Saturday, December 26, 2009

The Case For the Millionaires Surtax

Greg Mankiw links a former student courageously trying to protect the rights of Millionares not to pay more taxes here.

Here's the thing -- there are no reputable studies on the elasticity of the effect of tax changes on total taxes collected, and there's no logical reason that that number should necessarily, a priori, be less than one.

Here's why: in 2007, there were 495,000 tax returns filed for millionaires. That means a significant fraction were corporate CEOs, CFOs, finance people, and professional athletes/best-selling textbook authors/TV celebs.

Peyton Manning makes about $30 million a year -- let's explore his potential behavioral responses to changes in taxes. Let's raise Peyton's taxes by 10%. Under the logic of Alan Liard, Greg Mankiw's student, and under the logic that all economists know to be the truth, people respond to incentives. Peyton Manning is a person, so he responds to this tax hike by working 6% less, and decides now he's going to sit for the Colts playoff games since he makes less money per game, and he enjoys watching Tom Brady play in the playoffs more than being there himself. Doesn't really sound likely, does it?

Of course, Peyton Manning is going to play 16 NFL games and the playoffs even if you raise his taxes considerably. The same is true of a wide variety of other professions -- corporate execs usually have two choices, they can choose to work or not work -- there are no part-time CFO jobs, and it's probably tough to be a "part-time" hedge-fund manager as well... So, let's say Greg the textbook publisher or Chuck the hedge-fund manager decides, due to higher taxes, that they are just going to retire. In that case, the government loses 100% of the taxes Chuck or Greg would have paid! The multiplier is -10!!!

Except, according to logic which is totally obvious to a pre-schooler, if Greg the textbook author doesn't sell textbooks, then Thorstein the textbook publisher will. If Peyton the quarterback doesn't play in the playoffs or appear in Gatorade commercials, then Tom the quarterback will. If the CEO of Anthem, who routinely makes $40 million, quits due to high taxes, Anthem will pay the next CEO extravagantly. If Chuck the hedgefund manager doesn't manage Peyton's money, then Emilio the hedgefund manager will manage Tom's money...

So, in this case, microeconomists might derive an elasticity of -1 (a 1 percentage increase in the tax rate reduces tax collections by 1% if 10% of the rich decide not to work at all), while the true Macro elasticity would be closer to 1.

Note that this logic does not apply to everyone, but it is likely to apply to the vast majority of those who make more than 1 million dollars per year, and Greg Mankiw's students are completely oblivious to this kind of perfectly obvious logic...

Of course, another thing higher taxes might change is how much someone might try to cheat in order not to pay taxes -- well, if this is the case, then what we really need is to beef up the IRS.

The third thing it also might change is the pay that CEOs get. For example, if the top tax bracket were 99%, for all income over $5 million, tax opponents always describe this case as having the effect that people will just stop working after they get to $5 million. That's just not an option for the likes of Peyton Manning, however. What Peyton Manning (or any corporate CEO in the same position) would likely do is settle for just $5 million a year, since all income after that goes to the state. Then, once you get a Republican in office, and they cut that 99% top bracket from $5 million-plus to $25 million plus, Peyton Manning will renegotiate his salary up to $25 million, even though he's still playing 16 NFL games a year...

So, in this case, tax rates down implies total taxes collected from Peyton Manning up but total "production" from Peyton unchanged, but worsening inequality for the economy and less taxes paid for someone else. So, we'd need to look at whether the consumption spending of people like Tiger Woods, CEOs with their corporate jets, and investment bankers is better for long-run economic growth than the spending of the poor, who spend a large chunk of their disposable income on things such as education and health care...

This is essentially what has happened in the US, and that is why you shouldn't believe it when economists tell you we shouldn't tax millionaires.

But then, you might object, *nobody* would have an incentive to become CEO if their salaries are capped around $1 million (if I was designing a tax system, I would probably not go over 50% on taxes before $3-4 million, but I would make Peyton Manning's marginal rate closer to 70%...)

Well, I once took a poll of the students in my TA section. I asked them who they would rather date -- someone w/ a bachelor's degree who works 40 hours/week, makes $40,000 per year and pays no taxes, or someone w/ an MBA who makes $80,000, works 80 hours/week, and pays $30,000 in taxes.

Most of the girls said they'd go for the person w/ the MBA, even though, per hour, the 40 hours/week job would be more, b/c the MBA has a prestigious graduate degree, is ambitious, and makes a whopping $10,000 more overall. (I had them assume that the above were peak salaries...) I also asked them if they would take a promotion from the $40,000 job to the $80,000 job, even though it's much more work, and, after tax, a pay cut per hour, and again, most wanted to go for the higher-priced job.

The study I'd really like to see is if, since the early 1980s, as wages on Wall Street have gotten out of control, what has happened to the average age of retirement at firms such as Goldman Sachs. "Standard theory" of course does not even predict whether the income or substitution effect dominates, but I suspect that there are quite a few I-bankers on Wall Street who do not exactly love their jobs or working 100 hours a week, and will just retire once they've put away $10 million in the bank. Tax them more and that just delays retirement. And to the extent higher taxes preclude the possibility of putting away $10 million for your average I-banker and talent shifts out of finance (or NFL quarterbacking), I fail to see how this is such a bad thing for society...

Put another way, suppose the CEO of Anthem made $4 million rather than $40 million due to high tax rates on multi-million dollar incomes (which we do not currently have). While in the micro context, this would greatly reduce the government's revenue, in this case, Anthem would have higher profits, or could afford to pay it's other workers more, could cut prices to gain more market share, or might even be able to deny fewer claims. In other words, it wouldn't make the whole pie smaller, it would just make it more equally distributed. And, to the extent that the Anthem CEO no longer flies around in a private Jet, owns 6 houses, and drinks $1000 bottles of wine, redistributive taxes would quite likely make the pie bigger...

UPDATE: An email and commenter pointed out that the question I asked the students in my class was reinforcing cultural norms and stereotypes and came off as sexist. They are correct and I apologize. I had not properly edited my own post however -- when I framed the question in class, I did it in a much, much more pc way -- asking everyone how much each individual would want to make/work, and also asked the question about the spouse in a completely gender-neutral way, and also asked a variety of other questions, with all questions asked to both guys and girls (I edited my post to reflect this). The guys tended to prefer spouses who worked and made less. The girls also tended to want to make and work less -- confirming what microeconomists have already found about how the female labor supply is more sensitive to marginal tax rates than it is for men. And yes, these are due to sexist cultural norms.

28 comments:

  1. Good evening, Mr. Veblen.

    I read about this site at A Tiny Revolution, which noted that a Mr. Mankiw had taken offense to your commentary here. That was enough for me to like you already. As a retiree from union construction work, and still able to understand what you're talking about, well that's icing and cake all at once, one on top the other, even!

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  2. If higher effective tax rates have no impact on work effort then why don't we just tax everyone at a 99% tax rate for every dollar earned over one million?

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  3. >> 99% tax rate for every dollar earned over one million

    When you use extreme examples not nearly being proposed, at some point your reductio ad absurdum argument becomes a straw man.

    The proposal isn't "99%" tax rates. And the claim isn't that it has zero impact on individual work effort. The claim is that a small tax increase will have small impact on individual work effort and negligible impact on overall work effort.

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  4. I agree with your views on marginal tax rates. But as for your teaching practices... you ask the guys in your class which job they'd want, but the girls who they'd want to date? Wow.

    I found your post because it was linked from Naked Capitalism. Maybe your next post should be: which famous economist would Yves Smith like to date?

    What planet have you been living on?

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  5. Business owners can decide how much they leave in the business and how much they pay themselves. They'll buy new equipment, do improvements on their property, and go to training when taxes are high, then pay themselves higher salaries when taxes are lower. Higher taxes on millionaires might make entrepreneurship more attractive than employment.

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  6. Take a look at the marginal income tax rates after World War II up to 1980.

    Those who would argue that rates over 50% would cause people to quit working have to explain how the post-war economy of the U.S. boomed, with marginal rates of 90% then 80%.

    How many people would refuse a promotion because the increase in their income would make them be taxed at a higher rate? If they did, they'd be saying "I'd rather have no extra money than 50% of an increase." Nice logic. Americans in the 50s, 60s and 70s weren't that stupid.

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  7. Ok if I am a doctor and I am cut off at x amount of money, why do any more work for the year? If I have a great idea, worth millions, why would I make it here if I can go some where else and make more. If I am Bill gates do I base Microsoft here or in India where I can earn a lot more. If I am peyton Manning, am I worth more than matt Hasselback, I can get you a superbowl ring, Matt, not so much, so do i stay in Indy or go to Dallas, with better post football opportuntities?

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  8. There seems to be no shortage of experts and theories on how to tax the rich.
    These professors should devote more energies on how to become rich by creating something of value people want to buy. But that's much harder. Let's invent "efficient" taxation schemes instead.

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  9. for what its worth, my dad was a R/E developer/residential builder in the late 40's through about 1969. The majority of his earning years were spent in the 70-90% marginal bracket. what he did was not pay himself so well, but rather invested the earnings/profits in order to take capital gains rates. He sold his office and business and retired at 46. we never had a private jet or anything, but we certainly were comfortable-55 acre gentleman's farm in Clinton NJ- 1971 LS7 Corvette for my getting a haircut- that sort of thing

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  10. I recently came across your blog and have been reading along. I thought I would leave my first comment. I don't know what to say except that I have enjoyed reading. Nice blog. I will keep visiting this blog very often.

    Alena

    http://grantfoundation.net

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  11. The argument for adding just a little pain to a millionaire's tax return can be extended to evary taxpayer. Add little enough pain and nobody would change their behavior, increasing government coffers (at a lower velocity of money). Talk of airplanes and expensive wine is neither here nor there. We can presume that if everyone made the same income after taxes nobody would work hard, so the only question is the tax tipping point, and as a corollary what tips. Effort, wages vs. capital gains, and class warfare consequences are all candidates for tipping. This blog post adds almost nothing to the debate.

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  12. Re Anonymous from 9:28: It is correct that this post adds nothing an intelligent non-economist would not immediately find intuitive -- but it is also true that it contains many insights that conservative economists ignore. The micro elasticity of tax revenues w.r.t. tax rates need bare no resemblance to the macro elasticity, which is the one that matters. That the income effect for rich people is likely to be substantial is also fairly obvious and intuitive, as is the fact that poor people are likely to spend a greater proportion of their income on food, education, and health care, consumption items which are "good for growth" and the rich are much more likely to consume conspicuously...

    Show me a conservative writer who takes all of these things seriously.

    Re: Anonymous from 7:42 -- Interesting anecdote.

    Re: Anonymous from 1:48 and others -- I would not advocate tax rates above roughly 70% for any income group. For people who make "normal" incomes below, say, $400,000, I'd be happy with top marginal rates of 50%. 70% shouldn't click in until you get above $3-4 million... And yes, that's completely subjective...

    In the link cited, millionaires paid on average $658,000 income tax on an AGI of $2,971,000, and kept $2,313,000 for a rate of 22%. I don't know if these calculations are correct, but that sounds inefficiently low to me.

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  13. I agree with everything you say but would add that in a global economy where tax rates vary across state boundaries that a high marginal tax rate in one could cause a brain drain.

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  14. I recently came across your blog and have been reading along. I thought I would leave my first comment. I don't know what to say except that I have enjoyed reading. Nice blog. I will keep visiting this blog very often.

    Alena

    http://grantfoundation.net

    ReplyDelete
  15. Hmmm. Interesting stuff. :) But from your title I thought you were going to talk about taxing wealth.

    Now a wealth tax at, say, 4% can become a graduated income tax, but a very mild one. The income tax part is 0% until the tax on existing wealth is paid, and then jumps to only 4% on the extra income. There is always a healthy incentive to earn more income. :)

    Income tax, sales tax, VAT, and tariffs all tax economic activity and generate disincentives on it. A wealth tax, however, gives people an incentive to earn money.

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  16. I agree, I am posting a couple of the 'graphs here as my economic quote of the day.

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  17. One small correction: There are lots more people who are millionaires, the 495,000 in question are just people who earned more than $1 million a year.

    My guess is that based on assets, the typical definition of millionaires, the number would be 2-4x that.

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  18. > I would not advocate tax rates above roughly 70% for any income group.

    Why?

    What is the interest for society (i.e., most members of society) to allow unlimited income inequalities?

    I would suggest having tax going to 100% for anything beyond, say, 10 times the median household income.

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  19. OK, I'm quite late to the party here, but:
    does anyone know of any actual EVIDENCE about this. Considering how conservative economists go on about it, you'd think someone would have something quantitative..
    p.s. I just found this blog this evening and have spend about 2 hours reading papers you or the pages you link to reference. Quite educational.

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  20. Brent, I'd guess that we could raise taxes on high earners quite a bit before they fled this country.

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  21. ""Standard theory" of course does not even predict whether the income or substitution effect dominates"

    What I find remarkable is that supply-sider refuse to acknowledge that the income effect even exists. I lived it, myself:

    http://www.asymptosis.com/you-deserve-it.html

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  22. To be technical, a millionaire is someone with a net worth of $1M of more, you want to tax a person who has taxable income of $1M or more.

    Do grad students get dictionaries these days?

    It is common to use professional athletes in these rants, but they represent a tiny sliver of the population and have very limited careers.

    The last time the federal government attacked the use of private aircraft and yachts thousands of middle class workers lost their manufacturing jobs, and Senator Mitchell (D. Maine) did a really quick about face on the "luxury tax."

    My junior and senior level tax students do a much better job with this topic than an alleged Ph.D. candidate in economics.

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  23. "Do grad students get dictionaries these days?"

    Whenever someone has nothing appreciable to say, they look for gotchas like this. Snore.

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    ReplyDelete
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  28. If you had the choice between taking out $40,000.00 of your inherited cash which is part of a larger IRA to pay off debts (but did not have to sell stocks to get that $ & your tax bracket is $15% but perhaps less since I am on SSD & earn less than 14,000.00 a year) or take out a 9% re-fill on a 2nd home, which is being rented for $1000.00 a month that will be sold in 3 years with a contract)- is it as simple as comparing interest rates to decide that a 9% re-fill is a better deal than a 15% deal? ( the 9% is non-negotiable as I can only get a "no doc/no asset loan" at that tax brackets unfortunately)or are there other matters to consider.

    ReplyDelete