Getting Specific On Taxes And Growth

As I was writing last week, one key question for those who believe that higher taxes on high-income people will lead to sharply reduced economic growth is where’s the growth given the substantial reductions in average tax burdens and the giant reductions in marginal tax rates.

Another way of putting it might be to ask for some more specifics. How, exactly, are higher tax rates supposed to impoverish the country?

One mechanism I find very plausible is distortions. The tax code contains loopholes and deductions that distort the allocation of economic resources. When you make tax rates higher, the extent of the distortion grows. Currently, high-income people over-consume health insurance thanks to its favorable tax treatment and higher tax rates would encourage even more over-consumption of this one commodity. So I completely agree in this regard that it’s better to tax the rich by closing loopholes first and only raising rates later.

The other mechanism that seems to be on offer is labor supply. This makes a lot of sense to me as applied to low-income people. If you work at McDonald’s or drive a taxi then you face a real choice about whether or not to increase your hours worked at the margin in exchange for more money. Driving a cab at 2AM is obviously a huge pain in the ass and not especially lucrative. To the extent that cab drivers face higher income taxes, they have even more reason not to work so late since it becomes even less lucrative. And the availability or non-availability of late night cabs has a variety of downstream impacts on bars & restaurants, drunk driving, etc.

But it’s a lot harder to see this at the high end. A very large share of high-income professionals basically have a marginal wage of $0. The CEO of WalMart can’t cut back his hours by 5 percent in exchange for a 5 percent pay cut. What’s more, a lot of high-end work is characterized by zero-sum competition. It’s plausible to imagine higher income tax rates making veteran NBA players more likely at the margin to retire rather than play one more season at the minimum. But what are the downstream economic implications of Mike Bibby retiring? There overall quantity of NBA players is fixed and there are plenty of other people willing to step up and do that job. The average quality of NBA talent might decline, but so what? The players just play against each other. And it’s not just athletes. Fancy lawyers and high-frequency traders are playing against each other. Marginal changes in average quality don’t matter. If anything, reducing the average quality of America’s lawyers and finance guys would be beneficial if it inspired more people to do something else with their time.

Last, of course, one of the main reasons for taxing the rich is precisely that the utility of a rich person’s marginal dollar is so low. Giving the dollar to someone else will increase overall well-being. But another implication of this is that the strictly pecuniary motivation to earn more money is already extremely weak. Whatever it is that motivates Sergey Brin it’s obviously not that he’s dissatisfied with $19.8 billion and wants more money. Plausibly he wants to get more money than Bill Gates because that would prove a point (i.e., that Google is awesome), but these pure competition dynamics strengthen the case for taxation.