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?

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.

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.

You can’t redistribute income . . .

. . . but you can and should redistribute consumption.  Here’s Matt Yglesias discussing a recent post by John Quiggen:

John Quiggin makes the case that redistribution of income away from the top 1 percent is essentially the only thing that matters in American politics. After all, as Willie Sutton said, “that’s where the money is.”

I’m all for that, but I really do think it’s an unduly limited view of political life.

Income really is the Achilles heel of the progressive movement.  The income statistics simply don’t mean what progressives think they mean–something like “resources available for redistribution.”  If you want something closer to resources available, you’d use consumption, or wage income.  If you combine wage and capital income in the same aggregate, you are counting the same resources twice.  This is deeply counter-intuitive, yet all public finance economists understand this.  The policymakers in Nordic countries understand this.  But progressives don’t seem to understand this.  Even Paul Krugman, who must know better, keeps citing income distribution data, which is about as informative as examining the entrails of a chicken.

A rich guy with lots of income has three choices, consumption, savings/investment, and charity.  Let’s dispose of charity quickly.  Yes, we could redistribute the money Gates in spending on malaria in Africa, and give it to other Americans.  Would that be a gain?  I think everyone would say no.  On the other hand if a rich guy gives a lot of money to Princeton, to have his name on a building, perhaps that’s really a form of consumption.  I’m fine with treating it that way, if the tax authorities decide that’s the way to go.

But the real money here is obviously in the consumption/investment categories.  You can redistribute consumption from the top 1% and give it to average Americans working in a car factory, or a Walmart.  But it’s an illusion to think you can redistribute investment from the top 1%, so that average Americans can have a higher living standard.  Where do people think the car factory comes from?  Or the Walmart building?  BTW, this has nothing to do with trickle-down economics, a theory I reject.  This is simple accounting.  Money put into investment projects isn’t available to boost living standards for the lower classes, unless you don’t do those investment projects.

So what’s available to be redistributed?  Basically consumption (including a modest amount of vanity charity.)  And that’s it.  Now come back to me with the consumption distribution data, and let’s see what that looks like.  I predict that consumption inequality is far lower than income inequality.  And that consumption inequality is rising at a far slower rate than income inequality.  I’m not saying there’s no problem, but it’s way smaller than the progressives imagine, as the data they use is pure nonsense.  Consumption inequality is economic inequality.  Income inequality is . . . well it’s meaningless gobbletygoop.

This Will Wilkinson posts cites study after study supporting my consumption inequality claim.

I’m not trying to make an Ayn Randian argument here.  I favor 4 types of income redistribution, on utilitarian grounds:

1.  Education vouchers

2.  Catastrophic health insurance

3.  Government subsidy of HSAs for low income workers.

4.  Wage subsidies for low income workers, combined with abolition of minimum wages and occupational licensing.  Thus a single mom with two kids making $8 hour, might get a government subsidy of another $8 hour.  And someone making $16/hour might get a $4 hour subsidy.  But they have to be employed.  Have government jobs paying 1 cent per hour as a residual, for those claiming they can’t find a job.  Give them a $12/hour subsidy.

They would also get the other three subsidies discussed above.  As one’s income rose, one would get less and less of a HSA subsidy, but I’d probably make the education voucher and catastrophic insurance universal.  Importantly, I’d try to spend less on education than we do now.

You do all this redistribution with two consumption taxes; a VAT and a progressive payroll tax.  Plus perhaps some other taxes on efficiency grounds (carbon, land, etc.)  No personal or corporate income taxes, no forms to fill out.  K.I.S.S.

BTW, other than my quibble over “income,” I basically agree with the thrust of Yglesias’s post.

PS.  Oh, and get rid of the debt ceiling, for God’s sake.

Karl Smith, Matt Yglesias, and Greg Mankiw

Greg Mankiw linked to a post showing data for income inequality and tax progressivity.  Matt Yglesias argued that Mankiw is unreliable because the data he used is incomplete (income taxes only.  But actually it’s not just income taxes.)  Then Karl Smith presented the exact same data in the form of a graph rather than a table, and Yglesias praised Smith’s graph, while continuing to argue that Mankiw engaged in “malfeasance.”  I’m confused.  Here’s how Matt Yglesias interpreted the Smith chart:

 The rich pay a huge share of the total taxes in the United States because they have a huge share of the money.

But that’s not really what Karl Smith’s graph shows.  It’s not saying that if you make twice as much money you pay twice the taxes.  It shows something far more interesting, something that I was unaware of.  The graph shows that countries with more income inequality tend to adopt tax regimes with more progressivity.  I knew that was true between the US and Europe, but didn’t know it was also true within Europe.  That’s completely consistent with Mankiw’s (implied) claim that the US tax system is the most progressive.

PS.  The reason it shows progressivity related to inequality is that the line on Smith’s graph has a relatively flat slope.

Update:  On second thought  I may have erred in saying it was simply a function of the relatively flat slope; the intercept also matters.  Math isn’t my forte.

HT:  Commenter “example”