Monday, December 6, 2010

Taxing the Rich? You betcha!

Our colleague over at To Get Rich is Glorious, tries to scare us into believing an increase in the income tax for those in the top bracket will hinder economic development. He points to the bag tax in DC and the cigarette tax in Maryland as examples of what could happen if the Bush tax cuts are not extended.

This is a common argument against the administration proposal to let the tax cuts expire for those making over $250,00 per year, but does it hold water?

Here's a graph:
It's a little tough to read, but looking from 1988 to 2008 I pulled data on GDP (trillions chained to 2005 dollars), GDP percentage change (based on chained 2005 dollars), and overlay-ed the individual income tax rate for the top income tax bracket. I got the GDP numbers from the Bureau of Economic Analysis and the tax rate numbers from the National Taxpayers Union.

So what does the graph tell us? Honestly, not much. Seems like the 1990s were good times for US economic growth, despite and increase in taxes in 1991 and 1993. It also seems like the 2000s weren't some boon time spurred on the Bush tax cuts. These are incredibly strained causal arguments and I'm perfectly comfortable admitting that. At the same time, one can't make us fearful of a return to a tax rate we lived quite comfortably with during the 1990s.

You see, our colleague, to my mind, conflates several different economic topics in his examples. When looking at the bag tax, you're looking at substitution effect and some aspects of price-elasticity of demand. Turns out, people don't want to pay 5 cents for a plastic bag. In the example of Maryland and the cigarette tax, clearly the government overplayed its hand and came in excess of the elasticity of demand for cigarettes. They effectively priced the cigarettes beyond what people were willing to pay.

What does that tell us about letting the Bush tax rates expire for the top income bracket? Not much. The marginal utility of the first dollar earned beyond $250,000 (to use the administration's line) would be different from dollar $249,999, but the marginal utility of dollar $250,000 to $2 million is the same. If the marginal utility of each dollar earned is constant (at least as it relates to the tax paid on each dollar), then there is no evidence an individual would work less.

But wait, you say, look what happened to Maryland. They priced people out of buying cigarettes. You know, it sure looks like they did, but we aren't discussing a tax rate never considered before. We are talking about a tax rate that we lived just fine with for nearly a decade.

So beyond the sniff test, which makes it highly specious people would work less hard because the tax rate changes, this argument doesn't pass the economics test either. As an aside, not bad externalities to have people using fewer plastic bags and smoking less.

1 comment:

Colin said...

The problem with this analysis is that it does not account for all of the other myriad factors which affect economic growth. Comparing tax rates during the 2000s and 1990s would be useful if all other factors were held constant, but plainly this is not the case.

While taxes rose during the 1990s, this period also saw a number of pro-growth policies enacted such as the NAFTA and GATT (WTO) free trade agreements, a capital gains tax cut, welfare reform (which encouraged greater labor force participation) and stability on the regulatory front (indeed, we saw deregulation take place with the telecom deregulation bill of 1996 and the repeal of glass-steagall). In addition, we saw relative restraint in government spending.

Under Bush, meanwhile, we had some minor free trade deals (CAFTA, Australia, both of which are outweighed by the new South Korea deal alone), more regulation through SarBox and greatly increased government spending in addition to the tax cuts.

Perhaps most important is the innovation factor, with the 1990s heralding the dot-com boom -- a once in a generation (if not longer) development which served to drive growth (as noted by Paul Krugman).

The 1990s also benefitted from the end of the Cold War and opening of new markets along with diminished political instability. Really, it was a remarkable time.

Other points:

* Your statement that "the marginal utility of dollar $250,000 to $2 million is the same" is wrong. Just like everything else, dollars suffer from diminishing marginal utility, and there is every reason to think that the millionth dollar earned will generate less utility than the 300,000th (just as I derive greater marginal utilty from the 1500th dollar I make each month, which allows me to pay rent and eat, than the 2000th which allows me to go see a movie).

Furthermore, you make no accounting for the opportunity cost of free time. If I am allowed to keep less of what I make then it stands to reason that the point at which my marginal dollar will be outweighed by the value of my free time will be reached sooner.

* With regard to the sniff test, frankly I find it highly implausible that people will go to lengths to avoid a 5 cent bag tax or a $1 cigarette tax but will not adjust their behavior in the face of thousands of dollars in income tax (or where they anchor their boat). That is astonishingly hard to believe.

It's really quite simple: if you tax something you get less of it. I have yet to encounter anything for which that does not hold true.