Tuesday, October 12, 2010

Time Horizons: Marginal Taxes Edition

FLG's time horizons theory arises again. This time in a Greg Mankiw Op-Ed:
Now let’s put taxes into the calculus. First, assuming that the Bush tax cuts expire, I would pay 39.6 percent in federal income taxes on that extra income. Beyond that, the phaseout of deductions adds 1.2 percentage points to my effective marginal tax rate. I also pay Medicare tax, which the recent health care bill is raising to 3.8 percent, starting in 2013. And in Massachusetts, I pay 5.3 percent in state income taxes, part of which I get back as a federal deduction. Putting all those taxes together, that $1,000 of pretax income becomes only $523 of saving.

And that saving no longer earns 8 percent. First, the corporation in which I have invested pays a 35 percent corporate tax on its earnings. So I get only 5.2 percent in dividends and capital gains. Then, on that income, I pay taxes at the federal and state level. As a result, I earn about 4 percent after taxes, and the $523 in saving grows to $1,700 after 30 years.

Then, when my children inherit the money, the estate tax will kick in. The marginal estate tax rate is scheduled to go as high as 55 percent next year, but Congress may reduce it a bit. Most likely, when that $1,700 enters my estate, my kids will get, at most, $1,000 of it.

Put simply, Mankiw is analyzing the long-term marginal tax rate.

Kevin Drum objects:
But aside from the fact that Mankiw plays fast and loose with the actual tax laws, this is only true if (a) you're motivated solely by how much money you leave your children, and (b) you care about income 30 years in the future as much as you do about income right now. This doesn't describe any actual human beings, and I don't think it describes Mankiw. (I doubt very much that he doubled his production of outside writing after the Bush tax cuts went into effect.) If he'd laid out the incentives honestly — a small tax increase might reduce his incentive to write misleading op-eds by a small amount — that would have been OK. But that's not what he did.

Drum is, in effect, saying people are short-term thinkers. That their discount rate of future earnings is high.

Brad DeLong argues along different lines, and even tries to hijack the mantle of long-term thinking by invoking Burke. The issue is DeLong is using Burke to say that the economics aren't all that matter. That there are larger, moral questions at stake beyond mere money and commerce. Okay. But shifting ground from the economic question is to partially concede it, which FLG thinks any economist has to. Higher marginal taxes do discourage work. The question is not whether there are disincentives, but how much at different rates. But DeLong should really stay away from political theory. It ain't his wheelhouse and he invokes Burke to combat the charge of short-termism in ways that are strained. Burke wrote "But the age of chivalry is gone; that of sophisters, economists, and calculators has succeeded, and the glory of Europe is extinguished forever." That's an attack on the entire discipline of economics, and perhaps social science in general, which leads FLG to believe that when DeLong cites Burke, ultimately, he's conceding the professional economist ground and is reverting to non-economist mode. And there his expertise is null and void and is merely a citizen's opinion, which as they say are like assholes.

Tyler Cowen sums the choices up nicely:
I also view Greg's column as a chance to learn. What comes to mind are two possible defenses of our tax system-to-be:

1. In reality, eveyrone has a short time horizon, driven by short-term ego rewards and thus such high long-term tax rates can work.

2. The tax system will be an efficient means of price discrimination. The people with truly long time horizons can work around some of the high rates, especially for estates. The people with short time horizons will pay up and those are the same people whose labor won't be much deterred. (There is an interesting discordance in that Greg claims to belong to one camp but some of his critics wish to put him in the other.)

Again, it comes down to FLG's Time Horizons theory, which is an extension of The Big Assumption. We each have our own discount rate of the future. We then assume most other people have similar discount rates of the future, which is the key determinant of our political views. Mankiw's example is obviously an extreme case, a discount rate of zero. Communists, to take the opposite, assume people have very short-time horizons and therefore 100% taxation isn't an issue. And indeed we need the state to step in and perform a whole host of functions to ameliorate the steep discounting individuals do to the future.


David said...

Higher tax rates on high earners, however much they do or don't disincentivize work, pull money out of the investment pool and put it into the current-consumption pool. If someone making $10MM/year has his taxes go up by $1MM, he may reduce his consumption slightly, but more of the $1MM is likely to be at the expense of investments, including very direct forms of investment like venture capital and oil/gas drilling limited partnerships, as well as stock and bond purchases. In theory, of course, government could use its resources for investment, but mostly it doesn't. Even construction of capital assets, like bridges in useless places and the expansion of the Murtha Airport, are often economically pointless.

The Ancient said...

1) All these people who rattle on about what the rich will do with their smaller after-tax incomes have one thing in common -- they are non-rich.

2) At some level, it's hilarious that Krugman and everyone else on the left is using a model of Milton Friedman's. (Anyone seen data supporting that model?)

3) Keven Drum is an idiot, and Brad DeLong's opinions have little or nothing to do with economics.

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