Greg Mankiw has pointed to an old post of his on the deadweight loss of taxation that at first blush, sounds confusing:
The normally astute knzn is confused. In a comment on the previous post, he questions one of my assertions:“according to standard theory, the distortionary effect of taxes depends only on the substitution effect”Maybe I need a refresher course in public finance theory, but this doesn’t quite make sense to me. Suppose you have a large income effect and a large substitution effect, and the two are precisely offsetting, so that labor supply is perfectly inelastic. In that case, changes in labor taxation will not affect the quantity of labor supplied or the pre-tax wage. So in what sense can there be said to be a distortion?
Here is the logic:
Case A. No taxes. Andy earns $10 an hour and works 40 hours a week, for income of $400.
Case B. The government now levies a tax at 20 percent to fund a war. There are offsetting income and substitution effects. Andy still works 40 hours, now earning before-tax income of $400 and after-tax income of $320. The government collects $80 to pay for the war.
Now you might say the tax has no distortion, because hours worked remain the same. But you would be wrong. Consider another situation:
Case C. The government funds the war with a lump-sum tax of $80. Andy faces the same income effect as Case B (which makes him work more), but no substitution effect (which previously offset the income effect). Andy works 45 hours, for after-tax income of $370.
Notice that welfare must be higher in Case C than in Case B. How do I know? Because in Case C Andy could have chosen to work 40 hours, earning $320, the same outcome as Case B, but he chose not to. (By contrast, in Case B, if Andy had chosen to work 45 hours, he would have earned income of only$360.) Thus, Andy is better off under the lump-sum tax than under the income tax that produced the same revenue. The difference in welfare between Case C and Case B is the deadweight loss of the income tax.
This is not intuitive to most people. Most people would assume that the deadweight loss of a tax is the reduced work output that results from taxing labor. In this case, it is appropriate to consider both the income effect (if you cut income tax rates across the board, people will tend to work less because they feel richer, and want to consume more of that luxury good, leisure); and the substitution effect (people want to consume less leisure, because the lower marginal tax rates effectively raise their pay, meaning that they now have to sacrifice more consumption of other goods in order to secure an hour's more leisure.) The argument over the effect of marginal rate cuts on output is, in essence, an argument over whether the income effect outweighs the substitution effect--or whether they are both trumped by factors like labor market rigidities.
But1 the issue is not that people have less money and therefore have to choose a different consumption bundle; what causes the deadweight loss is that the market is not clearing as efficiently as it could. There are, at current income levels, utility enhancing deals that would be made under a lump-sum tax that are not being made because of the substitution effect.
1 Edited to make it clearer
In other words, the point is that economists view leisure as a good as well; it's not all about money and dollars. Economists will not say that A must be worse than B, despite a free choice to do B instead of A.
Another illustration of how economics and bean-counting are different.
Okay for analytics, but you brought up the concept of intuition.
People also consume govt policies; if you like the $80 per capita war because you think it provides extra security, freedom, whatever, then that welfare gain may trump any welfare loss from the taxation.
If you dont like the war, its a "total" waste even if an efficient tax is used.
The utility function has to be more human.
You pointed to Mankiw's old post (from 2007) but not the more recent one (here) that brought it back up.
I'm more on "the mysterious knzn's" side, in that (as an admittedly non-economist layman) I'm skeptical (to say the least) of this notion that higher taxes discourage work. Nothing I have ever seen or read has been convincing in this regard. But in his recent post Mankiw makes what is possibly an important concession:
The key phrase for me is "for many high income earners." It is entirely conceivable that there is some level of wealth at which point someone would decide to turn down a doubling of income simply because of the increased taxes. As far as I'm concerned, that point would have to be so far up the income scale (in the multi-millions at least) as to be effectively a non-argument against higher taxation; I have no sympathy for someone who argues against higher taxes because it would discourage someone making $10M a year from trying to make $20M. That also leaves aside my basic objection to the whole theory, which is that if 40 hours of work are required regardless if the pay is $10M or $20M who cares what the taxes are; unless the marginal rate were 100% you would still net more income, and therefore still have an incentive to take the new job.
Another question I would pose to Mankiw, if it wasn't on a nearly year-old post, is how in the world Hypothetical Andy decided in case C to work 5 extra hours to boost his income from $320 to $370, which doesn't even cover his "lost" taxes? That's not rational behavior, unless there is some other factor here that's not laid out in the hypothetical (maybe there is some earlier post that explains that in Case C Andy has a car payment or something). And the $10 difference between Case B and Case C, which I admit is a disincentive, still does not explain the decision to work the 5 extra hours and still does not explain why Andy wouldn't have still worked the hours if he really needed the money even under Case B. It's simply assumed to be true. The disincentive is assumed to be decisive, when in fact it is not (and is not even present at the 40-hour level).
liberalrob,
Since you think pay differences, even marginal ones, have no effect on inducing work, can you explain the reasons behind the common 1.5X rates for overtime? Under your logic, people who are currently working overtime would gladly work overtime anyway, and by increasing their wages the employer is simply throwing money away.
If the increased wages induces increased work, why does that not hold in the general case?
Skullberg ... be careful. liberalrob will just respond that employers *will* "force" people to work overtime in the absense of laws saying they must pay 1.5x.
The point is, he has an emotional love of taxes on the evil high-income people, and so he will rationalize away any criticism of such taxes, however hard that might be. Count on it.
I'm more on "the mysterious knzn's" side, in that (as an admittedly non-economist layman) I'm skeptical (to say the least) of this notion that higher taxes discourage work.
A large swath of working America doesn't work in corporate America, where taxes mysteriously disappear into the machinery just as surely as paychecks come out of it. When you're in small business or independent consulting, I can assure you that one obtains a very acute feel for how much of one's labor turns into taxes, because of the types of paperwork involved and the fact that the taxes are remitted to the IRS in large quarterly and/or annual chunks.
In the process of all this, you get to see first hand how your latest decision to earn more income directly or indirectly tips you beyond the threshold of being able to claim "x", deduct "y", or get pushed into a higher taxable bracket "z". And you bloody well better believe that can discourage work.
I have no sympathy for someone who argues against higher taxes because it would discourage someone making $10M a year from trying to make $20M.
This is not something you should dismiss so flippantly. A handful of "overpaid" CEOs/Athletes/Entertainers aside, most business decisions regarding the difference between $10M/year and $20M/year involve investments or the creation of new business entities, the former of which are risky and the latter of which are risky and require a substantial commitment of time. Investments funds variously provide for things as widely variant as 401(k) accounts and apartment complexes; business opportunities provide useful new goods and services while providing new employment opportunities for those who work therein.
In other words, you really need to stop letting class envy pollute your reasoning.
That also leaves aside my basic objection to the whole theory, which is that if 40 hours of work are required regardless if the pay is $10M or $20M who cares what the taxes are; unless the marginal rate were 100% you would still net more income, and therefore still have an incentive to take the new job.
"40 hours" is a figure of convenience. In general, the higher paying job usually includes longer hours and/or higher stress. If most of the difference will be confiscated by taxes, that is a very strong incentive for the income earner to respond to the opportunity to become a bigger income earner (and the broader economic activity and opportunities that it would generate) with "That's nice, but I was planning to do some skiing this winter."
Here is another actual example (although a little stylized since this happened a long time ago)of the dead weight loss of a progressive tax. My roommate in graduate school was from Holland which had a highly progressive tax rate. After he finished his Ph.d he was offered two jobs. One job was approximately $40K in American money the other paid $60K. After taxes though the take home pay was $25K for the first job and $30K for the second. Since the first job was significantly easier than the second and my friend valued the extra leisure at more than $5K he took the first job. I asked him how much the extra leisure was worth to him and he said $10k. He then told me that if there were no taxes he would have taken the second job. If we assume the pretax salaries reflect the marginal social value of the two jobs, the deadweight loss from the tax is:
the salary at the second job less the salary at the first job + the value of the increased leisure or $60K-$40K-$10K=$10K.
unless the marginal rate were 100% you would still net more income, and therefore still have an incentive to take the new job
Yes, but that incentive may not be big enough to justify putting in the extra effort.
And anyway, the whole talk about $10M vs. $20M is hypocrisy, plain and simple. Under current schedules, taxes do bite noticeably above $150K/yr in family income, maybe even earlier (depends on family size, where you live et. al.) -- not as much because of the bracket as due to phaseout of certain "middle-class" deductions and credits. This is not about "the rich" and never was -- unless of course you redefine the terms to suit your argument.
Skullberg asked:
To which Person replied:
Actually, I think the 1.5x convention (and it is a convention, an arbitrary figure that most likely was simply pulled out of the air) for overtime pay came about BECAUSE of employers historically forcing workers to work overtime for no extra pay. I'm sure the actual history is available somewhere. The 1.5x is a "sweetening of the pot" to try to mollify workers who work extra hours against their will, not to encourage them to work extra hours voluntarily. When an employer mandates overtime, I contend that this disincentive of taxation theory goes completely out the window; the incentive to not get fired must far outweigh the incentive not to pay higher taxes. This theory is expressly about disincentive to voluntarily work extra hours (or more productively, in theory, for the same hours) for extra pay.
Incidentally, I have to say that in places where I worked hourly (and therefore received the 1.5x bump for overtime work), overtime work was expressly FORBIDDEN unless specifically authorized by management. I never had the CHOICE to work extra hours, even if I had wanted to. So where's the incentive to work extra hours in that case, regardless of whether there is taxation or not? This theory has no application in any real-world scenario I am aware of or have experienced, which is why I was struck by Mankiw's qualifying statement about "high income earners."
liberalrob: "It is entirely conceivable that there is some level of wealth at which point someone would decide to turn down a doubling of income simply because of the increased taxes."
Mankiw is only claiming that there are many cases where someone would decline a job paying $X but would accept it if it paid $2X. Whether the difference in pay is caused by higher taxes or a stingier employer is irrelevant.
"And the $10 difference between Case B and Case C, which I admit is a disincentive, still does not explain the decision to work the 5 extra hours"
But that's exactly what "disincentive" means. Andy's situation is that once he's worked 40 hours for $320, he's right on the fence regarding working 5 more hours: he will for $50, but not for $40.
"and still does not explain why Andy wouldn't have still worked the hours if he really needed the money even under Case B"
"Need" is not binary, and the marginal value of money decreases the more you have. When Andy is earning less than $320, he's willing to work an extra hour for $8, so he does. At $320 his marginal utility of money has decreased such that he would demand say $8.25 to work another hour. So in case B he doesn't, and in case C he does.
Two thoughts here:
1. Mankiw's example is clear, but not overly convincing since I remember from my micro theory course how logic quite similar to the reasoning behind why a consumption tax is more efficient also can be used to demonstrate that poor people would be less likely than rich people to buy lottery tickets.
2. I support progressive taxes for social reasons, but from personal experience I strongly agree with both anony-mouse and Max above that they really do have an effect on willingness to take on additional work. I'm hardly rich, but when the incremental income is from non-employment activites (i.e. Schedule C), I've been amazed to find myself at a marginal rate of about 50% because of losing deductions or credits, fed & state income tax, self-emplyment tax, medicare tax. And I do find myself sometimes thinking "screw this."
liberalrob,
I'll see your "I as forbidden story" and counter with a "I was allowed" story from where I used to work. I did contract work through a staffing company in college, while there it was beneficial for the staffing company if I worked overtime (good reputation, increased revenue), good for the client (increased workload) and good for me (increased pay). I was actively encouraged to work as much time as I possibly could, so when I had no other plans I put in 10-12 hour days here and there to supplement my income.
Would I have worked more than 40 for 1x pay, probably somewhat, but the increase in compensation played a large role.
I believe the overtime work is encouraged for IT staffing. So now that I have shown you a real-world scenario where overtime incentives work, do you now accept that economic incentives work?
Also, I experienced a similar issue in retail as well, accounting for work on holidays and holiday seasons, where pay was augmented for the bad slots so people would take them.
squeak:
I can understand that, but those "thresholds of being able to claim or deduct" are EXTERNAL to the tax rate itself, and therefore not relevant to whether tax rates in and of themselves discourage work. I have no doubt that these external influences might conceivably play a part in decisionmaking (though I'm skeptical of how many people would actually think about them prior to making their decision, as opposed to regretting their decision after the fact the next time April 15th rolled around). knzn links to what I consider a common example, where a person making $25k and receiving benefits actually was worse off after taking a job that paid $35k due to lost benefits (as well as higher taxes).
The assertion here is that, taken in isolation, higher tax rates absolutely discourage work. That's what I'm disputing.
What does "class envy" have to do with anything? If you like, let's stipulate that there be no extra time commitment between the $10M and $20M job; both are 40-hour jobs. I'd even be willing to stipulate that no extra WORK be required; the $10M job is just as stressful and demanding as the $20M job. The theory states that simply due to higher taxes, I would have a disincentive to take the $20M job. I say that's baloney, although I admit there is probably some point where you're making all the money you can realistically spend (and in reality there has to be some kind of increased responsibility at the $20M job, in some form or other, that staying at $10M would not require you to assume). If you're going to assert this disincentive effect, you had better list all the qualifiers that it assumes away and account for them. As it stands, it has been asserted as a universal truth of economic theory, so it had better apply in all conceivable situations.
Assuming you go skiing in winter...
Once again, that's back to my point about Mankiw's statement about "high income earners." At some level the combination of the value of leisure time and lifestyle may outweigh the benefits of increased income, and increased taxation may indeed increase that effect; but at lower levels of income where the economic value of lost leisure time doesn't outweigh the incentive to increase income, no such effect exists (or its effect is essentially reduced to nil). That's not acceptable for a theory that makes an absolute assertion about taxation being a decisive disincentive to work. In my opinion.
liberalrob,
How many hours a week do you work?
The assertion here is that, taken in isolation, higher tax rates absolutely discourage work. That's what I'm disputing.
Alright, librob, I'll bite: What in your universe qualifies as a "higher tax rate" and "discourage", since you apparently dismiss the effects of diminishing returns in exchange for increased work as a disincentive to work more or harder?
Imagine you graduate from law school during the first Clinton term. You get a job on Wall Street, not Sherman & Sterling but a good smaller firm, at a salary of $100K/yr. You married your sweetheart who is a pediatric surgeon. She makes $400K/yr which uses up the zero and all the lower tax brackets. The first dollar you earn is taxed at the highest federal (39.6%) , NY State (10.6%) and NYC (3.6%) tax bracket not to mention social security, medicare and medicaid taxes. The 14% state and city hit is deductable from the fed hit so lets just round to 50% effective and marginal tax rate on your income. So your job adds $50K a year to household income over your staying home.
You have a baby, you wife takes calls to cover the hospital and of course lawyers might have to work nights or weekends at any time. So if you both work you need childcare. You are going to at least need a full time person - a couple like this probably needs a live-in. If you pay $500 week your $50K is down to $25k, if you do everything illegal. Add social security, worker's comp, mandatory time and a half for overtime, etc. if legal employees.
As a lawyer you work 2000 hours a year and your firm bills you at $150 hour, grossing $300k, of which $100K goes to Manhattan office rent and your support staff/equipment, $100K goes to your salary and $100K goes to the partners as profit. The state city and federal governments get $50K of your earnings. Your nanny and babysitters get $25K Net spendable gain to your family is about $25K a year (subtract dry cleaning, commuting, restaurant lunches). Most weekdays you get home at 9Pm and don't see your baby awake for the entire week. This weekend a big deal comes into the office and you have to work the entire weekend. If you quit, the $300,000 of legal services you add to the NYC economy will be replaced by you doing diapers and cooking meals. Even one full time nanny job will be lost to the economy.
you don't see any disincentive?
Brian:
It still begs the question, what's he going to do for $50 that he's not willing to do for $40? And the converse as well, what could he do for $50 that he could not do for $40 and still be worth his extra work? 40 bucks is 40 bucks, as they say.
Is this disincentive perhaps a particularly weak disincentive, in that it seems it can be overriden in many various ways? If that's so, why are we wasting so much ink on such a weak force?
40. And I am on salary, so there's no 1.5x for overtime. For that matter, there is no penalty for working less than 40 hours either, just as there is no benefit for working over 40 hours.
liberalrob,
What would it take from your company to get you to work 50 hours a week?
liberalrob,
I don't see you addressing my post.
Also, I've never held a job after college that paid hourly. In all my years on salary, I've never worked a standard 40 hour week. I've had no financial incentive (outside of possibly raise implications) to working more or less hours. I have worked 40+ hours out of a sense of pride in my work, benefit to the company and a general sense of responsibility to the job.
Now, knowing that you view work differently does inform how I read your posts. I will apply this lesson accordingly.
In % of your present salary, that is.
It still begs the question, what's he going to do for $50 that he's not willing to do for $40? And the converse as well, what could he do for $50 that he could not do for $40 and still be worth his extra work? 40 bucks is 40 bucks, as they say.
Only if your leisure time is valueless. At some threshold, the extra income allows you to make purchasing decisions that outweigh the loss in leisure. At $40, Andy says "Screw it, I'll spend the extra five hours a week watching TV in my dump." At $50, Andy decides he finally has enough money to rent a somewhat nicer apartment.
Doug_S
you don't see any disincentive?
To the economy, sure. To you? Not so much. Is it worth chucking that $300k job and overturning your entire life just because of one week of forced overtime?
The theory is not about the economy at large (is it?). The theory is, you as an individual will not take a higher-paying job if taxes are too high.
Do you see the distinction here? If low-tax advocates wanted to argue on the basis of the economy as a whole then fine, that's a different argument. But all the examples and arguments they have been presenting have been in terms of individual effects, not global, macro effects.
Threaten to fire me. (In my previous job, it didn't matter; they forced the entire IT department to work mandatory overtime and still laid off 25% a month later, including yours truly).
There's no reason for my company to want me to work 50 hours a week. If there was, I'm sure we would negotiate compensation. I don't see where this is heading, Yancey.
Is it worth chucking that $300k job and overturning your entire life just because of one week of forced overtime?
As I understood the hypothetical (and was it a hypothetical really?) the question was whether it was worth slaving away in a stressful job for $25K/yr after taxes, especially when your family already has over $200K/yr (50% marginal rate must mean the overall rate is lower, right?). If it were me, I'd answer "HELL NO!".
liberalrob,
That was a hypothetical question. If your company wanted you to work an extra 10 hours a week, what cash compensation would be your minimum asking for that extra ten hours in terms of your present salary?
I'm sorry, my friend, I'm trying to keep up with like 3 different threads here...
I never said all economic incentives don't work. I said I didn't see the economic disincentive of taxation being decisive in whether people choose to work more or harder. By the way if you haven't noticed, that's a concession on my part from my previous position, that there was no such effect whatsoever. Can you give me credit for that, at least?
After a recent discussion with Alan Reynolds at Cato, in which he refused to even acknowledge that the income effect even *exists,* it's refreshing to see such a clear discussion from a libertarian.
It ignores all the other reasons that people work, of course, besides money. But that's a whole other discussion.
One admittedly anecdotal example of the income effect, working in spades, and how that effect actually occurs, in the mind and the spreadsheet of a successful entrepreneur:
http://trueconservative.typepad.com/trueconservative/2005/12/you_deserve_it.html
I'll admit it is a concession, and with that, I hope you can complete the transition and hold the coherent position that incentives work.
"economic disincentive of taxation being decisive in whether people choose to work more or harder"
From a worker's perspective it doesn't matter how the value of the compensation next hour of work is figured (incentive pay, taxation), all that matters is the final value compared to his opportunity cost. The higher the rate the less the net compensation and with a fixed opportunity cost, the marginal worker chooses not to work.
This also doesn't effect simply hourly workers. I know of salary workers who pick up small side jobs to supplement their income on an hourly basis. Because they start at the 25% fed rate, plus state, local and other taxes, the hourly rate is pretty important. Billing out at $20 hour, nets you more like $12 after taxes, and so working 10 hours a week earns you only $120. That may or may not be worth giving up that time with friends or family.
While I do agree that there is some disincentive to work by taxation, that has nothing to do with "time and a half" for overtime.
About 1/3 of a workers compensation is benefits - pension, health insurance, vacation etc. Working overtime generates no additoinal benefits. If they worked for regular pay, they would essentially be getting only 2/3 of their normal compensation. Time and a half makes it consistent.
The 2/3 number is probably a little low, but not very. There is probably some "annoyance pay" due to unpredictability, and some genuine pay for eliminating more valuable leisure time, but that last bit is probably a small fraction of the 50% bonus.
I believe I see the misunderstanding. The claim is not that every or even any particular individual will work less due to higher taxes. The claim is that some individuals will work less due to higher taxes, therefore the economy as whole will not be as large due to a marginal decrease in work.
The examples are micro because it's easier to explain, but any 2-earner household with kids has probably gone through the math: Does the lower paying job return enough after expenses to justify working and taxes certainly factor into that equation. A fair number of households decide the second job isn't worth it and the output from second worker is then lost to the economy. If you change the tax rates - higher or lower - the calculation changes and some households will come to different conclusions about the utility of the second job.
I don't believe that anyone thinks that people will turn down more money for the equivalent effort if you raise their taxes.
Anecdotally, I once quit a moonlighting gig because after taxes it didn't pay well enough to justify the time away from my family.
I can't help but think of the Sopranos. When a guy was given an "enterprise", he was told a number he had to kick up. A casino? 5 grand a week. Chop shop? Ten grand. Anything after that was his. It makes for an interesting form of taxation. The taxes cause no disincentive, but it is arbitrary as all hell and prone to abuse.
What if your overtime rate was .5 the regular rate, and you were able to work overtime or not at your discretion? How much overtime would you be likely to put in?
"If you quit, the $300,000 of legal services you add to the NYC economy will be replaced by you doing diapers and cooking meals. Even one full time nanny job will be lost to the economy."
The first big is that demand outstrips supply in this job and this wouldn't create an opening for somebody else to fill who would otherwise be in a lower paying job.
The second assumption is that somebody who spent all the energy in law school and getting that big job, would give it up even if they take home pay wasn't all that good. He's still very wealthy so it doesn't feel quite like a low paying job. You can do a lot with 25K of fun money.
JordanT,
If you look at that example, the 25K is before work expenses: suits, dry cleaning, transportation, food outside of the home. Let's say that pushed the net income to 15K, that's just over $1000 a month for 40+ hours a week, some weekends and not seeing his family. I know for a fact that I would stay home.
I have some friends whose wife was considering going back to work after her maternity leave for her second kid. They ran the numbers, with her not being the main breadwinner and having a run of the mill office job, her net income was negative. Her income (~35K) was being taxed at the 25% and 28% rates, and after payroll, state and local that translated to a take home of something like 20K or 1700 a month. With childcare, a car payment, prepared foods, gas and clothes, they were spending closer to 1800. So she quit her job.
Skullberg: those who ignore my advice, are condemned to rediscover it.
"Her income (~35K) was being taxed at the 25% and 28% rates, and after payroll, state and local that translated to a take home of something like 20K or 1700 a month."
And what tax rate would have been sufficient for her to head to work? Do we need to drop it to 10%, 5%? Even with 0% taxes she's still only clearing ~900 a month. By her not working does this lessen the workforce by one person, or are there enough unemployed people out there to pick up this slack?
I realize that taxes may cause some people to drop out of the market, but my hypothesis is that current tax rates aren't high enough to cause this to happen in all but a few cases. And in those few cases there are enough workers unemployed that the overall workforce size doesn't change.
SG:
The next logical question on the con side is, "how many is 'some'?" Just how large an effect are we talking here, is it something we can live with in exchange for a more equitable, humane society? If it's just a relative few ultra-rich people for whom this disincentive is large enough that they will actually decide to forego extra productive work, which Mankiw implies with that "high income earners" statement, and their relative contribution to the economy is small (I have no idea, just a feeling based on raw numbers of people in each class), I think we can afford a bit smaller economy in exchange for social benefits to all. If the effect is so huge and overarching that even down to Wal-Mart greeters are significantly discouraged from working voluntary overtime (if there is such a thing, for them), maybe the tax-cutters have a point here. I doubt that is the case.
I would hope not. And that opens up the door on another conversation (possibly offtopic), what is the level of "effort" that justifies huge salaries and how do we (or can we) come up with some sort of guidelines for analysis of that? Just what do executives do that justifies apparently excessive compensation relative to the rest of the labor force? I don't buy that they're all type-A geniuses who work 80-hour weeks and sleep in their offices.
Probably double my current salary, for the permanent imposition on my time. But when I say that, I'm not carefully analyzing the pros and cons in terms of marginal tax brackets and benefits foregone and acquired. I'm thinking how much money in gross I want in exchange for what I consider an adverse working environment. And if I were already at a seven-figure salary, I'd seriously consider telling them to take a hike. Since I'm nowhere near that, quitting is not really an option.
So what's the punchline?
If it's just a relative few ultra-rich people for whom this disincentive is large enough that they will actually decide to forego extra productive work
Keep in mind, the ultra rich are often the most productive in some ways; they have the power to create companies and jobs more or less from thin air if they so choose. So if they decide to just play golf instead, it's a much bigger effect than if the average greeter decides to play golf.
That said, I join your skepticism that the current tax rates are too much of a disincentive for the wealthy. But I would note that at the bottom, the steep marginal rates associated with, for instance, SSI disability income (the fabled 100% marginal rate made flesh) and EITC probably have some impact on the working poor's decision-making.
Out here in the burbs, do you know how many "retired" lawyers I meet at parties? Generally the lawyer is a youngish woman (30-40) with a family and a high earning husband. The husband makes the bigger paycheck and the wife when she worked, worked for 1/4 to 1/3 of her nominal salary because of childcare expenses and progressive taxation of their joint income.
So on the macro scale, the economy invested three years of gradulate level school on her (probably her parents paid for it), she invested three years of youth, all that capital investment got her great skills and a high powered job. then the incentives kicked in and made it foolish for her to work.
Don;t tell me hers was a high powered job so someone else will jump at it. The net to the economy is one highly trained specialist who produces several hundred thousands of dollers of service output withdrawing their output from the economy.
liberalrob,
So, if you worked a 50 hour week at a salary that is double to what you work now, and the tax rate were raised on your top rate, isn't it fair to say that you would be less inclined to keep the job at 50 hours and more inclined to take a similar job that had half the salary but a 40 hour week?
Liberalrob,
Keep in mind that to get into the Top 1% requires an income of $364,657. I think you think the world is divided between guys make $50,000 and guys making $50,000,000. When in reality the range we're really talking about is the $50,000 to $500,000.
How hard do you think it would be for you to make 360k if you really wanted to?
If it's just a relative few ultra-rich people for whom this disincentive is large enough that they will actually decide to forego extra productive work, which Mankiw implies with that "high income earners" statement, and their relative contribution to the economy is small (I have no idea, just a feeling based on raw numbers of people in each class), I think we can afford a bit smaller economy in exchange for social benefits to all.
The top 1% make 21% of the income and pay 40% of all federal income taxes. These are the people who are paying for all of those social programs.
I should clarify that the top 1% is not 1% of the US population; it is the top 1% of taxpayers with an AGI > 0, or about 1.3 million tax returns.
Another interesting way of looking at it is that the top 1% of taxpayers pay the same total amount in taxes as the entire bottom 95%.
I'd have to say no, because I don't think in terms of marginal tax rates. I couldn't even tell you what my tax rate is now without looking it up. I couldn't tell you how much more I'd be paying in taxes if I was making double what I am now, and I couldn't tell you how much marginal tax rates would have to go up before I'd become aware of them impacting my net pay (probably quite substantially). I have never sat down and tried to calculate this stuff. I just fill out my 1040 every year and send it in, and I'm sure that's what I'd do no matter how much I made.
Now, take me out of the real world and how I really operate in life, and put me in a fantasy hypothetical where I do know these things and act on them, and I might very well act as your hypothetical indicates. Part of my objection to this disincentive effect is that I don't believe (or more accurately can't believe) that many people actually do this involved number-crunching to make a totally logical (in the Star Trek sense) analysis of whether to seek and/or accept higher pay. If I'm wrong about that, well, it won't be the first time. But I'm not just going to take your word for it that I'm an exception in being ignorant of my marginal tax rate situation and in not using it to evaluate my career choices.
I would say that it would be utterly impossible. I would have as much chance of that as of winning the lottery; possibly the odds would be even worse.
Chris, are you implying that tax revenues are equivalent to GDP?
What percentage of GDP is produced by the top 1% of wage-earners?
No, I did not mean to say they were the same; as I re-read your comment I see you said relative contribution to the economy not taxes.
Looks like the income of the top 1% is 13% of GDP, if you go with 2005 GDP at 12,434 billion and 1,592 billion in AGI from the top 1%.
That's not a good comparison either, as wages and other income are not a component of GDP. It does help to put it in perspective though. I'm not sure how you would measure "relative contribution to the economy."
Liberalrob:
"I would say that it would be utterly impossible. I would have as much chance of that as of winning the lottery; possibly the odds would be even worse."
If you had majored in something different? Went to grad school for finace or computer science or an MBA? You really think that a smart guy like you would have that much trouble?
I can honestly say from person experience it's not that hard.
liberalrob,
So, you are telling me you have no idea how much you pay in taxes, and if your taxes were raised by, let us say 10%, you wouldn't even notice it?
You are unusual. Ordinary people really do these calculations all the time, as a few above have actually demonstrated. Even you have demonstrated that your leisure time per unit has greater value to you the less of it you have.
Part of my objection to this disincentive effect is that I don't believe (or more accurately can't believe) that many people actually do this involved number-crunching to make a totally logical (in the Star Trek sense) analysis of whether to seek and/or accept higher pay
I can sort of understand this. Part of the problem is that the tax code is so damned complicated. I mentioned earlier that I quit a second job because the after-tax return wasn't worth the time away from my family. The trick was I didn't realize the after-tax return was so low until I did the previous years taxes. So after I had worked for about 9 months, tax time cam and I saw how much I was actually netting from the extra work. I promptly quit.
For grins, pay attention this tax season to how much of the last dollar you earn you actually get to keep. Don't forget payroll, self-employment and state income taxes as applicable. It can be kind of shocking.
Don;t tell me hers was a high powered job so someone else will jump at it. The net to the economy is one highly trained specialist who produces several hundred thousands of dollers of service output withdrawing their output from the economy.
Posted by Doug_S
Someone should tell you, because it is true. The loss to the economy is not her input. It is the degree to which she could have done the work more efficiently than her replacement.
When a $300,000/year lawyer removes herself from the workforce, the potential employer finds someone else who costs marginally more - $300,000+$x. The value of lost effort is $x, not $300,000.
Njorl,
Ahh, but that new employee is no longer working for her employer, so she then has to be replaced at a cost of $300,000+$x+$y, and then that person has to be replaced and so on and so forth. In a theoretically efficient labor market, $x+$y+... = $300,000, as that's what her cost to employ the first person in the chain.
But that's not the loss to the economy either. The loss to the economy is the $300,000 lawyer's output. Which in the case of a lawyer might well be negative...
Yes. I'm smart but I'm also a lousy student. Took me 6 years, two schools and three majors to wind up with a 4-year liberal arts degree and a very Presidential 2.0 GPA. To the extent that luck and connections are a factor in success in finance, that's not an option. CS has a heavy math requirement which is what got me in trouble in the first place. And I don't think I have the right attitude to succeed as an MBA. Wealth is not in the cards for me.
I know the absolute figure, of course (or I will when I fill out the forms). An increase would be noticeable if it reduced my expected refund below a certain amount, but otherwise, no. And as long as I get a refund the next several years (entirely due to mortgage interest deductions) I'm not likely to seriously question any fluctuations.
Don't forget "strange." Am I really so sui generis? (Yes that was gratuitous use of a latin term.) Is it really that common to obsess over tax forms?
liberalrob:
"I'm smart but I'm also a lousy student." Do you think you could have done better if you had tried harder?
Much of the increase in inequality is being driven by an increase in the reward for skills and education. The returns for undergraduate and graduate education keep rising as the market tries to keep people in school.
The average starting salary of a chemical engineering major is nearly 60k. The starting salary for a liberal arts major (psycology, communications, sport management, etc.) is 30k. The market is trying to push people into the harder majors the only way it knows how - by dramatically increasing salaries.
What I hear you say is you want to increase the taxes on the most educated to keep their wages from rising too far above those of the less educated. I really think that is both morally and economically destructive.
The best we can do to encourage people to stay in school and gather as many usefull skills as possible is to ensure that they can reap the rewards of that effort and skill.
Am I really so sui generis?
Now I think you're a lawyer or a judge.
But I personally don't think you're that unusual. Why would you be? We've established already that you aren't the marginal worker, and marginal anything is usually far less common than non-marginal anything. Most people probably do what you do; most of them probably don't even have a realistic choice of increasing their hours/effort for more pay, so the whole discussion is meaningless.
I think the marginal worker is far more likely (as discussed above) somebody married with children (not necessarily a high-powered lawyer--anybody, really), deciding whether or not to reenter the workforce, or else somebody quite wealthy deciding whether to work at all. For such people, unless they derive an overriding psychic benefit from their work, the calculation is probably made quite carefully. Life as a two-working-parent family is a huge pain in the ass, so you want to know that you're getting something out of it.
That is to say, where there are incentives to make the calculation (real option to work/not work and potential benefits and costs to be weighed in calculation) it is made with care; where such incentives are lacking, people (like you) rationally choose increased leisure over a worthless calculation.
So, it seems that the economists might be right about incentives and leisure after all.
Rob Lyman,
I agree that liberalrob is not, at present, a marginal worker. What I found troubling was the assertion that even a marginal worker would not respond to higher marginal tax rates by taking more leisure than he might have previously. I also found problematic the claim that only higher income people would respond this way if anyone did (poor wording by Mankiw, in my opinion).
I was endeavoring to demonstrate that liberalrob would indeed behave like a marginal worker if he were ever a marginal worker- and I was successful.
The "loss" of the 300,000 dollars worth of lawyer's output only appears to be that high because the substitute career of child care is not compensated by the market. The fact that the marginal lawyer is willing to make that trade off should be a signal that the value of child care delivered by high-income, highly educated families is quite high. But it is not a loss to anyone: the family's welfare is the same whether it is measured in the form of cash compensation or non-compensated household work. There is no loss (or "wasted social resources in education").
CLBetley,
The family's welfare is the same as the 25K input, not the 100K salary. The market is still out the 300K. The marginal family is effected if the resultant input is less than the alternative leisure time. If the taxes were less, the resultant income would be more, and the marginal worker may choose to still work.
Heh, I totally missed that at first. Unconscious humor on my part.
Yes, Jmo, it's conceivable I could have done better careerwise had I been a better student. It's somewhat irrelevant, since I didn't and now am where I am, and have to deal with things as they are. If everyone performed to their maximum potential I think that's all we could ask, and liberal philosophy is dedicated to establishing the conditions that permit and encourage that to happen. I hope my personal experience is a data point that sometimes, for whatever combinations of reasons, that does not happen; and we have to ask whether we want to arrange society to punish and marginalize such individuals or to attempt to support and include them. I can't agree that marginalizing the unsuccessful is the path to the Good Society we all want to establish.
Congratulations. Now, Yancey, since I am accepted as not being a marginal worker, I assume that means it is OK to not behave like one? And since I am not sui generis, there are other (perhaps many other) non-marginal workers who would behave just as I do? If so, then I too can claim success in demonstrating that there is a real-world example of the "disincentive of taxation" theory being a weak influence at best in at least some cases. It is not a universal determinant of behavior.
liberalrob,
I missed where anyone claimed that you were a marginal worker.
However, I must wonder how hard you would work if, let us say, you were taxed at 70%.
If everyone performed to their maximum potential I think that's all we could ask, and liberal philosophy is dedicated to establishing the conditions that permit and encourage that to happen.
Success is (usually) the product of hard work. If you reduce the incentives that success provides, people are less likely to work hard (see all the previous discussion about incentives). If someone doesn't work hard, they will not perform to their maximum potential. Therefore, your stated means (high taxes on high earners) does not reach your desired end (everyone performing to their maximum potential).
I see a contradiction here. Where do you disagree with my logic?
Economic models, because they make all sorts of unrealistic simplifying assumptions, are useful for teaching but not for mnuch else-- certainly not for making public policy. In the real world people have a choice perhaps whether to work or not, but very few people have a choice as to how many hours they work: this is set by their employer's fiat.
To Skullberg:
The market doesn't loose $300,000 of output, because the law firm will hire a substitute worker who has a different marginal trade off.
My point is that, from the family's viewpoint, the taxes are exogenously determined. So the choice to work or stay home is based on the relative utility of cash income versus non-compensated child care. In so far as each family is deciding for themselves how to allocate their members' time, the relative "price" they face is net of taxes, the value they have to offer the labor market is gross of taxes.
It is needlessly pejorative to describe the taxes determined in a democratic political system as wasteful of the human capital involved in any of these choices, because that capital is being put to use in either case. It's just that, in one case, the labor market, there is a market price, in the other, there is no cash compensation. So the best way to value the uncompensated child care delivered by the stay at home lawyer is the market value of hiring that lawyer full time, i.e. $300,000.