Taxes: Fairness and Incentives

Former Labor Secretary Robert Reich makes a case for raising taxes on high earners. He cites the IRS data on growing inequality (see earlier post) and, what's more:

The biggest emerging pay gap is actually inside the top 1 percent. It's mainly between CEOs, on the one hand, and Wall Street financiers – hedge-fund managers, private-equity managers (think Mitt Romney), and investment bankers – on the other. According to a study by University of Chicago professors Steven Kaplan and Joshua Rauh, more than twice as many Wall Street financiers are in the top half of 1 percent of earners as are CEOs. The 25 highest paid hedge fund managers are earning more than the CEOs of the largest five hundred companies in the Standard and Poor’s 500 combined. CEO pay is outrageous; hedge and private-equity pay is way beyond outrageous. Several of these fund managers are taking home more than a billion dollars a year.

Here's why Reich argues the government needs more revenue:

Taxing the super-rich is not about class envy, as conservatives charge. It’s about the nation having enough money to pay for national defense and homeland security, good schools and a crumbling infrastructure, the upcoming costs of boomers’ Social Security (the current surplus has masked the true extent of the current budget deficit, but it won’t for much longer), and, hopefully, affordable national health insurance. Not to mention the trillion dollars or so it will take to fix the Alternative Minimum Tax, which is now starting to hit the middle class.

So, how high does Reich think top rates should go?

What’s fair? I’d say a 50 percent marginal tax rate on the very rich (earning over $500,000 a year). Plus an annual wealth tax of one half of one percent on net worth of people holding more than $5 million in total assets.

Greg Mankiw responds:

If I were a redistributionist, here is what I might propose: A large fixed payment to every citizen, paid at the beginning of every month, financed by a proportional tax on consumption, such as a value-added tax.

That's very sensible if one takes seriously the possibility that, because they effect incentives, high marginal tax rates reduce saving and investment. Under Mankiw's proposal, there would be no tax on income which is saved - in theory, this should encourage investment and capital accumulation. The large fixed payment would result in very low - even negative - average tax rates for low-income earners. In a recent NY Times column, Bob Frank also argued for taxing consumption, rather than income, but in a much more progressive way:

As taxable consumption rises, the tax rate on additional consumption would also rise. With a progressive income tax, marginal tax rates cannot rise beyond a certain threshold without threatening incentives to save and invest. Under a progressive consumption tax, however, higher marginal tax rates actually strengthen those incentives.

But how worried should we be about the effect of marginal tax rates on incentives and behavior? By instinct and training most economists are inclined to believe incentives matter, but as I noted earlier, the economy actually grew faster in the 1950's and 1960's, when the top marginal tax rate was higher.

On a related note, the OECD has compared tax burdens (i.e. taxes as a % of GDP) across member countries (the OECD is a group of rich countries). Of the 30 countries in the study, Sweden had the highest tax burden (50.7%) and Mexico the lowest (19.9%), and the US (27.3%) was below the average of 36.2%. Its hard to see a clear connection between taxes and economic performance in the OECD data - certainly, high taxes haven't prevented some countries from being prosperous (of course, overall tax burdens are not the same thing as marginal tax rates). The NY Times has a nice story on the OECD data.