Yes, this is an important point. Here's an example of counterproductive policy:
I was running the numbers on an $800k inherited IRA and the incentives and consequences generated by the government's requirement that it be cashed out and taxed over the next eight years (instead of over my remaining life).
If I continue working, the government will take more than 40 cents on the dollar from the disbursements of this IRA, a total of $320k; on the other hand, if I retire early instead, the tax bill will be 20 cents on the dollar as my taxable income will be much lower and I'll get to keep an additional $20k/year. The difference is enough to pay for healthcare off the exchange for the eight years of my early retirement until Medicare kicks in. That's a substantial incentive to retire early.
And if I do so, the substantial drop in my taxable income leads to reduced federal, state, and local tax collections from me in excess of $100k per year, or a total of $800k+.
Correction: the healthcare bill under the early retirement scenario would drop as well: I'd save another $100k total over the 8 years of early retirement because about 1/3 of the health care costs would be subsidized. So the government would be picking up another $100k in costs over the eight years.
Total reduced taxes and increased government costs of pushing one family to retire early: $160k + $800k + $100k = $1m+
Geez, wait, we need to add another another $20k in annual reduced taxes to the government as my income wouldn't be subject to social security any more, so another $160k the government doesn't get to collect.
High taxes on people with low marginal propensity to consume reduce savings and investment even when they don't change behavior: Simply by virtue of paying a lot in taxes, they have less money left to save and invest.
This is why things like taxes on wealth or unrealized asset appreciation are especially destructive: They're heavily skewed towards people with low MPC, and thus result in a greater reduction in investment per dollar of revenue raised than taxes on consumption or even income.
All nice theory here. Except for the fact that people's behavior does not bear this out and never had. The people who are taxed the very most also work the very most. Your theory has no support. The people with lower tax rates work far less. Those are the actual facts so why are you talking about imaginary theories that are terrible at predicting actual behavior (unless it's to predict the opposite of what the theory says).
Careful. This is true in the short term but not in the long term. You have two things that cause people to work hard despite high tax rates.
One is that they are naturally the kind of people who work hard. They tend to face high tax rates because they are highly productive and hit high tax brackets. They are heavily motivated by non-financial considerations and may be relatively indifferent to taxes.
The other is path dependence. People get their lives set up - they invest in learning or in a business, they get married, they have children, they settle in a particular place, and so on - and those choices are either hard or impossible to reverse. When their tax rates go up, they may well decide that the least disruptive thing to do is to work harder, so that they replace the lost income and don't have to change any of the few other things they can change (like moving to a smaller house in a different neighborhood, moving their kids to new schools, etc., etc.)
In the long term, though - over generational timescales of 2 decades or more - you get profound behavioral changes. People invest less in learning and in businesses. Much less. Education makes less and less sense if all the increased income is going to be taxed away, as does starting a business. So now you have to subsidize education so there will be anyone with a high income to tax in the future. And all those easy gains from higher tax rates start to go away.
Taxing high incomes is like any other unhealthy behavior: the fun is all up front; the bill comes later. If all you do is look at the short term, it seems like a great idea.
I mean look I get why it happens. Im in the highest marginal tax bracket and I work all the time, way more than people with lower incomes. So does everyone else in this bracket. It's all doctors, lawyers, and CEOs...not people known for their fun flexible schedules. So I'm just saying, this theory is simply not true. For the reasons in your first paragraph.
Look I'd love if it was and there was a good reason for me not to pay six figures each year directly to the federal govt, but this is false theories and propaganda as far as I'm concerned. There is no evidence that tax rates make any difference on the behavior of workers, either high or low income. Investments is a different story.
I think "there is no evidence that tax rates make any difference on the behavior of workers" is a bit strong. There's plenty of anecdotal evidence that they do. A very simple example: if one married person earns enough to hit one of the higher tax brackets, their spouse is taxed at that rate on their first dollar of income. Dual-income middle-class parents have certainly told me it was a significant consideration when it came to deciding whether one of them (usually the mother) should take a career break when a child arrived. There's almost certainly been studies on that, not that I know where to find them. Most western countries keep their top marginal income tax rate just below 50%, presumably because they've found that higher rates drive behavior change even on a short timescale. There's also plenty of social-scale evidence consistent with behavior change associated with a pattern of high taxes and/or rich social benefits.
But it's hard to isolate the impact of marginal tax rates alone - excluding social benefits, subsidies to encourage education and investment that can offset high tax rates, etc. - over very long periods of time (decades) in a quantitative way, which is the most likely reason that satisfying quantitative, narrowly-focused evidence is not plentiful.
I think for the most part, once the basics are covered, people mostly care about making more money than others. Given that tax brackets are marginal and everyone is taxed the same on the the first several buckets, and it's only the "extra" income on top where rates go up, this results in it not having much impact on behavior. The example of a couple you mentioned is only relevant because they're planning on the child and one of them needing to scale back, but I think the behavior of their peers and people they feel the need to "keep up with" likely has more of an influence than tax rates. Because people don't want to have less money than those they feel are their peers.
So if me and my friends/neighbors all have a household income taxable in the highest bracket, and someone proposes raising that rate from 39% to 60%, I think most people's behavior will have more to do with what other's do, than the tax rate. Sure, it's only 40 cents left on the dollar for any additional work you do now, but that's still 40 cents more per dollar that you have more than everyone else. I don't think it would cause anyone to work less unless everyone across the board in that bracket did so, so everyone kept their same relative position. Sure, some people don't think that way, but they're not usually the highest earners or as competitive anyway. Most people who pay all their taxes via automatic W-2 withholding just don't really think much about taxes in the first place.
I work at a law firm so I have a lot of data on people's actual behavior over a long period of time, because I get reports every month showing precisely how many hours everyone works and exactly what their hourly rate is. Lawyers have a very clear more hours worked --> more money in their pocket structure to their compensation. It's only a small minority who adjust their behavior by working LESS once their hourly rate is higher, who decide "that's enough" because of higher tax rates. Most work MORE the higher their hourly rate, even though that will often tip them into higher brackets. It's still ultimately more money in their pocket at the end of the day.
Certainly there would be SOME point where this would tip into not seeming "worth it", but I think tax rates would have to be much higher to get there. If you can make an extra $5k a month post-tax, I don't think many people are going to much change their behavior or turn down that extra $60k a year just because those dollars are earned at 70% post-tax versus 60% post-tax. Though certainly they'd all say they prefer to keep the 70% post-tax.
That's really interesting. I have a friend who is a former - very successful - consultant who similarly believes people are primarily motivated by status rather than absolute wealth, and that anyone with the ability to spend on status goods (Rolex, Ferrari, etc.) should have most of it taxed away from them because it's all just status signaling, which they could do with a fraction of the income. No doubt most people have an element of relative status seeking. But top-tier consulting firms, like law firms, are pyramid hierarchies where anyone who is motivated by a mix of values is going to be selected out (into "real world" careers that allow for a mix of values). I accept that you are both reporting accurately what you see in your worlds, but suggest that you consider the possibility that the world you see is extremely unusual.
I have encountered yet another worldview that also considers taxes to be an afterthought. In that worldview (someone who worked at a university, where taxes are lower - but incomes also) the motivation was actually "having power over other people's lives". Again, I have no doubt that's a real thing, but I don't think it's terribly common - far more people want control over their own lives.
You discounted the couple having a child as being a particular situation, not typical. I suggest to you that, in fact, it's far closer to typical than the behavior of people who have made it - or aspire to - in a law firm.
Buffet has to sell stock to pay the tax. That stock is bought by someone, probably mostly an asset manager. That reduces the amount of money chasing stocks on a per-share basis, which reduces share prices a bit. Meanwhile, millions of retirees are selling stock to fund their retirements, now at slightly lower prices.
So, the retirees consume less.
It's so many of them and there's so much stock price volatility that no-one notices. But that's where it lands.
Buffet, who is directly taxed, now has less ability to invest (or consume). Indirectly, it impacts the income of every retiree who saved assets for retirement, but by very little. And their money is given to the poor. Because Buffet's net worth is so small compared to the government's spending over any length of time, the poor also don't notice the change.
I think your view of the world is often that of an overly enthusiastic 1st year econ studen that just learned about supply and demand and the invisible hand and thinks it directly applies to all things, no real-world adjustements needed, people can be accurately modelled as rational economic agents, etc.
But here I think this simple but useful framework would work better than your somewhat contrived "some people are cheap, some corporations are cheap" point. If you increase taxes or regulatory burdens, you decrease the benefit that economic agents (be they individuals or corporations) derive from their economic activity (all things being equal), and as a consequence they lower the amount of energy or money they invest in this activity — they simply do less. The supply curve shifts left!
I'm always surprised that, in this discussion, marginal utility hasn't come up. The usual pro-tax argument is that the marginal utility of a dollar to a poor person is much higher than to a rich person, so taxes should transfer dollars from rich to poor. The usual objection to this is that you can't compare interpersonal utility. But even if you could, the argument has another gaping weakness.
The problem is that, for rich people, marginal dollars have relatively low utility - but marginal time has relatively high utility; the rich are invariably run off their feet. The fact that they're rich means that a lot of economic activity - multiples of their marginal income - depend on... their decision whether, at the margin, to work or go to their kids' ballgames.
As a society, we want - we NEED - them to work. And offering them money isn't as strong an incentive as it would be for the rest of us (who can't - or don't - create the same kind of economic value with an additional hour of work). So, BECAUSE marginal dollars have relatively low utility to them, taxing them can be disproportionately expensive to the rest of us.
In other words, the marginal tax rate on the rich should probably be - I hate to say it - lower than it is for the rest of us.
It's not just a problem of earning less and doing less though. Even if a rich person is willing to bear an additional burden, their loss of income implies that in the near future they will have to (1) reduce their consumption expenditures, (2) reduce their investment expenditures, and/or (3) reduce their cash balance.
Of course, the government and its beneficiaries get to use additional tax revenues to increase their expenditures and cash balances, but the situation isn't symmetrical with respect to investment expenditures. Whenever a government attempts to "invest" in its own production, or in subsidies of private production, it is not being guided by profit-and-loss considerations, and often in the absence of price information altogether. Governmental "investment" lacks any meaningful market test of its fitness for maximizing consumer utility.
A key point that even many mainstream economists fail to grasp is that private thrift doesn't merely supply the financing for investment expenditures, it also furnishes the labor and other factor inputs needed for lengthening the time lag available for transforming inputs into outputs by restraining present consumption, thus enabling producers to take advantage of additional opportunities for boosting factor productivity. It is bad enough that high income tax rates deter private thrift, but the diversion of incomes towards the government consumes whatever savings are available.
Soaking the rich isn't the only source of this problem. Nowadays, printing fiat money and handing it out as entitlements is the more common fiscal procedure, but note that reducing real pre-tax interest rates and promising future old age benefits, etc. also deters thrift, while deficit financing also consumes the available savings. In fact, the empirical data over the past sixty years show that increases in the GDP share of government (which is almost entirely due to increases in Social Security and Medicare) come entirely at the expense of private investment, not at the expense of private consumption. It is the spending (especially spending on entitlements), not the tax rates, that has inhibited growth and reducing capital intensity of the economy (with all its negative consequences for productive sector workers and others not on the fiat money gravy train).
Yes, this is an important point. Here's an example of counterproductive policy:
I was running the numbers on an $800k inherited IRA and the incentives and consequences generated by the government's requirement that it be cashed out and taxed over the next eight years (instead of over my remaining life).
If I continue working, the government will take more than 40 cents on the dollar from the disbursements of this IRA, a total of $320k; on the other hand, if I retire early instead, the tax bill will be 20 cents on the dollar as my taxable income will be much lower and I'll get to keep an additional $20k/year. The difference is enough to pay for healthcare off the exchange for the eight years of my early retirement until Medicare kicks in. That's a substantial incentive to retire early.
And if I do so, the substantial drop in my taxable income leads to reduced federal, state, and local tax collections from me in excess of $100k per year, or a total of $800k+.
Correction: the healthcare bill under the early retirement scenario would drop as well: I'd save another $100k total over the 8 years of early retirement because about 1/3 of the health care costs would be subsidized. So the government would be picking up another $100k in costs over the eight years.
Total reduced taxes and increased government costs of pushing one family to retire early: $160k + $800k + $100k = $1m+
Geez, wait, we need to add another another $20k in annual reduced taxes to the government as my income wouldn't be subject to social security any more, so another $160k the government doesn't get to collect.
Total loss to government: $1.2m+.
Call me crazy, but I’m starting to think you should retire early.
You're not crazy. But that also means forgoing income. The government doesn't take all of it :)
Had I but a bit more stashed away, it'd be a no brainer.
High taxes on people with low marginal propensity to consume reduce savings and investment even when they don't change behavior: Simply by virtue of paying a lot in taxes, they have less money left to save and invest.
This is why things like taxes on wealth or unrealized asset appreciation are especially destructive: They're heavily skewed towards people with low MPC, and thus result in a greater reduction in investment per dollar of revenue raised than taxes on consumption or even income.
All nice theory here. Except for the fact that people's behavior does not bear this out and never had. The people who are taxed the very most also work the very most. Your theory has no support. The people with lower tax rates work far less. Those are the actual facts so why are you talking about imaginary theories that are terrible at predicting actual behavior (unless it's to predict the opposite of what the theory says).
Careful. This is true in the short term but not in the long term. You have two things that cause people to work hard despite high tax rates.
One is that they are naturally the kind of people who work hard. They tend to face high tax rates because they are highly productive and hit high tax brackets. They are heavily motivated by non-financial considerations and may be relatively indifferent to taxes.
The other is path dependence. People get their lives set up - they invest in learning or in a business, they get married, they have children, they settle in a particular place, and so on - and those choices are either hard or impossible to reverse. When their tax rates go up, they may well decide that the least disruptive thing to do is to work harder, so that they replace the lost income and don't have to change any of the few other things they can change (like moving to a smaller house in a different neighborhood, moving their kids to new schools, etc., etc.)
In the long term, though - over generational timescales of 2 decades or more - you get profound behavioral changes. People invest less in learning and in businesses. Much less. Education makes less and less sense if all the increased income is going to be taxed away, as does starting a business. So now you have to subsidize education so there will be anyone with a high income to tax in the future. And all those easy gains from higher tax rates start to go away.
Taxing high incomes is like any other unhealthy behavior: the fun is all up front; the bill comes later. If all you do is look at the short term, it seems like a great idea.
I mean look I get why it happens. Im in the highest marginal tax bracket and I work all the time, way more than people with lower incomes. So does everyone else in this bracket. It's all doctors, lawyers, and CEOs...not people known for their fun flexible schedules. So I'm just saying, this theory is simply not true. For the reasons in your first paragraph.
Look I'd love if it was and there was a good reason for me not to pay six figures each year directly to the federal govt, but this is false theories and propaganda as far as I'm concerned. There is no evidence that tax rates make any difference on the behavior of workers, either high or low income. Investments is a different story.
I think "there is no evidence that tax rates make any difference on the behavior of workers" is a bit strong. There's plenty of anecdotal evidence that they do. A very simple example: if one married person earns enough to hit one of the higher tax brackets, their spouse is taxed at that rate on their first dollar of income. Dual-income middle-class parents have certainly told me it was a significant consideration when it came to deciding whether one of them (usually the mother) should take a career break when a child arrived. There's almost certainly been studies on that, not that I know where to find them. Most western countries keep their top marginal income tax rate just below 50%, presumably because they've found that higher rates drive behavior change even on a short timescale. There's also plenty of social-scale evidence consistent with behavior change associated with a pattern of high taxes and/or rich social benefits.
But it's hard to isolate the impact of marginal tax rates alone - excluding social benefits, subsidies to encourage education and investment that can offset high tax rates, etc. - over very long periods of time (decades) in a quantitative way, which is the most likely reason that satisfying quantitative, narrowly-focused evidence is not plentiful.
I think for the most part, once the basics are covered, people mostly care about making more money than others. Given that tax brackets are marginal and everyone is taxed the same on the the first several buckets, and it's only the "extra" income on top where rates go up, this results in it not having much impact on behavior. The example of a couple you mentioned is only relevant because they're planning on the child and one of them needing to scale back, but I think the behavior of their peers and people they feel the need to "keep up with" likely has more of an influence than tax rates. Because people don't want to have less money than those they feel are their peers.
So if me and my friends/neighbors all have a household income taxable in the highest bracket, and someone proposes raising that rate from 39% to 60%, I think most people's behavior will have more to do with what other's do, than the tax rate. Sure, it's only 40 cents left on the dollar for any additional work you do now, but that's still 40 cents more per dollar that you have more than everyone else. I don't think it would cause anyone to work less unless everyone across the board in that bracket did so, so everyone kept their same relative position. Sure, some people don't think that way, but they're not usually the highest earners or as competitive anyway. Most people who pay all their taxes via automatic W-2 withholding just don't really think much about taxes in the first place.
I work at a law firm so I have a lot of data on people's actual behavior over a long period of time, because I get reports every month showing precisely how many hours everyone works and exactly what their hourly rate is. Lawyers have a very clear more hours worked --> more money in their pocket structure to their compensation. It's only a small minority who adjust their behavior by working LESS once their hourly rate is higher, who decide "that's enough" because of higher tax rates. Most work MORE the higher their hourly rate, even though that will often tip them into higher brackets. It's still ultimately more money in their pocket at the end of the day.
Certainly there would be SOME point where this would tip into not seeming "worth it", but I think tax rates would have to be much higher to get there. If you can make an extra $5k a month post-tax, I don't think many people are going to much change their behavior or turn down that extra $60k a year just because those dollars are earned at 70% post-tax versus 60% post-tax. Though certainly they'd all say they prefer to keep the 70% post-tax.
That's really interesting. I have a friend who is a former - very successful - consultant who similarly believes people are primarily motivated by status rather than absolute wealth, and that anyone with the ability to spend on status goods (Rolex, Ferrari, etc.) should have most of it taxed away from them because it's all just status signaling, which they could do with a fraction of the income. No doubt most people have an element of relative status seeking. But top-tier consulting firms, like law firms, are pyramid hierarchies where anyone who is motivated by a mix of values is going to be selected out (into "real world" careers that allow for a mix of values). I accept that you are both reporting accurately what you see in your worlds, but suggest that you consider the possibility that the world you see is extremely unusual.
I have encountered yet another worldview that also considers taxes to be an afterthought. In that worldview (someone who worked at a university, where taxes are lower - but incomes also) the motivation was actually "having power over other people's lives". Again, I have no doubt that's a real thing, but I don't think it's terribly common - far more people want control over their own lives.
You discounted the couple having a child as being a particular situation, not typical. I suggest to you that, in fact, it's far closer to typical than the behavior of people who have made it - or aspire to - in a law firm.
I may be wrong, of course; it happens.
Good discussion! Thanks.
You make a good point. Unfortunately, our host rarely reads comments, so he is unlikely to see it. Maybe you should email him directly.
I think he is oversimplifying a bit. Earning or doing less is not the only way to respond defensively to tax increases.
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Also if you tax Warren Buffet more and give the money to the poor and they consume more goods and services, who consumes less?
Buffet has to sell stock to pay the tax. That stock is bought by someone, probably mostly an asset manager. That reduces the amount of money chasing stocks on a per-share basis, which reduces share prices a bit. Meanwhile, millions of retirees are selling stock to fund their retirements, now at slightly lower prices.
So, the retirees consume less.
It's so many of them and there's so much stock price volatility that no-one notices. But that's where it lands.
Buffet, who is directly taxed, now has less ability to invest (or consume). Indirectly, it impacts the income of every retiree who saved assets for retirement, but by very little. And their money is given to the poor. Because Buffet's net worth is so small compared to the government's spending over any length of time, the poor also don't notice the change.
Bryan,
I think your view of the world is often that of an overly enthusiastic 1st year econ studen that just learned about supply and demand and the invisible hand and thinks it directly applies to all things, no real-world adjustements needed, people can be accurately modelled as rational economic agents, etc.
But here I think this simple but useful framework would work better than your somewhat contrived "some people are cheap, some corporations are cheap" point. If you increase taxes or regulatory burdens, you decrease the benefit that economic agents (be they individuals or corporations) derive from their economic activity (all things being equal), and as a consequence they lower the amount of energy or money they invest in this activity — they simply do less. The supply curve shifts left!
I'm always surprised that, in this discussion, marginal utility hasn't come up. The usual pro-tax argument is that the marginal utility of a dollar to a poor person is much higher than to a rich person, so taxes should transfer dollars from rich to poor. The usual objection to this is that you can't compare interpersonal utility. But even if you could, the argument has another gaping weakness.
The problem is that, for rich people, marginal dollars have relatively low utility - but marginal time has relatively high utility; the rich are invariably run off their feet. The fact that they're rich means that a lot of economic activity - multiples of their marginal income - depend on... their decision whether, at the margin, to work or go to their kids' ballgames.
As a society, we want - we NEED - them to work. And offering them money isn't as strong an incentive as it would be for the rest of us (who can't - or don't - create the same kind of economic value with an additional hour of work). So, BECAUSE marginal dollars have relatively low utility to them, taxing them can be disproportionately expensive to the rest of us.
In other words, the marginal tax rate on the rich should probably be - I hate to say it - lower than it is for the rest of us.
It's not just a problem of earning less and doing less though. Even if a rich person is willing to bear an additional burden, their loss of income implies that in the near future they will have to (1) reduce their consumption expenditures, (2) reduce their investment expenditures, and/or (3) reduce their cash balance.
Of course, the government and its beneficiaries get to use additional tax revenues to increase their expenditures and cash balances, but the situation isn't symmetrical with respect to investment expenditures. Whenever a government attempts to "invest" in its own production, or in subsidies of private production, it is not being guided by profit-and-loss considerations, and often in the absence of price information altogether. Governmental "investment" lacks any meaningful market test of its fitness for maximizing consumer utility.
A key point that even many mainstream economists fail to grasp is that private thrift doesn't merely supply the financing for investment expenditures, it also furnishes the labor and other factor inputs needed for lengthening the time lag available for transforming inputs into outputs by restraining present consumption, thus enabling producers to take advantage of additional opportunities for boosting factor productivity. It is bad enough that high income tax rates deter private thrift, but the diversion of incomes towards the government consumes whatever savings are available.
Soaking the rich isn't the only source of this problem. Nowadays, printing fiat money and handing it out as entitlements is the more common fiscal procedure, but note that reducing real pre-tax interest rates and promising future old age benefits, etc. also deters thrift, while deficit financing also consumes the available savings. In fact, the empirical data over the past sixty years show that increases in the GDP share of government (which is almost entirely due to increases in Social Security and Medicare) come entirely at the expense of private investment, not at the expense of private consumption. It is the spending (especially spending on entitlements), not the tax rates, that has inhibited growth and reducing capital intensity of the economy (with all its negative consequences for productive sector workers and others not on the fiat money gravy train).