It’s not even controversial in Washington.  And yet nearly 100% of Americans are outraged when they find out about the marriage penalty.   Most don’t even know why it exists, why their reps support it.

Just one more reason why academics should pay no attention to “public opinion” polls.  There is no such things as public opinion, there is only election results.  No one knows what Americans would believe about Medicare if that sat down with all the government programs and tax revenues in a spreadsheet front of them, and told they had to equate the NPV of all future taxes with the NPV of all future spending.  We simply don’t know.  And anyone who argues otherwise isn’t thinking deeply enough about the issue.

Whether you want more or less money spent on Medicare, I guarantee that I can frame a poll question that gets the result you want.

Warren Buffett faces a 90% plus tax rate

I actually don’t know the exact tax rate, but from what I can tell it’s probably well in excess of 90%.  Unfortunately, Warren Buffett seems to know little or nothing about tax theory, and hence has been arguing that his tax rate is equal to the amount of tax paid, divided by his income.  As I argued here, income is a nearly meaningless concept in economics.  All tax incidence questions need to be addressed in terms of consumption.  I don’t know how much Buffett consumes each year, but this article suggests the amount is rather low:

Warren Buffett, perennially ranked among the world’s richest men, lives a lifestyle that hasn’t changed much since before he before he made his billions. He is often referred to as the world’s greatest investor, and his long-term track record suggests the title is well deserved. He is also legendarily frugal, residing in the same house in Omaha, Nebraska, that he bought in 1958 for $31,500. He is well known for his simple tastes, including McDonald’s hamburgers and cherry Coke, and his disdain for technology, including computers and luxury cars. Underlying his legend is one simple fact: Buffett is a value investor. It’s the hallmark trait of both his professional and personal success.

Let’s assume his consumption is less than $600,000.  In this op ed he says he paid nearly $7,000,000 in taxes:

Last year my federal tax bill “” the income tax I paid, as well as payroll taxes paid by me and on my behalf “” was $6,938,744. That sounds like a lot of money. But what I paid was only 17.4 percent of my taxable income “” and that’s actually a lower percentage than was paid by any of the other 20 people in our office. Their tax burdens ranged from 33 percent to 41 percent and averaged 36 percent.

There are so many things wrong with that statement that I hardly know where to begin.  The tax rate he cites is probably a rate on investment income.  But the tax rate on investment income should be zero–only consumption should be taxed.  His taxes paid are probably over 90% of taxes plus consumption.  Even worse, taxes on capital income represent double taxation, as the money was first taxed as labor income, and then taxed again as capital income.  He ignores that problem; perhaps he’s not even aware of it.  He also confuses nominal and real tax rates.  In the US the tax on investment income applies to nominal earnings; the tax rate on real earnings is far higher–over 100% for many Treasury securities.  And as Greg Mankiw points out he ignores that fact that much of his earnings were taxed at the corporate level.

Warren Buffett should be paying far less in taxes, perhaps less than me.  The people who should be paying lots more in taxes are the billionaires with their 400 foot yachts, mansions, and fancy parties.  I’m sure if they tried to do that the bill would be filibustered by liberal democratic congressmen from NYC.  Much of Manhattan’s economy is providing luxurious goods and services to the rich.  Don’t believe me?  Then read this link.  Dems say they want “fairness,” but oppose the only way to make the tax system fairer–higher taxes on wealthy lifestyles.

Many people find tax theory counter-intuitive, so think of it this way:

1.  Buffett’s consumption is the resources he takes out of the economy for his own personal enjoyment.

2.  Taxes paid are what he contributes to the common good.

It’s very possible that the wealthy should be paying far more taxes.  But Buffett should be paying far less than he currently pays.