Friday, March 06, 2009

What is his evidence?

Michael Boskin writes in today's Wall Street Journal:

Increasing the top tax rates on earnings to 39.6% and on capital gains and dividends to 20% will reduce incentives for our most productive citizens and small businesses to work, save and invest -- with effective rates higher still because of restrictions on itemized deductions and raising the Social Security cap. As every economics student learns, high marginal rates distort economic decisions, the damage from which rises with the square of the rates (doubling the rates quadruples the harm). The president claims he is only hitting 2% of the population, but many more will at some point be in these brackets.

I know Boskin is one of my betters, but I am having hard time with this statement. These were the tax rates during the Clinton years, and people seemed to work awfully hard then. I also wonder if it is necessarily the case that our highest paid citizens are in fact our most productive. Given what we now know about the decisions taken by investment bankers, does Boskin really want to argue a strong correlation between productivity and very high pay?

[Update. David Barker in the comments paper points me to an Ed Prescott paper arguing that taxes affect the labor supply. He uses a cross country comparison to do so. But so far as I can tell, his results derive from a simulation model with some assumed parameters about the size of the capital stock across countries and the value of leisure. There are no controls for the relative size of the social safetuy net by country. I can't find a standard error in the paper, so it is hard to know what the results really mean. I certainty don't see firm evidence supporting Boskin's quadratic rule.]


David Barker said...

Hi Richard,

Here is some evidence:

The question isn't whether rates affect work effort - they must, just as all prices affect behavior. The question is how big is the elasticity.

David Barker

David Barker said...

The inverse square rule (wealth destroyed is the square of the tax rate increase) comes from models of dead-weight loss. See

Whenever a price changes a lot of people will not be on the margin, and they will think that the price change is unimportant. I don't follow the price of breakfast cereal, for example, so it seems strange to me that some people switch from Cheerios to generic Os when the price goes up a penny. There are such people, however, otherwise General Mills would have already raised the price.

I am on the margin when it comes to tax rates. The tax reform act of 1986 changed my life. So did the 1997 change in AMT depreciation. I cut back on consulting when I found that taxes took 56% of my earnings. I follow the twists and turns of income, capital gains, estate, and property tax policy and adjust the operation of my real estate business accordingly.

To a person with a full-time, salaried position, this might seem strange. Taxes might not even affect consumption very much, only savings. But I think there are enough people like me that a change in tax rates will make a big difference.

Anonymous said...

David Barker-- do you find bragging about how stupid you are is a good way to win debates.

Anyone who pays over 50% of their income in income taxes has to be either too stupid or two ignorant to take seriously.

Anonymous said...

A person who struggles with the difference between "too" and "two" will probably never find himself in Dr. Barker's tax bracket, but it is a fact that, in certain situations, marginal rates are as high as he describes.

Anonymous said...

The question isn't whether rates affect work effort - they must, just as all prices affect behavior.

Taxes go towards government spending (or paying off debt, which is paying for previous spending). Therefore every dollar of "work disincentive" from tax revenue is matched by a dollar of investment ("work incentive") from government spending. Whether either public or private investment is more appropriate in a given situation is up to an empirical debate, but it should be clear that when there is a dearth of private investment/demand then perhaps public investment/demand might be called for.

David Barker said...

Therefore every dollar of "work disincentive" from tax revenue is matched by a dollar of investment ("work incentive") from government spending.

Because of deadweight loss from taxation the dollars do not match up.

Anonymous said...

Where did the dollars go?

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