Wednesday, November 23, 2011

Time Horizons: Marginal Income Tax Rates

Paul Krugman points readers to a paper arguing that the marginal income tax rate should be around 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.

FLG's concern is 2. It is too low. And, using FLG's time horizons theory, he can say exactly why -- the econometrics that Krugman hangs his hat on only deal with short-term effects. What, pray tell, do the authors of the paper have to say about long-term effects?

Perhaps most critically, does an estimate based on a single period model still apply when recognizing that people earn and pay income taxes year after year? First, earlier decisions such as education and career choices affect later earnings opportunities. 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 multi-period 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.

Just because there isn't any compelling evidence doesn't mean that the logic that under a 70% tax rate fewer people will become cardiologists, or other human capital intensive professions, and that those who are will, with enough time to plan, decide to retire earlier than they would've otherwise.

1 comment:

Anonymous said...

And furthermore: ability to plan. If it's 70 per cent, they will plan to make a swell office and hire a secretary with large jiggly breasts and heat their offices to 75 degrees, since that all comes off the top, and furthermore it will suddenly make sense for the business to buy them a car. The income goes down, and the fun things the business buys them go up. dave.s.

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