Tuesday, February 12, 2008

Marginal Taxes on the Rich

In response to the opening sentence of my last post, Greg Mankiw asks:
Have you ever turned down a money-making opportunity that you would have accepted if it paid twice as much?
I'll outsource the first part of the answer to "a student of economics," who comments on Greg's post via the comments section of my last post:
Greg asks the wrong question in an effort to get the answer he seeks.

The correct question should be, "would you turn down that opportunity if ALL your other money making opportunities also pay twice as much?"

It's not clear that I would do anything different if all my options improved by the same amount. There are only so many hours in day. In fact, perhaps I would actually work less and play more if I were twice as rich (assuming, of course, all gov't services magically continued without cost).
I do recall once having two job offers at comparable pay, and I'm sure that, if the one I rejected had paid twice as much, I would have taken that one instead. But it's pretty obvious that has nothing to do with taxation; it has to with what other opportunities are available. If both jobs had paid twice as much, I would have made the same choice that I did.

Part-time opportunities are a separate issue. I don't have a clear memory on this point, but it's quite possible that I've turned down consulting work that I would have accepted if it paid twice as much (though again, if all opportunities paid twice as much, I'm not sure how the income and substitution effects would sort out). In my case, though, the example (if there is one) would make my second point: that the incentive effects of higher marginal tax rates are not all bad. If I did turn down an assignment, it would be a job in support of one side or the other in a legal case or an interest arbitration. Given the near zero-sum nature of such proceedings, the negative externalities associated with my activities would have been quite high. In this case, the tax is Pigovian, and I'm confident that it's nowhere near high enough to equate the private rewards with the social value of such work. I've made a similar point before.

[UPDATE: Boy, my two sentences introducing a different topic are generating quite a large tangent. PGL at Angry Bear has this to say.]

UPDATE2: In a Update, Greg gets into the whole income and substitution effects business and argues that he is asking the right question because he is isolating the substitution effect, which is what matters for deadweight loss. But for most real-life examples, he's still wrong. It's fairly obvious in my example of having two job offers, but it's true in a lot of more subtle cases too, that one is not really making a substitution between labor and leisure; rather, one is substituting one labor opportunity for another. Usually, one doesn't have a firm offer for the alternative opportunity, but one has some reasonable idea of what opportunity may become available. If a job offer gets doubled, it becomes unrefusable simply because one will never get another offer so big.

It's true that, to the extent that one has marginal opportunities, as in my consulting example, there may be labor-leisure tradeoff, but even there to a large extent it may actually be an intertemporal tradeoff between different labor opportunities given a more-or-less fixed amount of total leisure over time. And I would reiterate my point that the taxes in these marginal cases are often Pigovian.

[UPDATE3: While we're on the topic, let me point back to this post in which I argue that progressive taxation (though not high overall taxation) can actually encourage entrepreneurial activity.]

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Anonymous brian said...

Given the near zero-sum nature of such proceedings, the negative externalities associated with my activities would have been quite high.

Isn't this assuming that you would be supporting the side that reduces social value? Wouldn't there be positive externalities if you're supporting the "good guys" in some social value sense?

Tue Feb 12, 09:48:00 AM EST  
Blogger ProGrowthLiberal said...

The Pigouvian counterargument is a good one but as I suggested under your other post, there are several other problems with Mankiw's straw man.

Tue Feb 12, 09:53:00 AM EST  
Blogger knzn said...

Brian, you make a good point, to which I have two responses: first, my impression is that in most such cases, there are no "good guys" or "bad guys" in a social value sense, there are just two sides haggling over a pot of money, but...second, to the extent that there are good guys and bad guys, the bad guys usually pay more (I think because working for the good guys is in itself a compensating differential). I haven't really thought this through, but it seems that higher marginal taxes would tend to encourage people to work for the good guys rather than the bad guys. In general, though, we'd expect them to discourage working for either side, which probably means that the outcome would be more "random" and less based on the sort of knowledge that "dueling experts" might generate. So it does seem that the consultants create some social value, in that the they make the outcomes fairer, but the amount of social value generated is much less than the amount of resources used.

Tue Feb 12, 10:45:00 AM EST  
Anonymous brian said...


On your first point, if there are no "good guys" or "bad guys" in any social value sense, then there's no externality, right? If they are simply haggling over a pot of money, there is no social value to be generated, just as you and I dividing up $100 between ourselves doesn't bring up efficiency concerns (unless we get into the messy business of directly comparing our marginal utilities).

Your second point is good, but it relies on some reason for the desirability of random outcomes in arbitration. Maybe it's me, but I don't see such social value in arbitrations, and having them be decided by a coin flip does not seem to be necessarily preferable to a system where stakeholders argue.

Of course, the irony is that while I don't agree with some of your points, I agree with your conclusion: the social value generated in arbitrations (if any) is less than the resource costs.

Tue Feb 12, 12:16:00 PM EST  
Blogger knzn said...

If there are no "good guys" or "bad guys" in any social value sense, then any particular resources expended by one side or the other create an externality because there is a social cost to the other side that is not taken into account. If one side hires a consultant to help their case, it may be worth the cost to that side, but there is an externality because it hurts the other side (by exactly the same amount, meaning that the externality is as large as the total resources expended, except to the extent that they help the overall system by increasing the chance of a fairer outcome).

I wasn't saying that random outcomes are better. I was saying they will tend on average to be worse, because people will end up with less expectation of fair outcomes if the decisions are random. But the amount by which random outcomes are worse is considerably less than the amount of resources used to produce a "knowledgeable" outcome. (This has to be the case because of the externality involved. Each side has an incentive to use more than the socially optimal amount of resources.)

Tue Feb 12, 12:47:00 PM EST  
Anonymous Anonymous said...

This is all very interesting, and although I unfortunately cannot spare the time to sift through all the arguments, I agree with the intial points made by you, knzn, and angry bear.
I don't see leisure as socially unproductive and it may in fact have higher social benefits at the margin (for busy consultants) than the extra work, particularly if is spent on healthy activities, devoting more time to child rearing, families, or other relationships, or volunteer activities that assist the less fortunate building a functional environment for themselves.
At the margin, such activities may also be less of a strain on the environment than the alternative of more work.

Tue Feb 12, 02:50:00 PM EST  
Anonymous Anonymous said...

This is a very topical post for me.

Why? Because I'm seriously considering leaving my job.

I'm posting anonymously, so here's my situation. My wife is a relatively "high earner", making somewhere in the neighborhood of $250K/year. I am successful, making somewhere in the neighborhood of $125K/year. I pay marginal tax rates of roughly 50%, everything included.

So, by being a high earning couple we hit a double-whammy.

Not only is every marginal dollar I earn taxed at obscene rates, it is also a smaller percentage of our overall income, and thus suffers from diminishing returns.

So yes, higher marginal tax rates are directly impacting my inclination to work.

Tue Feb 12, 04:31:00 PM EST  
Anonymous Anonymous said...

Last anonymous - your situation is an argument for separate taxation for married couples. In the separate taxation model, the lower income spouse can enjoy a lower marginal tax rate. Of course, that would not work for your situation as you make relatively obsene amounts of money. But in all truth, does your wife want to support you? I understand that many well-to-do folks like you may want to have a stay-at-home spouse, particularly if children are involved. Is that your situation (will you fire the housekeeper, gardener, and nanny and take over their jobs?) or would your wife be supporting a beach bum and would you be risking your future, something that might concern you if there is a risk of marital breakdown?
In the end, career people are career people and their labour supply is relatively inelastic.

Tue Feb 12, 06:11:00 PM EST  
Anonymous James said...

knzn: Are you really unsure if costs influence behavior?

Tue Feb 12, 06:32:00 PM EST  
Anonymous Anonymous said...

Continued from previous - in a separate tax regime, income splitting through job sharing results in lower tax rates, unless the base income is too high. Of course, that means less work, but again, leisure is likely undervalued.

Tue Feb 12, 06:34:00 PM EST  
Anonymous Jacob said...

Knzn, I think we have moved beyond the realm of economics and into metaphysical doctrines when you talk about high marginal tax rates encouraging people to work for the "good guys".

knzn, The kind of incentives we're talking about here are not applicable to the "real-life examples" you give. The highest income earners are the group earning the most in capital gains. If marginal taxes for the rich are raised in the US, they now have incentives to take their money out of the US to foreign countries, or to not invest at all and consume their capital stock, decreasing worker productivity and wages, probably the opposite effect of what you were aiming. When you add to the fact that Mankiw's argument about incentives to even work at all or start a business venture, the loss is considerable.

The idea underlying all policies of taxing the rich at high rates and is that the higher income and wealth of the more affluent part of the population is a fund which can be freely used for the improvement of the conditions of the less prosperous (von Mises). Taxing the rich is more often than not taking savings from one group and giving it (through wasteful government programs) for present consumption of other groups.

My ideal tax is a "neutral tax"; a tax that would try not to distort production from any way it would go in the absence of taxation.

Tue Feb 12, 06:34:00 PM EST  
Blogger knzn said...

James, I am quite confident that costs influence behavior to some degree; the question is how big the effects are and how pernicious they are. For individuals, I don't think the marginal changes in behavior as taxes change from the current level are very large, and I'm not sure what direction is the overall effect those changes have on social welfare.

For married couples, I do think the behavior changes are large enough to be important, given that the FICA limit applies individually while progressive income taxes apply jointly. I see this as more a problem with the way the tax system is set up than with the level of marginal tax rates. And again, I think the effect on social welfare is ambiguous. A particular issue in the case of couples is the benefit that children derive from the attention of their own parents, and the benefit that society derives from having members who have had such attention. Do parents fully internalize these benefits? I doubt it.

I should also point out that, even if the various externalities are not large enough to make marginal increases in the tax rate welfare-enhancing, I think they are large enough to make the net welfare effects of those increases small. That is, current tax rates are reasonably close to an optimum, and therefore marginal changes don't have a large effect on welfare.

Jacob, Just note that I didn't bring up the "good guys/bad guys" issue. I was just arguing that, when agents use resources in a zero-sum game, there is a large externality, and the resources are essentially wasted. The "good guy/bad guy" thing comes in if you think that the game is not really zero-sum for society as a whole, and then not all of the resources are wasted if they result in a positive outcome for society. But still most of them are wasted, I would say, because I don't think the social benefits of one side (the "good guys") winning are very large.

Tue Feb 12, 08:37:00 PM EST  
Anonymous LookingForSensibleParties said...

After being referred to this thread:

One annoying argument people make that there is no downside for taxing high income earners (eg doctors) is to create a false dichotomy about the choices the individual faces. "Will he really quit medicine and go raise Alpacas if we raise his taxes from 50% to 60%? Will that broker kick it up and go care for newborn babies?" The fact is that that income and productivity is derived from multiple smaller choices: what is important is whether that person will work that extra hour - do that extra surgery, or work out a trade.

Note: I am not saying the USs utility function is not insane (I get up at 5:30 and get home at 7:30pm, work on vacation). But do not make the mistake turning the tax know does not come with an impact/tradeoff.

Tue Feb 12, 09:56:00 PM EST  
Anonymous Anonymous said...

"would you turn down that opportunity if ALL your other money making opportunities also pay twice as much?"

This shouldn't change anything. Suppose workers choose, after every hour of completed work, whether to work one more hour. Now suppose some worker exists in two worlds, identical in every way except one has a 20% tax rate and the other has a 60% tax rate.

In the 20% world, the cost of leisure is high, so we would expect the worker to be more inclined, each time the decision comes around, to choose less of it.

In the 60% world, leisure is relatively cheaper. We would expect the worker to be more inclined, at each hour, to choose more of it.

In the end, the individual in the 20% world will have said "yes" to an additional hour more times than in the 60% world.

Tue Feb 12, 10:39:00 PM EST  
Blogger Daniel said...

Student asks the right question and it pains me to say that Mankiw is wrong. However, student's example clearly shows a change in attitude associated with the increase in income. More income = more time to slack off. I believe Mankiw discusses the behavioral effects of increases in labor in his textbook: some people will work more because their labor is worth more, some will work less to give more time for leisure.

Tue Feb 12, 10:59:00 PM EST  
Anonymous Anonymous said...

Doesn't the backward bending supply curve of labor fit in here? Like you said, if you got paid more you might actually work less. So I think the assumption that people would work more under such a situation is not necessarily true.

I think the bigger cost of a high marginal tax rate is the incentive it creates to enter into tax avoidance (or tax deferral) transactions. This leads to unintended consequences - would small businesses behave the same if they didn't get a tax deduction by overspending on items eligible for a Section 179 deduction. As an accountant I can say most definitely not.

Thu Feb 14, 09:20:00 AM EST  
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