The economist.com

Friday 10th, April 2009

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

By Thomas Piketty

In his opening statement, Chris Edwards argues that higher taxes on the rich would lead to a huge fall in productive effort and an enormous destruction of real economic activity. Well, this claim is wrong. It is based upon a misreading of the extensive empirical evidence on labour supply elasticity, and upon an extremely naïve model of how the very top end labour market really operates.

Referring to a study by Feldstein, Chris Edwards argues that "the elasticity of taxable income with respect to income tax rates is about 1, so that cutting the top rate from 40% to 30% would boost taxable income by about 16%". Chris Edwards goes on even further, claiming that every new $1 billion raised in federal income revenue "will destroy about $1.76 billion of activities in the private sector".

There are many problems with these claims. In his 1995 paper based upon the 1986 Tax Reform Act, Feldstein did indeed support the view that the top end elasticity of taxable income was equal or larger than 1. He then used his elasticity estimates to predict that President Clinton's 1993 decision to raise to the top marginal rate (from about 30% to about 40%) would result into a large fall in reported taxable income, and eventually a fall in total tax revenues.(1) The first problem is that this is not at all what happened. If we let aside a short-run shift in the timing of compensation (many bonuses were cashed right before the tax reform), there exists extensive empirical evidence showing that top reported incomes kept rising after 1993 approximately at the same pace as before 1993, and that the long run elasticity response to the 1993 tax reform was not significantly different from 0, and in any case much smaller than 1.(2)

In their authoritative survey on taxable income elasticities, based upon dozens of careful empirical studies, Emmanuel Saez, Joel Slemrod and Seth Gierz conclude: "The most reliable longer-run elasticity estimates range from 0.1 to 0.4, suggesting that the U.S. top marginal rate is far from the top of the Laffer curve".(3) These findings reflect a wide consensus among economists, and they ought to be taken seriously.

Next, and most importantly, available empirical evidence suggests that only a small fraction of these 0.1-0.4 consensus elasticity estimates has something to do with real labour supply and productive effort. In particular, it has long been shown that the bulk of the elasticity response for top incomes comes from income shifting between various tax bases. For instance, lower personal top tax rates might lead to a rise in top taxable incomes reported to the individual income tax, but this rise can be almost entirely offset by a corresponding decline in taxable profits reported to the corporate income tax.(4) Although this has attracted less attention by economists, and is harder to identify econometrically, the rise in top executive compensation could also be offset by a decline in the wage bill going to other workers in the company. In any case, the key point is that most of the-limited in size-behavioural response of top incomes to top tax rates seems to be due not to a real change in economic activity and output, but simply to a re-labelling of income outlays over various tax bases. Using the terminology introduced by Saez and his co-authors in their survey, the behavioural response of top incomes involves substantial tax externalities-which like all externalities have a tremendous impact on welfare and policy analysis.

This is really the critical point. According to the standard textbook model, an increase (or a decline) in the labour income of a given individual should be interpreted as a rise (or a fall) in his or her marginal product, i.e. his or her contribution to total economic output. That is, if Mr Smith's wage rises from $30,000 to $50,000, then it must be that Mr Smith has produced $20,000 of extra economic output. The beauty of the market system is precisely that the increase in Mr Smith's wage should in principle correspond to the creation of new economic value and well-being, and is not obtained at the expense of anybody else (i.e. even with fully selfish economic agents there is no externality on others that is not being internalised by the price system). This textbook model probably provides an (approximately) accurate description of 99% of the labour market. However it is extremely naïve-to say the least-to imagine that it adequately describes the pay determination process at the very top end of the labour market. Assume that the CEO of AIG or GM manages to get an increase in compensation, say a rise from a $5m to a $10m total annual compensation. It is truly heroic to conclude from this observation that his or her contribution to AIG or GM output has increased by $5m, and that the total output of AIG and GM has risen by that much. There is tremendous evidence showing that the invisible hand of the market simply does not work in this very peculiar segment of the labour market, and that top executives will keep setting their own pay to the highest possible levels (with no connection whatsoever with their marginal product, which nobody can properly estimate) as long as they are not prevented to do so. Historical evidence suggests that highly progressive taxation on very high incomes is the most efficient way to achieve this goal.

This brings me to my last point. The main objective of raising marginal tax rates on the rich is not to raise additional tax revenue, but rather to keep top compensation under control and to curb the grabbing hand. In fact, the proposal that I am making - introducing a 80% marginal tax rate on all annual incomes in excess of 1 million euros, leaving the rest of the tax system unchanged-would probably raise limited additional tax revenue. First because it would apply to only a small fraction of the population-less than 0.5%. [This is fortunate: in the current recession context, it would be pretty silly to raise tax on substantial fractions of the population]. Next because the main effect of this 80% marginal rate would probably be to reduce drastically the incentive to take away more than 1 million euros from one's company, so that the number of taxpayers in the 1 million+ euros bracket would probably fall substantially. This is what happened during the 1932-1980 period, and available evidence suggests that this would actually a good thing. I.e. this would not correspond to a fall in real productive efforts and economic output, but rather to a redistribution of income flows. Maybe the right analogy is the following: one should think of taxing the rich pretty much in the same way as taxing pollution activities. In the case of pollution, a number of green tax advocates have argued that such a tax can deliver a so-called "double dividend": it can eradicate pollution, and at the same time raises substantial tax revenue. Unfortunately this is wrong: if they work effectively, green taxes won't raise much revenue-just like taxes on the very rich, to some extent. In other words, the debate that we are having right now about taxing the rich is not a debate about raising aggregate tax revenues or making the government bigger. The question as to whether the government should be bigger or not is a very interesting and complicated issue-and would require a thorough discussion of many different kinds of tax instruments and public spendings. The answer would probably be different for countries like the U.S. and countries like Sweden. As a matter of fact, I happen to be extremely sceptical about the government's ability to properly spend 50% of national income. But this is a completely different debate from the one we are having right now-and this should be the topic of another debate!

(1) See M. Feldstein, "The Effect of Marginal Tax Rates on Taxable Income: A Panel Study of the 1986 Tax Reform Act", Journal of Political Economy 103 (1995).

(2) See A. Goolsbee, "What Happens When You Tax the Rich? Evidence from Executive Compensation", Journal of Political Economy (2000).

(3) See "The Elasticity of Taxable Income with Respect to Marginal Tax Rates: A Critical Review", 2009, forthcoming in the Journal of Economic Literature.

(4) See R.H. Gordon et J. Slemrod, "Are "Real" Responses to Taxes Simply Income Shifting Between Corporate and Personal Tax Bases?", in Does Atlas Shrug? - The Economic Consequences of Taxing the Rich, Harvard University Press, 2000.

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