Krugman on optimal taxes

As you may have noticed, I try very hard not to get in to the business of rebutting Paul Krugman’s various outrages. The article “The economics of soaking the rich” merits an exception. I will ignore the snark, the… distoritions, the … untruths, the attack by inventing evil motive, the  demonization of anything starting with the letter R, and focus on the central economic points.

Paul correctly cites recent work by Diamond and Saez, estimating the optimal top marginal tax rate at 70%, and Christina Romer’s concurring opinion.

The howlers are well epitomized by

“Why do Republicans adhere to a tax theory that has no support from nonpartisan economists and is refuted by all available data? Well, ask who benefits from low taxes on the rich, and it’s obvious.

And because the party’s coffers demand adherence to nonsense economics, the party prefers “economists” who are obvious frauds and can’t even fake their numbers effectively.”

1) 70% is not carved in stone.

Diamond and Saez made a big splash precisely because their estimates were so novel and so much higher than the prevailing consensus. For example, Greg Mankiw, also a previous CEA chair, and not a fraud, writing the excellent “Optimal Taxation in Theory and Practice” in the Journal of Economic Perspectives, a nonpartisan (or left-leaning) academic journal, not a fraud, with with Matthew Weinzierl and Danny Yagan, writes
A well-known early result of the Mirrlees (1971) model is the optimality of a zero top marginal tax rate. …
All this leaves the policy advisor in an uncomfortable position. Early work, following Mirrlees (1971), assumed a shape for the ability distribution, a social welfare function, an individual utility function, and a pattern of labor supply elasticities that yielded clear and surprising results— declining marginal tax rates at the top of the income distribution. Some recent work has yielded dramatically different results more consistent with existing policy, but many of the key assumptions are open to debate.
Lesson 3: A Flat Tax, with a Universal Lump-Sum Transfer, Could Be Close to Optimal 
The claim that the optimal marginal tax schedule is generally flat has been challenged often in the nearly four decades since Mirrlees (1971). Most prominently, Saez (2001) finds optimal tax rates that increase steadily from incomes around $50,000 to $200,000. Of course, the optimal tax schedule is sensitive to assumptions about the inputs discussed in the previous lesson: the shape of the distribution of abilities, the social welfare function, and labor supply elasticities. None of these three components of the problem is easily pinned down. 
You get the picture, the optimal top tax rate is in fact a highly contentious number, depending on many assumptions, all very hard to measure or even to define really.

As Mankiw et al point out, the position “let’s implement textbook optimal taxation theory” might be a bit uncomfortable for Krugman’s position that all things that start with D are holy.
Lesson 6: Only Final Goods Ought to be Taxed, and Typically They Ought to be Taxed Uniformly
Lesson 7: Capital Income Ought To Be Untaxed, At Least in Expectation
There is a lot of controversy on these too — the best way to get an AER publication is to disagree with orthodoxy, but they are still the rough orthodoxy, and there are sensible non-evil people who agree with them.

2) Even in Diamond, Saez, et Al, 70% is the total tax, not the federal income tax, and it is the marginal rate not the average rate.  (Though not always as you’ll see in a minute)

We have to add up every wedge between one dollar of extra revenue you create for your employer, and the value of what you receive in turn. That includes the  federal income tax, plus state and local income taxes,  property taxes, excise taxes, estate taxes, and so forth. We have to include sales taxes, personal property taxes, payroll taxes on employees you might hire. We have to include your share of corporate and business taxes (corporations raise prices to pay their taxes, so you’re paying in the end). It’s a marginal rate — we have to include phaseouts of tax benefits, and loss of income-related subsidies.

Greg Mankiw calculated his marginal tax rate at over 90% (Sorry, I can’t find the link anymore). He thought about, what if he takes a consulting job, pays all tax on it, saves it, paying taxes on dividends and intrerest, gives it to his kids, paying estate taxes, and they spend it. Even greg forgot about sales taxes and property taxes (if they buy a house) in this calculation. In California, where I live, the top rate is at least 42% federal + 13.2% state (not deductible anymore)  + about 10% sales tax + about 6% property tax (1% of house value per year, house = 5 times income) +  .. it goes on like this.

Watch what you wish for. A 70% all in marginal rate might well be a tax cut for many households. I once semi-humorously proposed an alternative maximum tax.

Krugman and company are proposing a 70% top federal rate on top of all the others, which is… a bit deceptive relative to the 70% total marginal tax rate even in his cherry-picked sources.

3) Disincentives. Krugman correctly points out the central tradeoff.
So why not tax them at 100 percent? The answer is that this would eliminate any incentive to do whatever it is they do to earn that much money, which would hurt the economy. 
But then Krugman, and those he cites, take an extremely narrow view of this disincentive effect.

By and large the “optimal redistribution” theory considers only the static question, how many hours will you work.
 If a rich man works an extra hour, adding $1000 to the economy, but gets paid $1000 for his efforts, …
 And, correctly, I think, this literature by and large agrees with the labor supply literature that once people have found jobs and careers, they tend to work about 40 hours a week or so even at pretty high tax rates. We can argue about that, but I think it’s more productive to look at all the margins that are ignored here.

The big margin for economic growth is peoples human capital decisions — the decision to go to school, to take hard courses (computer programming) rather than softer more pleasant ones, the decisions to start businesses and invest enormous time when young developing them. The optimal redistribution literature just ignores all of this. And, like the decision to relocate, it depends on the total tax bite, not just the marginal tax bite. How much will I earn, after all taxes — what lifestyle will I lead — if I go to med school, or just stay where I am? High tax countries do not immediately see people staying home from work. But they do not see vibrant business formation and human capital investment. (Chad Jones has a great new paper on this.)

The other margin is avoidance. Throwing around high statutory tax rates in the 1950s as if anyone actually paid them is past disingenuous at this point, as often as the opposite has been pointed out. (Diamond and Saez engaged at least recognized that nobody paid 90%, but engage in a subtle .. sleight of hand. They assume that all corporate taxes were paid by wealthy people in the 1950s — the one and only burden or indirect calculation in the paper, and contrary to the usual assumption that capital supply curves are flatter than labor or product demand.)

The one thing we should learn from the New York Times and others’ probes in to Trump Tax Land is just how far very wealthy people will go to avoid paying taxes. Especially estate taxes — there is nothing like the government coming for nearly half your wealth to concentrate the mind. I venture that we would have gotten a lot more out of the Trump family with a 20% VAT and no income tax or estate tax!

A 70% or 80% marginal federal income tax would be first and foremost a boon for tax lawyers and accountants. If one were in the mood to match Krugman’s attacks of which party has which dark motives to serve which evil interest, the direction would be easy.

Moreover, Krugman gets the benefit of labor to society wrong in an astonishing econ 1 way
If a rich man [or woman, Paul, please!] works an extra hour, adding $1000 to the economy, but gets paid $1000 for his efforts, the combined income of everyone else doesn’t change, does it? Ah, but it does — because he pays taxes on that extra $1000. So the social benefit from getting high-income individuals to work a bit harder is the tax revenue generated by that extra effort — and conversely the cost of their working less is the reduction in the taxes they pay.
If you are paid your marginal product, as you are in a competitive market, then you are paid how much revenue your efforts add to your employer’s bottom line. But society benefits by the consumer surplus, the area under the demand curve, and loses that consumer surplus when taxes put a wedge between your effort and your wage. When Steve Jobs worked hard and sold us all Iphones, he made a ton of money, and apple made a huge profit. But we all benefitted by far more than we paid Apple.

No, the world is not a static, zero-sum game.

4) Garbage in, garbage out.

Every result in economic theory starts from assumptions and derives conclusions. This one is the same. Before we get to the distribution of talent, the accumulation of human capital, and the rest, this whole business starts with the presumption that the US Federal Government is a benevolent dictator, whose job it is to take from Peter to give to Paul — to maximize the sum of everyone’s utility, and yes making intrapersonal comparisons to do it — constrained only by Peter’s willingness to work if faced with a steep tax rate.

If you don’t buy that basic assumption, along with all the others along the way, you don’t buy the result. If, in particular, you look at the world circa 1850, or even in Krugman’s cherished 1950, and you look at how amazingly better off we all are today, and you conclude that the government’s job is to foster economic growth as fast as possible, then all bets are off.

No, the world is not a static, zero-sum game, in which we fleece the rich one just enough to keep him playing.

I think it’s time to reactivate my no-Krugman new year’s pledge.