Tuesday 7th, April 2009

This house believes that the rich should pay higher taxes - Opening statement

By Thomas Piketty

Let me give three reasons why I believe the rich should pay higher taxes. For the sake of concreteness, let us say that we are talking about introducing an 80% marginal tax rate on all annual incomes in excess of 1 million euros, leaving the rest of the tax system unchanged. I believe that such a policy reform could and should be implemented immediately in countries such as the United States, the UK, France or Germany. I do not want to be too dogmatic about the exact numbers: it could be that the right policy should rather involve a 70% marginal rate in excess of 2 million euros, or a 90% marginal rate in excess of 500,000 euros. But you get the idea: we are talking about a major increase in top marginal rates (currently around 40%) applied to very, very high incomes (less than 0.5% of the population).

1. A political reason. If we do not take this kind of policy action, there is a serious risk that citizens will ask for much more damaging, anti-market policies. In the coming months and years, it is going to be increasingly difficult to explain to the citizenry why we must pour billions of taxpayers' dollars into financial institutions and major corporations, while at the same we let top executives keep taking home millions of dollars in net annual income. My work with Emmanuel Saez (Professor of Economics, University of California, Berkeley) has established that top incomes have grown at an unprecedented speed over the past three decades. In the United States, the share of national income going to the top 1% of the population has gone up from less than 9% in the late 1970s to about 23% in 2006, the highest historical level of income concentration ever observed since the creation of the federal income tax of 1913, with the sole exception of 1928 (24%). (1) This represents an income transfer of about 14 points of national income, that is, roughly the total income share going to the bottom 40% of the population. The growing anger about top incomes has already led to a strong political demand for sector-specific policy action on top compensation, in the United States and elsewhere: pay cap in certain sectors and companies, heavy taxes on particular bonuses, etc. Such a piecemeal approach is bound to fail: it can easily be bypassed by designing creative compensation packages, and at the end of the day it creates more economic distortions than an across-the-board tax hike on all top incomes. The growing middle-class anger can also fuel general anti-globalisation resentment, a growing demand for protectionism and the like. Tax progressivity is arguably the least distortive way to redistribute more fairly the gains from globalisation and market competition.

2. An economic reason. The idea that heavy taxes on very top incomes would entail huge economic distortions is purely ideological and is based upon zero empirical evidence. According to textbook models of labour supply, cutting taxes on people making $1m should lead them to work more intensively and more efficiently, so as to increase their marginal product (i.e. their contribution to total output), which by definition is supposed to be equal to their equilibrium pre-tax wage. It is, however, extremely naive to imagine that this standard model provides an adequate description of labour supply and wage determination at the very top end of the labour market. No empirical study has ever been able to show that the rise in executive compensation leads to increases in executive output and productivity. In contrast, extensive empirical studies have long shown that the rise in executive compensation is better explained by a crude skimming model than by efficiency considerations. For instance, it is well known that top compensation rises as much with lucky profits (variations in profits that are solely due to factors outside managerial control, such as exchange rates and world prices) as with general profits, and all the more so in firms with dispersed ownership.(2) To understand what is going on in this very peculiar segment of the labour market, it is important to keep in mind that it is virtually impossible to estimate even approximately the marginal product of top executives in large corporations. For jobs that can be replicated-one additional waiter in a restaurant, one additional worker on a factory line-marginal products are relatively meaningful economic concepts. But for jobs that cannot be replicated-a CFO, a CEO, or for that matter all high-ranking executives-nobody has any idea what their marginal product might be. The invisible hand of the market is of little help here, and it tends to be replaced by the grabbing hand of those who have the power to set their own pay, and who have an obvious incentive to try to convince others that their marginal product is worth several millions of dollars, unless the tax system reduces drastically their incentive to go beyond a certain limit.

3. An historical reason. Some observers might have forgotten, but President Roosevelt did create a 91% marginal rate bracket for annual incomes in excess of $200,000 of his time (approximately $2m in 2009). Between 1932 and 1980, that is, during half a century, the top marginal rate was on average equal to 80.2%.(3) What can we learn from this historical experience? Well, this certainly did not kill American capitalism. Apparently this did not prevent the market economy from functioning and growing; in fact growth rates were pretty high historically. In graduate school, I was taught that the main negative side-effect of these 80-90% top marginal rates was to spur in-kind payments. The story goes as follows: the top executives of the 1950s and 1960s were unable to pay a lot of cash to themselves, so they would pay themselves with fancy cars and restaurants, private jets and big offices; in the 1990s and 2000s, lower tax rates allowed them to get more cash, so they reduced in-kind benefits, and this is much more efficient. I must confess that for a number of years I did teach this story to my own students. I finally realised that there was one simple problem with this story: a complete lack of empirical support. If anything, in-kind benefits are even bigger today than what they were in the 1950s and 1960s. When you can get a lot of cash, why wouldn't you get a private jet as well? In fact, the more I look at the empirical evidence, the more I think that the confiscatory marginal rates applied to the very high incomes of the 1932-80 period were a pretty smart policy. Maybe it's time to have a fresh, non-ideological look at the pros and cons of highly progressive taxation at the very top end.

(1) See T. Piketty and E. Saez, "Income Inequality in the United States, 1913-1998", Quarterly Journal of Economics, 2003. Updated series are available on Emmanuel Saez's web page (table A.3).

(2) See e.g. Bertrand & Mullainhattan, "Are CEOs Rewarded for Luck? The Ones without Principals Are", Quarterly Journal of Economics, 2001.

(3) See e.g.

Thomas Piketty est directeur d'études à l'EHESS et professeur à l'Ecole d'économie de Paris.