More Empirical Research on Tax Policies tanks Right Wing Memes

I’m now trying to dig up my fall copy of the Journal of Economic Perspectives.  This link will take you to a pdf file of a new research article published there called ‘The Case for a Progressive Tax: From Basic Research to Policy Recommendations’. The authors are MIT professor Peter Diamond–who should be on the FED Board of Governors now– and Emmanuel Saez. Emmanuel Saez is a UC Berkley economics professor and director of the Center for Equitable Growth. Diamond won the Nobel Prize in 2010.   Paul Krugman has some early analysis up on his blog today having found the paper via Mark Thoma’s website.  This one ought to send the Republican party into propaganda overdrive.  I’m still reading it but I thought I’d share some of it with you.

The interesting thing is this comes as I was reading this study from Wider Opportunities for Women that shows that just under half the population–approximately 45% of US citizens–are living hand to mouth.

As 25 million Americans and their families continue to struggle to find jobs or full-time work and many newly created jobs are in low-wage industries, a new report on family economic security shows that 45 percent of Americans are unable to cover their basic expenses. Based on a comprehensive analysis of economic and demographic data by Wider Opportunities for Women (WOW), the new report finds many families are living without economic security even when household breadwinners are working. The findings suggest that federal budget cuts to programs like job training, career and technical education, unemployment insurance, and child care programs could compound the crisis facing American families.

I also was reading the newly revised GDP growth numbers which have lowered to 2% which is definitely not enough to send unemployment figures in the right direction.   Some of the inventory numbers look bad too.  We could potentially get more mass layoffs from companies since we still appear to have way more capacity than customers in the country.

Anyway, back to the academic study that shows that the top bracket on top income earners should “optimally” be set at about 70%.  So, much for the “taxing the job creators” is horrible meme once again.    This study is the latest in a long line of them that shows that highly progressive tax systems are beneficial.  Rich people even do better under them.  The 70 percent solution is considered the optimal rate given the goal of these types of models which is basically as follows.  (Hang on, this is from the paper and it’s in economist speak, so bear with me.  If you’re not used to thinking in terms of calculus based maximization models given specific definitions of things so you can do the math, it can read like stereo instructions.) This is the basic explanation in the introduction of the goal of this line of research.

Models in optimal tax theory typically posit that the tax system should maximize a  social welfare function subject to a government budget constraint, taking into account that individuals respond to taxes and transfers. Social welfare is larger when resources are more equally distributed, but redistributive taxes and transfers can negatively affect incentives to work, save, and earn income in the first place. This creates the classical trade-off between equity and efficiency which is at the core of the optimal income tax problem. In general, optimal tax analyses maximize social welfare as a function of individual utilities—the sum of utilities in the utilitarian case. The marginal weight for a given person in the social welfare function measures the value of an additional dollar of consumption expressed in terms of public funds. Such welfare weights depend on the level of redistribution and are decreasing with income whenever society values more equality of income. Therefore, optimal income tax theory is first a normative theory that shows how a social welfare objective combines with constraints arising from limits on resources and behavioral responses to taxation in order to derive specific tax policy recommendations. In addition, optimal income tax theory can be used to evaluate current policies and suggest avenues for reform. Understanding what would be good policy, if implemented, is a key step in making policy recommendations.

What this basically is looking for is a level of tax that will not cause disincentives to work, factor in the federal budget requirements, and consider what the society needs to achieve its overall goals of having good infrastructure, providing jobs, educating people. etc.  It also mentions that you have to consider this analysis subjectively because it is based on achieving society’s group vales and goals as expressed through the political process. In our case, our values and goals are express through democracy.   This is important because their study shows that you can actually tax rich people a lot without creating disincentives for them.  That’s exactly the opposite of what Republicans usually bleat and it really kicks that dead horse of a Laffer curve one more time.

Here’s Krugman’s thoughts on what will probably come out of the right wing meme manufacturers.

In the first part of the paper, D&S analyze the optimal tax rate on top earners. And they argue that this should be the rate that maximizes the revenue collected from these top earners — full stop. Why? Because if you’re trying to maximize any sort of aggregate welfare measure, it’s clear that a marginal dollar of income makes very little difference to the welfare of the wealthy, as compared with the difference it makes to the welfare of the poor and middle class. So to a first approximation policy should soak the rich for the maximum amount — not out of envy or a desire to punish, but simply to raise as much money as possible for other purposes.

Now, this doesn’t imply a 100% tax rate, because there are going to be behavioral responses – high earners will generate at least somewhat less taxable income in the face of a high tax rate, either by actually working less or by pushing their earnings underground. Using parameters based on the literature, D&S suggest that the optimal tax rate on the highest earners is in the vicinity of 70%.

OK, I hear loud screams from the right side of the room. Parsing those screams, I hear the following arguments:

1. Theft! Tyranny! OK, I hear you. This can’t be argued on rational grounds; I think there are a lot more important moral issues in the world than defending the right of the rich to keep their money, but whatever.

2. They’ll go Galt! This amounts to saying that D&S’s estimate of the “behavioral elasticity” is too low. Maybe, but they’re pretty careful about that, and your gut isn’t better than their econometrics.

3. You’ll kill job creation! This is where it gets interesting.

Right now the official rhetoric of the right, and a fair number of people who consider themselves centrist, is that high-income individuals are “job creators” who must be cherished for the good they do.

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.

Of course, he doesn’t actually lose all of that $60,000, since he ends up paying less in taxes. So there is a loss of revenue from that withdrawal of effort. But that’s precisely what the Diamond-Saez calculation takes into account, and the reason the optimal top tax rate isn’t 100%.

This sort’ve follows what Warren Buffet is saying when he says sure, raise my taxes.  When you’re talking incomes as high as his, the benefit of having a little bit more just isn’t that great compared to the benefit of having a lit bit more when you are you or me.   Our little bit more goes to basic bills for at least 45% of us. They really don’t miss anything they don’t already have.  This probably could apply to corporate taxation too.  At some level of project income, effective taxes paid is usually not the major expense of any project, so when you do the present/future value analysis, taxes really don’t cut into the future cash flows.  There are many more expenses that are much more significant.   In the case of the uppermost income earners, they don’t really feel it until around 70 percent.  Remember, this is US data and not from places like Sweden or Norway where people are demonstrably happier about pitching in to build a better country and society and don’t have an entire political party plus a portion of the opposition party working to bring the rest of the country and the economy to its knees.

There’s also a good argument presented against zero taxation of capital gains which is another right wing sacred cow.  There’s an entire section on if it makes sense to tax income from labor differently than income from capital.  In a review of literature, the authors show how favoring capital over labor tends to shift money from labor to capital.   This is because the tax system does not distinguish between capital gains from entrepreneurial activities like actually setting up a business, producing something, and hiring yourself and others and speculating in dicey derivatives.   Hopefully, you can skim over the literature review, the rationale behind the model, and the discussion of results and find some of the interesting things.   The analysis uses pareto coefficients and elasticities which are have intuitive explanations but are normally not the things people remember from their microeconomics classes.  In this case, the elasticity is how sensitive various income earners are to changes in tax rates.  The Pareto coefficients are a measure that show optimal marginal tax rates that maximize revenue collection and individual and social “welfare”.   Welfare economics studies how a society is efficient and welfare maximizing in that it produces the maximum amount of  stuff and the resulting benefit from using the stuff to the society.  It should do so at the lowest costs also which implies that all resources in the society are used the best way possible.

I’m continually amazed by the number of studies that have been done that basically contradict the political narrative of many politicians and true believers in a system they don’t frankly understand.  I’m also amazed at the number of people that really don’t know what constitutes a functional and efficient market.  They also don’t understand what capitalism is any more than they understand what socialism is.  On the way back from Denver, some extremely wealthy real estate investor who had just gotten back from a customized jaunt to Bhutan was telling me that he loved capitalism because it was all about being allowed to take on risk.  He really was describing entrepreneurship which can flourish under a lot of different economic systems including mercantilism which is the economic system on which this country was founded.  I actually think sometimes that Republicans really don’t want capitalism, they want a return to mercantilism with its limitations on wages, focus on exploiting resources, hoarding of gold and silver, use of colonies, and jingoistic approach to foreign countries.   Risk taking isn’t inherent to the definition of capitalism.  But then, maybe all this confusion is  because of this:  “Fox News viewers less informed about current events than those who don’t watch news at all, study finds”.   The propaganda machinery in this country is highly efficient.

Anyway, I hope this study finds its way to some states–at the very least–and does some good.  It’s not really a good idea to base your economic policy on wishful thinking and fairy tales.