A couple of commenters and emailers have asked me to defend my assertion over at TPMCafe that:
At the time, Gore was offering tax deductions or credits for practically anything one might do, from getting born to entering a nursing home. These sorts of tiny lump-sum deductions are generally frowned on by economists; they distort activity, are costly to administer, and unlike marginal rate cuts, provide no positive incentives to increase work.
This is not actually particularly controversial, and the economics is (I think) kind of interesting and important, but at the same time, the explanation is not quite right for the TPMCafe format, so I'll try it here. For anyone who cares, it's below the fold, as it's rather lengthy and a little bit technical. Apologies for those who know all this and find it old hat; this is only for wannabe tax wonks.
One very useful way to think about labor markets is to model consumers as trading off between two things: leisure (L) and consumption (C). This is simple, to be sure, but it yields some powerful insights, so it's a useful framework to have in your package of analytical tools. There is a straight tradeoff between those two things; any consumer who wants to consume more (over their lifetime), must ultimately give up consumption in order to do so.
Now we introduce a second framework to explain how consumers make tradeoffs between rival goods when prices change. Any price change has two effects on consumption:
- The Income Effect: An increase in the price of one of your goods effectively reduces your income; your income now buys less than it did before. Conversely, a fall in the price of one of your goods allows you to buy more with your income, raising your demand for the goods you consume.
- The Substitution Effect: An increase in the price of one of your goods causes you to alter the mix of goods you can consume. Usually, this means that you substitute away from the (now) more expensive good, but in rare cases, known as Giffen goods, price increases can actually cause you to consume more of them.
Economics students often use a little grid to model how price changes play out. So let's say that wages increase. This raises income, but also raises the cost of leisure.
The effect is to unambiguously increase the demand for consumption. But it is not clear what effect it will have on demand for leisure, because we don't know whether the income effect or the substitution effect on leisure is bigger. That's an empirical question to be resolved (she said hopefully) by data analysis. Without an empirical estimate, we don't know whether an increase in wages will cause people to work more, because they want to make more money, or less, because they're suddenly richer and can therefore afford to buy more of that valuable luxury good, free time.
Okay, if you're not bleeding out your ears, or asleep, here's why this matters for tax policy. A change in the marginal income tax rate models exactly like a change in wages, only in the opposite direction. Which is to say, if I raise your taxes, you've effectively just taken a pay cut--as everyone who's ever taken a high-paying new job in New York City can attest. Supply-siders should note that this is one reason that the simple story about cutting taxes increasing peoples' incentives to work and save doesn't always operate as advertised. They might just decide that they no longer need to work as hard to maintain their standard of living.
But of course, there are other ways to cut taxes besides altering the marginal rate. We could also give everyone a flat deduction--$500 off every tax bill, say. And that models rather differently from a marginal tax cut. Unlike a marginal tax cut, a new tax deduction doesn't make leisure more expensive. So people consume a little more stuff, but some of them also decide to consume a little more leisure. Since [Economic Output = Labor Productivity X Labor Supply], GDP is pushed downwards.
The targeted tax cuts of which Clinton/Gore were so fond are bad for another reason: they distort peoples' choices. In general, if an activity isn't a good idea without a small tax deduction, it isn't a good idea with one, either. Finally, they add to the complexity of the tax code, and if there's anything that economists from left to right agree on, it's that the simpler the tax code is, the better it is for everyone.
That's why economists are not fun of the targeted tax deduction, or the deduction in general. If we want to give more money to the middle class, then we should reduce their marginal tax rates, not pepper the tax code with a thousand little deductions. Larry Summers knew this, and agreed with it; it's just politically, that was the only way the Clinton Administration (and prospective Gore Administration) thought it could accomplish various goals.
You wrote: "Unlike a marginal tax cut, a new tax deduction doesn't make leisure more expensive."
Why not? Consider college students who work only a part of the year. When I was in that position, I generally didn't factor in federal and state incoming tax into how much I was making, because I was certain that I would receive all of those back in deductions.
Clinton certainly was the master of the targeted tax deduction, but he and Gore were hardly the only practitioners. I wonder how many deductions in the tax code are targeted toward businesses.
Anyway, for some reason these kinds of targeted deductions are enormously popular, probably because they sound like they're free.
Can I echo Rickm in asking for elaboration on why tax deductions don't make leisure more expensive? I'm thinking in terms of EITC, but maybe tax credits are different?
Anyway, I'd love some elaboration.
Rickm, Josh: the argument is roughly that a revenue-neutral tradeoff of lump-sum tax credits for marginal tax cuts will increase willingness to work. And this is the case because most people actually pay taxes. If your income is low enough that you're paying no tax after the tax credits, then the marginal tax rate (whatever it is) won't affect your consumption/leisure choice. But then, if we cut your marginal tax rate to 0, the same thing happens. And if your income is actually less than your claimable credits, we can always reduce your credits without affecting anything. And finally, if you pay no tax you presumably have a relatively low income; I haven't looked at the numbers, but I'd be surprised if a significant fraction of people have both a choice about how much they work and a zero net income (if you're not paying any taxes because you're poor, presumably you don't have enough money for necessities and therefore want to work more/earn more money anyway).
But consider a worker/family that earns $40,000 a year and has a 10% marginal tax rate, and so pays $4000 a year in taxes. If we give them a 2.5% rate cut, their tax burden goes down to $3000 a year. If we give them a $10000 tax credit, so their net income is $30,000, they also pay only $3000 a year.
But suppose the worker is deciding whether to work overtime to earn $50,000 a year instead. With the marginal cut, the overtime will give him an extra $10,000*(1-.075)=$9,250 a year in income. But the tax credit doesn't affect anything other than that $10,000 we already credited him, so his overtime will only net him an extra $9,000 a year. Thus, the gains from an extra hour of work are relatively less, because the tax credit doesn't affect decisions on the margin. You get the same benefit regardless of how much you work.
Megan's statement assumes you're still on the "paying taxes" part of the curve after the deduction. If a deduction allows you to work more without paying more taxes then it acts like a marginal rate cut, but only in a very narrow band of income. Outside that band, it doesn't change the taxes paid on your marginal hour of wages, so it doesn't make marginal leisure more expensive.
Hy understanding is that you buy leisure time at the price you'd fetch if you were working.
So at my marginal tax rate of say 50%, My wage of $40/hour essentially the $20 that I see.
Every hour I relax instead of working costs me $20. If the marginal rate is 25% then leisure now costs me $30 (in lost income).
I become richer from the hours I've worked at $30/hour instead of $20, but I could also earn more by working more, so I need more justification to *not* work.
Rickm and Josh, deductions and credits make leisure more expensive for people who make just a little more than the cutoff for a particular bracket (in Rickm's case, the cutoff between the 0% bracket and the 10% or 15% bracket), so the deduction or credit will lower your marginal rate by dropping you into a lower bracket.
Megan is simplifying the argument by ignoring this as a rare exception, which it probably is except for very large deductions (like deductions for state taxes and for mortgage interest).
Josh, EITC works differently than most credits. The credit amount for EITC varies depending on how much you earn, so it's actually more like a change in marginal tax rates than an ordinary credit. Ordinary deductions and credits reduce your taxes owed by a fixed amount if you qualify and do not vary depending on your income (well, it's actually a bit more complicated than that because many deductions and credits phase out as income increases, so these raise the effective marginal rate for people in the phase-out range).
Dave, the logic of the topic is that if you become richer you might choose to buy leisure time even at $30/hour even if you didn't buy it at $20 per hour when you were poorer. However, if a "targeted" credit makes you richer you are certainly inclined to buy more leisure than you did when you were poorer, at the same price.
Upper middle class people who earn $80 per hour aren't the ones who are working 60 hours per week in a full time job and a part time one. It's the people who have crummy jobs that pay less than $10 per hour that do that, even though it would only cost them a few dollars per hour to quit the second job.
-dk
I wonder if people actually know what their marginal tax rates are? It's possible that most people wouldn't distinguish that much between a marginal cut and a lump sum rebate, because they don't think marginally, they only think in terms of "taxes high" or "taxes low." In other words, people might react to their average tax rate, even though economic theory predicts they should react to marginal tax rates. But I question whether people know the difference, or can tell you with any accuracy what their marginal rate is.
The problem with this is that anecdotally the leisure effect doesn't seem to occur. I don't know of anyone that gets raises or tax cuts and starts working less.
I think the reason is that raises and tax cuts come in small doses. This gets you into one of those "if you give a poor man a penny" issues. Every 3% raise (or equiv tax cut) doesn't push you from a 2 income to a 1 income family or from a guy who works OT to a guy who doesn't. Even though after 10 years you're 35% richer, since it always came in 3% increments you always think to yourself "Well if we weren't a 1 income family last year, 3% isn't going to do it." The extra 3% just ends up going towards a 3% bigger lifestyle. I mean you can always use a bigger plasma TV...
"... any consumer who wants to consume more (over their lifetime), must ultimately give up consumption in order to do so. ...."
Should the word "leisure" appear in this sentence? perhaps "must ultimately give up leisure"?
If not, there is a subtlety that I'm missing
"any consumer who wants to consume more (over their lifetime), must ultimately give up consumption in order to do so. "
Very Zen. (or faux zen, anyway)
Dick,
I have to disagree with you.
People earning $40 or more an hour are definitely the ones making trade offs between leisure and consumption. They're also working more than 40 hours a week.
you said:
In general, if an activity isn't a good idea without a small tax deduction, it isn't a good idea with one, either
Car to explain why this does not apply to the
capital gains and/or dividend tax.
A capital gains tax is a tax on an activity, investing, which reduces the amount of that activity from what it would have been in a neutral system.
A tax deduction for, say, buying a house, is a subsidy to that activity, which increases the amount of that activity above what it otherwise would have been.
Thus, reducing the captial gains tax reduces a distortion; introducing or increasing a deduction increases distortion.
yes, this is the standard labor econ model, but there is one major assumption in it that violates intuition: namely, that leisure costs only foregone income. but since much leisure involves spending in some form (e.g. taking a vacation, hiring a maid, adding HBO to your cable package, etc.), the model doesn't mirror reality all that well. to some extent, leisure IS consumption, or vice versa. so the income/substitution effects become much less clear and the trade-offs become more murky, which is one reason why this is such a difficult empirical question.
i think the underlying point is still valid in the aggregate, and probably at the margins. but this model doesn't tell the entire story.