A Few Points on Taxes

I thought I'd weigh in on the tax policy debate with my views and why I hold them:

1.) Investment income should not be taxed at all. This is mostly for efficiency reasons. Taxes on capital are extremely inefficient for a variety of reasons and tend not to raise nearly as much as projected mostly due to behavioral responses. There is also an element of not punishing virtue, as investment taxes add an extra layer of taxation for those who choose to save and invest.

2.) The federal tax code is fairly progressive. However, this mostly offsets the regressive taxation at the state and local levels. In total, our tax system is slightly progressive, and that is about where it should be (in my opinion).

3.) Very few people don't pay taxes. A significant number don't pay INCOME taxes, but these folks do tend to pay payroll and sales taxes (among others).

4.) For all the talk about tax reform (which I support), people oftentimes overestimate the ability of the political system to achieve real tax reform. They also overestimate the efficiency gains to be had here. They are certainly real, but much smaller than many would like to imagine. Tax reform (reducing rates and getting rid of credits and deductions to keep it revenue neutral) will lead to a more efficient tax system, but it won't be a panacea (and it probably won't even happen).

5.) Tax hikes on "only the rich" go well beyond the rich. Let's say we raise taxes on anyone making more than $250,000 a year or the top "2%". Well, that isn't the top 2% everywhere. In New York, where the cost of living is high, $250,000 is the top 5%. So, if you live in New York, the tax hike that was supposed to hit "only" the top 2% is actually hitting the top 5% in your city. This is an unavoidable problem when it comes to federal taxes in a large country. It is also true that trying to adjust tax brackets for cost of living in each state or city would add a lot of complexity to the code and is likely not a goal worth pursuing. Still, the fact that so called tax hikes on the rich affect a lot more folks in some areas than others is relevant.

6.) On the same note, tax hikes on today's rich is a tax hike on tomorrow's upper middle class. Take the Buffet Rule. The Buffet Rule raised taxes on those making above $1 Million per annum. But, it was not adjusted for inflation. Over time, inflation and real income growth (growth after inflation) would lead to the "Buffet Rule" hitting a much larger swath of the population than originally intended (or supposedly intended). We have a real world example of this happening with the AMT which was originally designed to soak the rich. This is a manifestation of the saying "If you try to soak the rich, we'll all end up taking a bath". Even tax hikes for the rich that are adjusted for inflation still affect larger and larger segments of the population over time due to "real" bracket creep (incomes grow even after inflation over time).

7.) Debating whether or not tax hikes "kill jobs" has little to do with the actual negative economic impact that taxes have. High tax rates do tend to have a depressing effect on GDP per capita over time through supply side channels. The effect is hardly noticeable unless you look at relatively comparable countries over relatively long periods of time. We do, for instance, have evidence that taxes on labor do reduce labor supply over time. This has more to do with the efficiency-equity tradeoff than anything else. This, not the effect on job creation, is the main economic reason to limit tax rates along with the fact that taxes move resources from the private sector to the less efficient public sector.

8.) Sweden and Denmark have high taxes and high standards of living. Hong Kong and Singapore have low taxes and high standards of living. There are big asterisks with all of these countries (many other pro market policies in Sweden and Denmark and lots of forced savings in place of taxation in Singapore), but the point remains. Standard of living has a lot to do with the economic policies a country chooses, but things like culture and geography matter a lot too (perhaps more). Taxes need to be at a level where they can fund basic public services and below a level where they are so confiscatory that they destroy incentives to engage in productive behavior. But, between those two extremes, there is a good deal of leeway. In other words, if taxes are within this wide range, culture and other economic policies unrelated to taxation (no policy or culture is totally unrelated to their tax policy of course) account for most of the differences in standard of living between countries.


I suppose this list is a combination of my reading of the empirical evidence and my personal feelings with regards to tax policy.

In summary, taxes that are not confiscatory don't have devastating economic consequences, but the equity-efficiency tradeoff still applies with regards to redistributive taxation, we should use utilitarian considerations when considering the level of taxation on various groups but still set a cap on how high we are willing to let taxes go for the sake of preserving a free society, simplistic proposals to tax the rich often have the effect of hitting significant swaths of the upper middle class at least at some point in the future (and don't raise a whole lot of revenue which I didn't mention above), there are a lot of successful low tax and high tax countries which suggests non tax factors matter a lot when it comes to determining how high a nation's standard of living.

PS: I sort of wrote this off the cuff, so I didn't include links for many (or any) of the claims I made. Obviously, many of the points were my personal opinions (or deductive logic) and thus don't need links. However, I also made many empirical claims. If anyone wants to challenge one of these claims, please speak up and I will happily provide the evidence.

Innovation and Government (Mariana Mazzucato)

The idea of the "entrepreneurial state" has been in vogue lately. The idea, quite simply, is that the government and not private enterprise has been the main driver of innovation. The concept is simple enough. After all, government funded research has played a role in almost all of the consumer goods we take for granted today, be it the iPhone or the internet.

But, what advocates of this "entrepreneurial state" neglect to mention is that government has never been good at making useful consumer items that enhance the standard of living of a population. Google, Youtube, iPhone, Facebook, etc are all made possible by technology that has at least some of it's roots in government funding, but in the end all of these things were brought to us by private entrepreneurs pursuing their own self interest (not to suggest that financial self interest was the sole motivator).

The technology that the government developed was developed for defense related purposes. Without private entrepreneurs, the technology was basically useless to average consumers. This seems fairly obvious to me, but apparently this is lost on Mariana Mazzucato, who thinks that imposing heavy taxes on the profits of tech companies to pay for government led entrepreneurial investment would be a big boon for innovation.

The free flow of information is one of the most essential conditions for innovation. The idea that companies who use technology that was pioneered by government "owe" huge tax payments to the government is a recipe for stagnation. Indeed, this sort of thinking is behind the problems associated with copyright laws that also stymie innovation.

Mazzucato seems to think that very few people know about the role that government financed research has played in technological innovation, and I would assume her explanation of this has something to do with her view that anti government ideologies have increased in influence. But, it seems to be Mazzucato who needs to be educated on the process of innovation. Perhaps her pro government ideology has blinded her to the important role that private entrepreneurs have played in innovation and the inability for government to make items that are directly useful to consumers.

She is certainly right that the narrative that technological innovation is entirely a private sector phenomenon with government only hindering progress is wrong. However, her own narrative that private entrepreneurs are free riders and that government is really capable of outdoing the private market when it comes to consumer goods strikes me as even more wrong. This is a complex issue, but Mazzucato criticizes a simplistic and incorrect narrative by embracing an even more simplistic and incorrect narrative. 

It is not necessarily a private sector vs public sector argument here. Both play unique roles in the process of innovation that the other one is not capable of doing. The private sector simply doesn't provide the kind of basic research needed, and the public sector doesn't provide the kind of consumer goods that greatly improve quality of life. Instead, the key ingredient in innovation is the free flow of information. A free flow that would be significantly hindered if Mazzucato's ideas were to implemented.

Spain and Florida

Paul Krugman argues that the key difference maker in the economic fortunes of Spain and Florida is Florida's membership in a fiscal union. Scott Sumner notes that Krugman is correct, but that supply side factors play a large role as well.

This reminds me of an IMF paper on Spain's labor market that concluded:

"Spain stands out by the structure of its collective bargaining, which takes place at the intermediate level and greatly constrains wage flexibility, and by the very high severance payments for permanent workers, which accentuate the insider-outsider problem."

and:

"The unemployment rate could be substantially reduced by effectively decentralizing collective bargaining, thereby reducing excessive wage demands and allowing more wage flexibility. Reducing unemployment benefits and lowering the tax wedge would also help reduce unemployment by lowering the cost of labor. Finally, deregulating product markets reduces unemployment including by boosting activity and labor demand."

Europe is suffering from low aggregate demand, which accounts for high cyclical unemployment. The ECB, not fiscal austerity, is almost entirely to blame for this.

Still, well before the cyclical downturn, many European economies had chronically high unemployment, thanks to bad labor market policies. As Scott Sumner often points out, Europe has both demand side and supply side problems that both need to be addressed if we are ever to see a real labor market recovery in places like Spain (and France, Italy, etc).

PS: The main reason the USA has weathered the recession better than Europe is better monetary policy (albeit still inadequate), but our more flexible labor markets are part of the story as well.

On Income Mobility

There's been a great deal of discussion about income mobility lately, largely stemming from Greg Mankiw's excellent essay. Many have responded by noting that most measures of relative income mobility put the USA below most other developed nations.

Somebody once explained income mobility to me by comparing it to a race. Relative mobility would measure how the ranking of the race participants changes over time. Absolute mobility (another way to look at mobility) would measure the absolute progress in the race that each of the racers make over time (ignoring the ranks).

I would caution against reading too much into relative income mobility data. It would make sense that societies with more equal income distributions would have higher relative income mobilities. To go back to the race analogy, the various racers are much closer in proximity to each other in a more "equal" race than in an "unequal" race. This means that much smaller changes could lead to larger changes in the various ranks in the race.

The point isn't to discount relative income mobility data. It is to say that data purporting to show that other countries have higher income mobility than the USA is really just more data showing that other countries have more equal income distributions than the USA. The supposedly higher mobility is really just a statistical artifact of greater equality. Of course, absolute mobility data has drawbacks as well, so I am not recommending looking at that in isolation either (namely the fact that it mostly reflects average income growth).

Income mobility is hard to measure. Instead of using very flawed methods of measuring, we should focus on institutional barriers to upward mobility. I would categorize licensing, high implicit marginal tax rates, and monopolies as such.