Sunday, January 6, 2019

Krugman on optimal taxes

As you may have noticed, I try very hard not to get in to the business of rebutting Paul Krugman's various outrages. The article "The economics of soaking the rich" merits an exception. I will ignore the snark, the... distoritions, the ... untruths, the attack by inventing evil motive, the  demonization of anything starting with the letter R, and focus on the central economic points.

Paul correctly cites recent work by Diamond and Saez, estimating the optimal top marginal tax rate at 70%, and Christina Romer's concurring opinion.

The howlers are well epitomized by

"Why do Republicans adhere to a tax theory that has no support from nonpartisan economists and is refuted by all available data? Well, ask who benefits from low taxes on the rich, and it’s obvious.

And because the party’s coffers demand adherence to nonsense economics, the party prefers “economists” who are obvious frauds and can’t even fake their numbers effectively."

1) 70% is not carved in stone.

Diamond and Saez made a big splash precisely because their estimates were so novel and so much higher than the prevailing consensus. For example, Greg Mankiw, also a previous CEA chair, and not a fraud, writing the excellent "Optimal Taxation in Theory and Practice" in the Journal of Economic Perspectives, a nonpartisan (or left-leaning) academic journal, not a fraud, with with Matthew Weinzierl and Danny Yagan, writes
A well-known early result of the Mirrlees (1971) model is the optimality of a zero top marginal tax rate. ...
All this leaves the policy advisor in an uncomfortable position. Early work, following Mirrlees (1971), assumed a shape for the ability distribution, a social welfare function, an individual utility function, and a pattern of labor supply elasticities that yielded clear and surprising results— declining marginal tax rates at the top of the income distribution. Some recent work has yielded dramatically different results more consistent with existing policy, but many of the key assumptions are open to debate.
Lesson 3: A Flat Tax, with a Universal Lump-Sum Transfer, Could Be Close to Optimal 
The claim that the optimal marginal tax schedule is generally flat has been challenged often in the nearly four decades since Mirrlees (1971). Most prominently, Saez (2001) finds optimal tax rates that increase steadily from incomes around $50,000 to $200,000. Of course, the optimal tax schedule is sensitive to assumptions about the inputs discussed in the previous lesson: the shape of the distribution of abilities, the social welfare function, and labor supply elasticities. None of these three components of the problem is easily pinned down. 
You get the picture, the optimal top tax rate is in fact a highly contentious number, depending on many assumptions, all very hard to measure or even to define really.

As Mankiw et al point out, the position "let's implement textbook optimal taxation theory" might be a bit uncomfortable for Krugman's position that all things that start with D are holy.
Lesson 6: Only Final Goods Ought to be Taxed, and Typically They Ought to be Taxed Uniformly
Lesson 7: Capital Income Ought To Be Untaxed, At Least in Expectation
There is a lot of controversy on these too -- the best way to get an AER publication is to disagree with orthodoxy, but they are still the rough orthodoxy, and there are sensible non-evil people who agree with them.

2) Even in Diamond, Saez, et Al, 70% is the total tax, not the federal income tax, and it is the marginal rate not the average rate.  (Though not always as you'll see in a minute)

We have to add up every wedge between one dollar of extra revenue you create for your employer, and the value of what you receive in turn. That includes the  federal income tax, plus state and local income taxes,  property taxes, excise taxes, estate taxes, and so forth. We have to include sales taxes, personal property taxes, payroll taxes on employees you might hire. We have to include your share of corporate and business taxes (corporations raise prices to pay their taxes, so you're paying in the end). It's a marginal rate -- we have to include phaseouts of tax benefits, and loss of income-related subsidies.

Greg Mankiw calculated his marginal tax rate at over 90% (Sorry, I can't find the link anymore). He thought about, what if he takes a consulting job, pays all tax on it, saves it, paying taxes on dividends and intrerest, gives it to his kids, paying estate taxes, and they spend it. Even greg forgot about sales taxes and property taxes (if they buy a house) in this calculation. In California, where I live, the top rate is at least 42% federal + 13.2% state (not deductible anymore)  + about 10% sales tax + about 6% property tax (1% of house value per year, house = 5 times income) +  .. it goes on like this.

Watch what you wish for. A 70% all in marginal rate might well be a tax cut for many households. I once semi-humorously proposed an alternative maximum tax.

Krugman and company are proposing a 70% top federal rate on top of all the others, which is... a bit deceptive relative to the 70% total marginal tax rate even in his cherry-picked sources.

3) Disincentives. Krugman correctly points out the central tradeoff.
So why not tax them at 100 percent? The answer is that this would eliminate any incentive to do whatever it is they do to earn that much money, which would hurt the economy. 
But then Krugman, and those he cites, take an extremely narrow view of this disincentive effect.

By and large the "optimal redistribution" theory considers only the static question, how many hours will you work.
 If a rich man works an extra hour, adding $1000 to the economy, but gets paid $1000 for his efforts, ...
 And, correctly, I think, this literature by and large agrees with the labor supply literature that once people have found jobs and careers, they tend to work about 40 hours a week or so even at pretty high tax rates. We can argue about that, but I think it's more productive to look at all the margins that are ignored here.

The big margin for economic growth is peoples human capital decisions -- the decision to go to school, to take hard courses (computer programming) rather than softer more pleasant ones, the decisions to start businesses and invest enormous time when young developing them. The optimal redistribution literature just ignores all of this. And, like the decision to relocate, it depends on the total tax bite, not just the marginal tax bite. How much will I earn, after all taxes -- what lifestyle will I lead -- if I go to med school, or just stay where I am? High tax countries do not immediately see people staying home from work. But they do not see vibrant business formation and human capital investment. (Chad Jones has a great new paper on this.)

The other margin is avoidance. Throwing around high statutory tax rates in the 1950s as if anyone actually paid them is past disingenuous at this point, as often as the opposite has been pointed out. (Diamond and Saez engaged at least recognized that nobody paid 90%, but engage in a subtle .. sleight of hand. They assume that all corporate taxes were paid by wealthy people in the 1950s -- the one and only burden or indirect calculation in the paper, and contrary to the usual assumption that capital supply curves are flatter than labor or product demand.)

The one thing we should learn from the New York Times and others' probes in to Trump Tax Land is just how far very wealthy people will go to avoid paying taxes. Especially estate taxes -- there is nothing like the government coming for nearly half your wealth to concentrate the mind. I venture that we would have gotten a lot more out of the Trump family with a 20% VAT and no income tax or estate tax!

A 70% or 80% marginal federal income tax would be first and foremost a boon for tax lawyers and accountants. If one were in the mood to match Krugman's attacks of which party has which dark motives to serve which evil interest, the direction would be easy.

Moreover, Krugman gets the benefit of labor to society wrong in an astonishing econ 1 way
If a rich man [or woman, Paul, please!] works an extra hour, adding $1000 to the economy, but gets paid $1000 for his efforts, the combined income of everyone else doesn’t change, does it? Ah, but it does — because he pays taxes on that extra $1000. So the social benefit from getting high-income individuals to work a bit harder is the tax revenue generated by that extra effort — and conversely the cost of their working less is the reduction in the taxes they pay.
If you are paid your marginal product, as you are in a competitive market, then you are paid how much revenue your efforts add to your employer's bottom line. But society benefits by the consumer surplus, the area under the demand curve, and loses that consumer surplus when taxes put a wedge between your effort and your wage. When Steve Jobs worked hard and sold us all Iphones, he made a ton of money, and apple made a huge profit. But we all benefitted by far more than we paid Apple for the phones.

No, the world is not a static, zero-sum game.

I should add though, that economics really doesn't care how much taxes you, or "the rich" pay. Economics cares about the marginal rate, how much you pay on the extra dollar. There is not much of an economic case, really, for low taxes on the rich, or anyone else, so long as taxes do not distort economic decisions. That's the case for a very broad base -- and a low rate. Krugman et al are beyond misleading if they characterize the case for low taxes as handouts for the rich. No, the case is incentives for the rich -- and everyone else. (Incentives are particularly bad at the low end, where you lose a dollar of benefits for every dollar of earnings.)

4) Garbage in, garbage out.

Every result in economic theory starts from assumptions and derives conclusions. This one is the same. Before we get to the distribution of talent, the accumulation of human capital, and the rest, this whole business starts with the presumption that the US Federal Government is a benevolent dictator, whose job it is to take from Peter to give to Paul -- to maximize the sum of everyone's utility, and yes making intrapersonal comparisons to do it -- constrained only by Peter's willingness to work if faced with a steep tax rate.

If you don't buy that basic assumption, along with all the others along the way, you don't buy the result. If, in particular, you look at the world circa 1850, or even in Krugman's cherished 1950, and you look at how amazingly better off we all are today, and you conclude that the government's job is to foster economic growth as fast as possible, then all bets are off.

No, the world is not a static, zero-sum game, in which we fleece the rich one just enough to keep him playing.

I think it's time to reactivate my no-Krugman new year's pledge.


  1. Marginal tax rates...yes. But...I managed a Hedge fund in NYC in the late 80's. I calculated my marginal tax rate then at nearly 80%. City state and federal taxes were over 50% the remaining 30% included sales tax, payroll tax. etc. etc.etc. I even calculated the PV of my estimated estate taxes just for the privilege of expiring. Recently, a hedge fund offered me employment at low seven figures. I respectfully declined as the stress of working for 20 cents on the buck was an enormous incentive to keep my human capital out of the market.

    1. Sadly, there are other marginals you may have not included -- for example those related to means-tested government (higher Medicare premiums, e.g) and private programs (college financial aid, e.g.).

    2. Are you hiring, David?

  2. Is there an effective response to/critique of Krugman's point that there's no real correlation between low marginal tax rates and economic growth? I had always assumed the opposite to be true. Are free-market types completely off base here?

    1. As implemented in developed economies since WWII, there is no good empirical evidence for marginal tax rates moving GDP growth rates one way or the other.

      Indeed, some of Cochrane's points above suggest that there ought to be such a link, but really deserve rebuttal. The suggestion that high average tax rates damage allocation of human capital doesn't entirely hold up. Cochrane speculates:

      "How much will I earn, after all taxes -- what lifestyle will I lead -- if I go to med school, or just stay where I am? High tax countries"

      Well, there are no shortage of applicants for medical school in any developed country. The number of students enrolling and graduating is largely determined by institutional capacity. By World Bank data, in 2014 the US had 2.6 physicians per 1,000 population, compared with 2.8 in the UK, 3.2 in France, 3.8 in Spain, 4.1 in Germany and 4.2 in Sweden.

      Numbers of students studying STEM subjects don't paint the United States in a particularly strong light viz-a-viz higher tax European countries either.

      Perhaps those were bad examples, and the case can still be made that low-tax America does a better job of allocating human capital to high-productivity high-growth businesses and new capital ventures. Perhaps (it's not clear cut), and perhaps differing tax schedules are major factor in differing outcomes. The argument, however, is far more tenuous than John suggests above.

    2. The fact that _pre-tax_ wage inequality is much lower in Europe is consistent with human capital investment being distorted by progressive taxation, in a quantitatively major way (as argued by Guvenen and coauthors here: The fact that Germany has more doctors is not a useful statistic since they make a lot less than their US counterparts. And the fact that more high-skilled job candidates (e.g. PhD students) from Europe try to get jobs in the US than vice versa speaks for itself (although, of course, taxes are not the only relevant margin here).
      GDP growth

    3. MD's are probably a poor example because the licensing of MD's is absurdly restrictive in the USA.

  3. Oh man, here we go again. Taxes really get people going.

    Do we get an honorable mention for Ramsey Taxes and such, too? Ha. What about marginal deadweight loss, hmm? Bust out the graph paper and equations. Welfare analysis. Fun times.

    Paretto improvements and Paretto Efficiencies would probably be only marginally (ha ha) useful. It all starts with the setup and assumptions as Dr. Cochrane states.

    Did you mean D to stand for Distortions?

    As a side note, the US Government used to pay for its operations via tariffs. What was the year income tax came into existence? 1913 or so, yes? (Somewhat fuzzy on the exact year.)


  4. I couldn't figure out hohow Krugman waved his hands and said that the markets weren't competitive and so a lot of those high incomes are likely monopoly rents. It's a small group fo people who make incomes around $10 mil. And we know what who they are: the top of the banking, law, professional services food chains, VCs, football coaches, some CEOs, entertainers, athletes. Effective rent-seeking is done by large organizations. I don't really see how you tell a story of that flowing to incomes for the occupations in question. Whatever return there is to rent-seeking you could allocate just as well to the worker on the factory floor.

    1. In 2016 16,000 filed returns with 10M+ in taxable income. Even if you doubled the amount paid in taxes for that group (conveniently assuming everything is static, no taxes would be avoided, and that would work), it would bring in an extra 120B. Not even close to solving our economic woes, or paying for huge new social programs.

  5. John - in your post, you added tax rates like this:

    "In California, where I live, the top rate is at least 42% federal + 13.2% state (not deductible anymore) + about 10% sales tax + about 6% property tax (1% of house value per year, house = 5 times income) + .. it goes on like this."

    Let me point out two corrections.

    First, the 10% sales tax is not on all income, nor even all spending. Therefore, you cannot add it linearly with the other rates.

    (E.g., if your income tax is 50%, then the 10% sales tax will result in only a burden that's 5% of income. And if only 80% of your spending is on taxed goods, then really it's only 4% of income, not 5% of income. Rent is a huge expense, and one where we don't pay sales tax. Groceries and food to-go are for the most part not taxed either in CA.)

    Second, I'm not sure I follow your point about property tax. (a) Your property taxes are the same for different levels of income, until the point at which you buy a bigger house. So should property tax really add in to our calculation of whether we're already close to the 70% marginal rate? (b) If you are paying property taxes on one owner-occupied house, then you are also saving taxes on the imputed income that would arise from charging yourself rent.

    Anyway, thanks for making me think.

    1. I had the same thoughts as a California resident. Thanks for typing them out and saving me the trouble :)

      All I will add is that deductions are also missing. (Yes of course state income tax is no longer deductible—nor is property tax.) But plenty of other deductions are out there.

  6. John -- I think this is that Mankiw piece you couldn't track down.

  7. Once upon a time I thought that tax rates should be set to optimize economic growth. I have changed my opinion.

    In the past generation the richest people in the United States, such as Mr. Cochrane's neighbors in Silicon Valley have become hard core acolytes of a political party that fetishizes the current tax system and wants much higher rates. E.g. Krugman.

    I think we should accommodate them. I would like to raise the marginal rate for the "1%" (>$425,000) to 50%. We need to raise Social Security and Medicare taxes from their current 15.3% total to 20% and remove the cap on the amount of wages subject to OASDI tax.

    In the spirit of charity, I would remove some of the nastier little gotchas from the system, such as alt-min and the $1,000,000 cap on wages. Why cap wages when the government gets 70% of them? Perhaps 80% when you count state and local taxes.

    I understand that my idea is completely contrary to economic wisdom. But, Given the current configuration of political forces in this country, an economically optimal system is just plain impossible. The only way to get the political conversation to move forward is to give the left what it wants.

    "Example is the school of mankind, and they will learn at no other."
    Edmund Burke

    H.L. Mencken once said that: "Democracy is the theory that the common people know what they want, and deserve to get it good and hard."

  8. The US income tax system has become too complicated and unenforceable. Just ponder adjusted gross income or the ability to offshore income. We have to admire Mitt Romney for actually releasing his tax forms, but he showed an average tax rate of about 10%.

    I would prefer we switch to a system of property taxes, pollution taxes, sales taxes, and import tariffs, all relatively enforceable. And a much much smaller federal government.

    And surely we can figure out a way to eliminate payroll taxes on the first $20,000 or so of wages. Why punish those who work and employ?

  9. Here is the Mankiw link:

    "once the entire tax system is taken into account, my family’s marginal tax rate is about 90 percent. Is it any wonder that I turn down most of the money-making opportunities I am offered?"

  10. I used to like Krugman's articles but I agree this one is particularly disingenuous. I was shocked to read his "zero sum" argument.

    There's so much wrong with it I am even beginning to wonder if he even wrote this article himself - is it conceivable that he was too busy and had some junior person write it for him instead?

    I particularly appreciate your point that it is not about "hours worked". Everyone obsesses about incentivising people to work "harder" - and miss the point. It is that *risk taking* has to be rewarded. A person isn't going to quit his job and try founding a startup unless his profit after tax is significantly higher.

    The same goes for corporation tax. Why would investors risk billions in R&D if they get almost the same returns after tax? It wouldn't be rational.

    Finally - the structure of the global economy is so different than the 50s - much more globalised with much freer movement of people and capital. I would never assume that some policy that coincided with good growth then is therefore the right policy to pursue now.

    1. John Cochrane makes the bogus claim, not Krugman: "No, the world is not a static, zero-sum game."

      Economies are zero sum!

      Increasing costs are the only way to increase incomes, profits, GDP.

      I can't sell you something for $100 while you incur a cost of $50.

      Free lunch economics argued that cutting taxes and government spending will increase wealth, gdp, worker incomes, etc based on the static benefit of government spending continuing after taxes and government spending are cut.

      When an economist proves Social Security beneficiaries cash their benefit into $20s and then burn the cash 98% of the time will I believe "cutting entitlements" in a meaningful way won't crash the economy.

      Why would cutting Social Security taxes and benefits in half, ie, eliminate the employer tax, result in employers increasing the number of over age 65 or disable worker payroll costs by 7% new hires? Sales will not increase, so worker productivity would need to fall 7%. Economies are zero sum. Cut income to consumers, consumption spending must be cut.


      Zero sum.

      Economists can not escape nature where zero sum is the law.

  11. "to take hard courses (computer programming) "
    Rofl. Programming computers really isn't that hard. My grades in computer science courses were much higher than, say, my grades in Russian History despite my spending more time on the latter.

    1. Exactly. I'm a professional software engineer in Silicon Valley, but also a history PhD with a focus on economic history. In my assessment, the disciplines from easiest to hardest rank this way: computer science, economics, ... [big gap] ... history. At least that's how I perceived it as a student who took course work pretty seriously. (If my goal had been to skate by with minimum effort, perhaps things would have looked different.)

      Especially if your goals are merely career-oriented, computer programming is damn simple for anyone who is at home with basic logic and ordinary algebra.

  12. If you are relying on Mankiw to rebut Krugman and Saez, shouldn't you at least mention lessons 1, 4, and 5? 1: Optimal marginal rates depend on distribution of ability; 4: The optimal extent of redistribution rises with wage inequality, and 5: Taxes should depend on personal characteristics as well as income. If the proposition is that optimal marginal rates could be zero, but then you totally ignore the same paper saying in 3 of 8 lessons that the characteristics of the economy and wage earners are also critical, what's the point? I can argue they should be 90% because of inequality and ignore the other factors myself - now we're on equal footing.

  13. As I recall, during the debate over the corporate tax cut, various people got trotted out as "economists" to predict that (1) most of the benefit of the tax cut would go to increased worker pay checks and (2) that investors would invest so much more money that growth would permanently go up by ~2% per year forever. That those two positions were inconsistent did not seem to trouble Republican politicians at all. On top of that, some people were predicting that net tax collections would go up. ¯\_(ツ)_/¯

    It does seem that this is an area where less wishful thinking and ideology and more attention to the reasonableness of the assumptions and models would be a public service. Start with a clear statement of what is being "optimized."

    1. Why decreasing the IRS contribution to labor costs from over 50% to less that 21% increases the incentives to pay workers more, and pay more workers, makes sense only to masochist economists.

      "I want to have no reductions in taxes for paying workers! Only when paying workers cuts my profits dollar for dollar will greed drive me to hire workers, and reduce my profits to zero!"

  14. My question is what would someone like Buffet, Bloomberg or Bezos pay? As their "Wealth Appreciation" would still increase by billions a year that isn't taxed for decades. Or a wealthy person buys a work of art for a million, wait 20 years and it is worth $200 Million....I paid no taxes and it produced no jobs and really is just a tax dodge for the select group. Don't even get me talking about "carried interest". My believe is we need to tax wealth appreciation as the actual wealthy don't necessarily take significant yearly income...thereby they avoid paying meaningful taxes versus the wage slaves. A very unfair playing field....which is producing and enforcing wealth inequality. I think the people who create things....should be rewarded...but at this moment....the playing field is very LOPSIDED when it comes to paying Taxes.

    If my wealth is via income I pay taxes each year, but if my wealth is owning stuff I may defer paying taxes possibly forever with a good tax estate planning staff! The talk of changing tax rates is just rearranging deck chairs.

    1. I earn wages from my employer and pay tax on that. I take those already taxed wages and buy a painting by an obscure artist. The artist becomes famous and the painting grows in value. One, I have already paid taxes once on the cash - the second round of taxation is different. Two, what if I am illiquid? I now have to sell my painting to pay a tax bill? Nobody even knows what the painting is worth until it is actually sold again. So we are just estimating the value of unsold art and forcing taxation based on that estimate? Great example.

    2. You make a good argument for exempting art, and other assets whose value is extremely subjective, from such a scheme. But there are plenty of other assets whose value can be determined and/or predicted within a fairly narrow range that can be taxed on the minimum expected value. And there are already mechanisms in the law for claiming credits in later years if the value changes unexpectedly.

      But the principle is sound. Progressive taxation recognizes that the first dollars one earns are less disposable than the last ones, and therefore seeks to equalize the burden among all taxpayers.
      If I have no money in the bank and I somehow earn my first million$ this year, should I pay tax on that at the same rate as Bill Gates's 1500th million$ of increase in his net worth?

  15. First observation: Did Cochrane supply empirical data to refute the hypothesis that marginal income tax rates have no effect on growth or even a positive effect on growth? No.

    Second observation: Trump Inc. not only attempted to avoid taxes but successfully avoided paying contractors and suppliers at one time (perhaps before the reputation effects caught up to him), a common enough phenomena elsewhere in the US economy. That is not a problem as long as one assumes that litigation costs do not face budget constraints.

    Perhaps a general culture of lawlessness is why the US should be very careful about taxes in general. Moreover, the USA currently has a President who appears to view freemarket capitalism as a zero-sum game and presumably that view is also held by close to 40% of voting adult Americans.

    Third observation: There was no mention of the Nordic social democracies' high marginal tax rates and tremendous socio-economic accomplishments.

    Perhaps pundits who oppose high marginal tax rates in North America should simply admit that relatively poor social cohesion does not allow for high marginal tax rates.

    A parallel argument can be made for choosing authoritarian regimes. Pluralistic democracy is clearly the best choice but sometimes the conditions for effective peaceful cooperation among key political constituencies does not exist. In that case, an authoritarian regime appears preferable to the alternative of civil war.

    American-sponsored attempts at top-down violent regime change have so far yielded poor results (unless one discounts the value of citizen lives to zero). There might be benefits for US security from constantly displaying its military might but that is another discussion.

    So, yes, in conclusion, Americans do not always play well together and due to the lack of sufficient social cohesion, high marginal tax rates should be avoided as the costs of enforcement and economic disincentives on the margin outweigh any expected collective benefits.

    -Erik Poole

  16. We should all admire John’s pledge to abstain from Krugman bashing and we should forgive him when, as will inevitably happen, he falls off the wagon. Krugman bashing is much like alcohol. The opportunities are everywhere and the pleasures intense. But when one wakes up the next day, the problems are still there.

    If you don’t fully appreciate how much PK allows ideology to drive reason, consider this.

    In this 2011 blog Krugman celebrates the Diamond and Saez JEP article (before, as he admits, he finished reading it) If you read it, you will note he makes the same silly mistake as he made in his NYTimes column: weirdly conflating marginal and total value. You’ll also note the recent column, like the 2011 blog, ignores the mainstream public finance research that disagrees with the Diamond-Saez analysis. John is not the first to point this out. Mankiw’s 2012 piece and this Scott Sumner blog make the same points We shouldn’t expect Krugman to summarize a complex, unsettled literature in a column but perhaps he could use the words spent attacking other’s motives to acknowledge those other views.

    (BTW, we shouldn’t allow Krugmania to tarnish Diamond and Saez. Their stuff doesn’t settle anything—and I don’t think they claim it does—but it provides a helpful point of view. I don't teach public finance but if I did, I'm sure that article would be on the reading list.)

  17. The work by Diamon and Saez that Krugman and John are referring to is the paper called "The Case for a Progressive Tax: From Basic Research to Policy Recommendations." At least this is what Krugman links to in his article. Based on this, I think there are a couple of additional points that should be brought up that I did not see John or Paul address.

    First, the 70% marginal rate from Diamond and Saez is based on an income tax with very few deductions, exemptions and other means of engaging in tax avoidance. When Diamond and Saez adjust their estimation process to include tax avoidance responses in the current tax structure, the revenue maximizing tax rate falls from 80% to 54%. In addition, the maximizing rate decreases to 48% when only state and payroll tax rates are included. This is a significant issue, as a 70% tax rate with our current tax structure would be far from a revenue maximization point according to the Diamond and Saez paper Krugman refers to.

    This also becomes important when looking at Krugman's graph of the top rate and growth rates. Yes, the top rate was 90% in the 1950's, but very little income was actually taxed at this rate. Because of this, the actual impact to the incentive to work, save and invest was likely relatively small even with the high rate.

    Second, the Diamond and Saez optimal tax rate estimates are generated using the assumption that the taxpayers paying the top rate generate no additional social value of consumption for each additional dollar of income. I am not sure how reasonable this assumption is and any positive amount will reduce the optimal tax rate.

  18. The incentive effects from higher taxation are unclear, and it's funny to see folks argue for opposing effects for rich and poor. To wit:
    If you give the poor more money (e.g. via welfare), they will be incentivized to work less because they will have all they need.
    If you give the rich more money (e.g. by lowering taxes), they will be incentivized to work more in order to get more.
    What if this is backwards? Maybe taxing the rich will cause them to work more since it will take more effort to get true "fuck you" money and be able to retire. On the other hand, maybe giving the poor more money will cause them to work more because it will make the good life within reach because they can now make it to some minimal threshold of quality of life - e.g. if a nice place to live costs 1000 per month and I can only make 500, then giving me 500 in welfare will actually incentivize me to work.
    I'm not sure which of these effects is real, but I find it curious that psychologically we posit opposing effects for these two groups such that economists tell us to give less money to the poor and all the rich to keep more....

    1. It should be an over riding principal of social welfare policy design that the highest effective marginal "tax" rate from the withdrawal of benefits (through means testing etc) is no higher than the top marginal tax rate on earned income. :-)

      Personally I expect that the maximum should be about 50%.

    2. I have always thought the Republicans' views of incentives to be "bass-ackwards" as well.

    3. I like 50%, on the principle that beyond that, the government is taking home more than you are, and that feels unfair.

    4. Welfare given to poor people is given to them either regardless of how much they work or given precisely because they *aren't* working. Money "given" to rich people in the form of tax cuts is "given" to them for working.

      What happens when you pay someone not to work? Probably they'll work less. What happens when you pay someone to work more? They'll probably work more. So no, there is nothing funny about the conclusion you're mocking at all. It's basic logic.

  19. Ideally, corporates and schedule C of individual should be even lower than current reduction regime. Individual, highest bracket, should go up, but not to the extent that Krugmeister or that kid might suggest. A robust and adequately funded IRS should police games involving playing with the difference of the two income tax systems (biz v person).

  20. Free lunch economics calls for low tax rates, because tax dodges like paying workers, training workers, protecting workers, must cost capitalists dearly.

    The outrage of paying workers $100 and having the IRS pay $50 and States kick in another $5 to $10 in taxes not paid results in managers paying workers too much. These workers then buy too much, creating too much demand, then too much investment which is then subsidized by the IRS with investment tax dodges of $50-60 per $100 paid to workers building capital. Too much demand for workers drives up wages, and consumption, and investment.


    Instead cut tax rates as low as possible so capitalist suffer $79 in lost profits for every $100 paid to workers. But only if government subsidizes workers with food stamp, health care housing, plus exempts businesses from paying taxes that fund needed roads, and schools that train workers so employers no longer need to train, and pay to retain trained workers.

    To paraphrase Milton Friedman's columns circa 1970 calling for job killing tax cuts to cut excessive consumption driving economic growth....

  21. ' (Incentives are particularly bad at the low end, where you lose a dollar of benefits for every dollar of earnings.) '

    Ha! Low income people often pay marginal rates OVER 100% Especially with regards to health benefits foregone. Low earners can't even do their income taxes by themselves anymore. They have to pay HR Block and competitors to run the numbers for a cost, often, of several hundred dollars per return.

  22. One thing I didn’t understand about the original article was his basing arguments off of utility theory. I am not a trained economist so if someone can clarify. My understanding was that prospect theory proved that utility theory is just a theory. The additional $1,000 on a $1m salary doesn’t necessarily have a diminished utility if it is in the context of a loss. I can remember the exact chapter in thinking fast and slow but DK points it out quite clearly in an example of two twins who accept jobs on varied ends of the utility curve.

  23. I've never understood the orthodoxy of no taxation of capital income.

    In the real world there is no clear distinction between capital income and labor income. The owner-operator of a small business (or hedge fund) can pay himself a salary and call it labor income, or a dividend and call it return of capital.

    If a hot-dog stand earns $100, who is to say how much is the return on the capital equipment, and how much is the return on the labor?

    You have to do econometrics, how much the labor is worth on the open market, and what the expected return on the investment in the hot-dog stand should be. And the tax laws don't use econometrics.

    And you can get weird answers that are highly dependent on assumptions, i.e. Uber drivers sometimes do OK and the economics sort of tie out, and other times they work long and weird hours and get paid barely enough to cover direct costs and depreciation and risk, and you have to assume some compensating differential of being their own boss or something.

    Or you get Mitt Romney getting paid in equity that was supposedly worth less than the IRA contribution limit, that later 'appreciates' so it's worth 9 figures.

    Anyway, Krugman notwithstanding, let's have a reasonable progressive income tax with a top rate in the area of 15-30% that's applicable to all income over some threshold with none of this nonsense where Kushner can pay 0 tax and Bezos can defer forever, and a progressive VAT.

  24. Impossible to define an optimum tax rate independent of the government structure. I our case, lacking a competitive money system and being a republic, there is no proportional democracy, and no justification for specifying an optimum. The calculation is almost always n equilibrium against a static cost of the institution because they have no real measure of institutional liquidity, no model, useless analysis. One has to get the supply/demand model extracted, or the distribution model extracted for a particular government, then ask what is a coherent tax relative to that structure. I doubt any economist has done that.

  25. Krugman has no respect for people with other opinions. He thinks anyone who disagrees with -- on taxes or anything else -- is evil and corrupt. He needs to learn the principle of charily.

    Krugman always talks about how great Sweden is. Well, Sweden has no minimum wage, has more economic freedom than the US, and has a less progressive tax structure (the maximum tax rate kicks at about $88k in income, with a rate of 56%).

    He talks about how well the economy did when marginal rates were 70%, but this is misleading,. The growth in the work force was much higher then, but per capita GDP growth was about the same. In addition, despite the higher tax rates, tax revenues to GDP have been pretty constant over this period, implying that, when rates are high, rich people hide income or move income (and themselves) to other jurisdictions.

    Just because some rich people benefit from (usually government-imposed) monopolies, doesn't mean they all do. Should we punish all rich people because some rich people enjoy economic rents? Wouldn't it be better to attack (government-imposed) economic rents?

    When you "soak the rich" you are essentially lowering the nation's savings rate, which is already too low (and why we have huge trade deficits). The rich usually re-invest their high marginal incomes, while if we give it to the feds, they usually "invest" it in projects that don't earn the cost of capital -- that is, it is value destroying. The real reason to lower taxes is to keep the money in the private sector, not waste it in the public sector. I'd be ok with a highly progressive consumption tax, but a highly progressive income tax won't solve our problems.

    I totally agree with Krugman that there is no reason to attack AOC for her dance video, which I found appealing. But he seems to think that just because a few Republicans belittle the video, they all do. I think it's a small minority. By attributing the characteristics of a few to the whole class, Krugman is exposed as a bigot.

    Generally, Krugman has some good insights on some issues, but I think he is extremely arrogant, biased, and close-minded (and you can quote me on that).

  26. Alexandria Ocasio-Cortez ---
    Last night on CBS Sixty Minutes I witnessed the emotional caring and economics ignorance of the charming Alexandria Ocasio-Cortez (when interviewed by Andersen Cooper) ---
    Also at
    Alexandria Ocasio-Cortez on January 6, 2019
    “But once you get to the tippie tops In the 1960s, on your $10 millionth (dollar of income), sometimes you saw tax rates as high as 60% or 70%.
    Jensen Comment
    Yes indeed many nations taxed the highest income ("tippie tops") taxpayers 70% or higher in the 1960s. What Alexandria seems to be ignorant about is the economic reason virtually all nations later lowered their top rates by 20%-50%, including the USA, Canada, Iran, Norway, Sweden, Finland, Denmark, England, France, and all other European nations. She does not seem to know that they all lowered those top tax rates and the reason for lowering the Tippie Top tax rates. They did so because taxing the tippie tops at such high rates proved counterproductive to a point where their nations' economies were worse off in the 1960s ---
    For more details see

  27. The question of taxation to achieve social goals along with all of the accompanying theory, must include a discussion of the core problem of historic wealth disparity.

    "We rarely hear, it has been said, of the combinations of masters, though frequently of those of workmen. But whoever imagines, upon this account, that masters rarely combine, is as ignorant of the world as of the subject. Masters are always and everywhere in a sort of tacit, but constant and uniform, combination, not to raise the wages of labour above their actual rate [...] Masters, too, sometimes enter into particular combinations to sink the wages of labour even below this rate. These are always conducted with the utmost silence and secrecy till the moment of execution; and when the workmen yield, as they sometimes do without resistance, though severely felt by them, they are never heard of by other people". In contrast, when workers combine, "the masters [...] never cease to call aloud for the assistance of the civil magistrate, and the rigorous execution of those laws which have been enacted with so much severity against the combination of servants, labourers, and journeymen."- Adam Smith

    How to effectively deal with the monopolistic culture
    of crony capitalism?

  28. Quote "If a rich man works an extra hour, adding $1000 to the economy, but gets paid $1000 for his efforts, the combined income of everyone else doesn’t change,..." End quote.
    That's not correct. The value to both parties is the same. Everyone else receives the work from him and that is their income raised, he spends the money and receives the work from them and that is his income raised.

  29. And, correctly, I think, this literature by and large agrees with the labor supply literature that once people have found jobs and careers, they tend to work about 40 hours a week or so even at pretty high tax rates.

    Does that include wives and more so wives who are mothers?

    "The majority of women with children prefer homemaking role"

  30. When Steve Jobs worked hard and sold us all Iphones, he made a ton of money, and apple made a huge profit.

    I find Steve Jobs a bad example, I think that he loved what he did and he would have done it for far less, but the guy running the paper mill that makes great toilet paper in probably driven mostly by profit, or a high paid wife with a higher paid husband.

  31. No, the world is not a static, zero-sum game, in which we fleece the rich one just enough to keep him [or her, John, please!] playing.

  32. The world currently is a dramatically negative-sum game. It is just physics, so much energy in, so much energy out. In the last few decades we have burned around fifty cubic miles of diesel equivalent. That is about one million gallons per cubic mile and in approximate dollars value about 100 trillion dollars. Value as energy "infinite". As in Southpark " .... and it's gone". There is no diesel cycle.

    Most of that energy was borrowed from the future using enormous amounts of credit. Maybe we are taxing the rich in the next generation.

    And, from the Jones article, what do we have to show for it: Walmart, Uber and Amazon!

    We will eventually get back to energy balance but not with this economy.

  33. Arguments about the marginal income tax rate are academic in the absence of a specification of the taxable income bracket that the marginal tax rate applies to.

    Consider a marginal tax rate of 80% applied to the highest taxable-income bracket under two scenarios. The marginal income tax rates are: 10%, 20%, 30%, 50%, and 80% (a Fibonacci series). Under Scenario A, the income brackets (in thousands) are 15, 30, 45, 75, and 120, respectively. Under Scenario B, the income brackets (in thousands) are 15, 45, 105, 255, and 615, respectively. Taxable income less than or equal to 15,000 is exempt from tax (marginal rate = 0%).

    A taxpayer reporting $1 million in taxable income for the year experiences a marginal tax rate of 80% in either scenario, but experiences an average tax rate of 74% under Scenario A, versus an average tax rate of 54.8% under Scenario B. The taxpayer's after-tax income is $260,000 under Scenario A versus $452,000 under Scenario B.

    The top marginal income tax rate is not the whole story.

  34. For those who think that the economy is a zero-sum game, how do they explain the difference in standard of living between the modern man and the caveman?

    1. Development of surplus. Specialization.

    2. Specialization increasing productivity makes it a positive sum game.

  35. Cochrane cites Mankiw et al. (2009) as his counter to the authority of Diamond and Saez (2011), cited by Krugman.

    The Diamond paper came later, and so might be expected to discuss and rebut the prior Mankiw work. And it does, in "Appendix: Comparison with Mankiw, Weinzierl, and Yagan (2009)".

    Cochrane cites heavily from Mankiw but does not mention Diamond's rebuttal.

    Does the Mankiw paper really remain standing after Diamond? Or, do the two authorities simply cancel each other, leaving a sense of "no decision"?

    Perhaps Cochrane himself could elaborate.

  36. This is a fight about values, with Cochrane recapping his here:

     "If, in particular, you look at the world circa 1850, or even in Krugman's cherished 1950, and you look at how amazingly better off we all are today, and you conclude that the government's job is to foster economic growth as fast as possible, then all bets are off."

    Astonishing reductionism. Is growth always and everywhere what matters most?

    I applaud Krugman for challenging the right about values (although I do think he is mistaken when he suggests nefarious motives).

  37. There's another subpoint to be made under Cochrane's third point, which is the US taxes marginally at a household level and with the rise in dual income families along with persistent increases in assortative mating, high marginal tax rates for high earning couples could have a larger economic impact than forecast because these structural economic and family-unit changes took place during a period of comparatively low marginal tax rates and weren't empirically tested during the 70% or 91% marginal tax regimes.

  38. Diamond and Saez's conclusions - any conclusions meant to optimize 'utility' - rest on the highly subjective choice of a 'social welfare function.' You can get a wide range of results that are all equally scientifically valid based on what parameters you decide you like. It's ridiculous for Krugman to refer to the 70% "optimal" rate like it were an empirically demonstrated conclusion. It's not. There's a huge value judgment baked into it that largely predetermines the outcome. Indeed, if rich people really do derive no utility from their own marginal income, as is assumed by Diamond and Saez, why are they - as Krugman speculates - fighting so hard to keep it?

    1. "It's ridiculous for Krugman to refer to the 70% "optimal" rate like it were an empirically demonstrated conclusion."

      Did he? I read Krugman as asserting that 70% was not wrong (or stupid or crazy). That's very different from asserting that 70% is right.

      Cochrane asserts that the jury is out on 70% and I think he and Krugman actually are in agreement on this.

    2. I would say his characterization of people who favor a lower tax rate on the rich as frauds whose opinions are refuted by all the data suggests that he believes the putative 'optimal tax rate' is indeed an empirically demonstrated fact, rather than something that depends on one's preferred social welfare function.

  39. Personally, I like how Krugman writes when he sticks to the internal logic and empirical validity of economic theories. It's always concise, clear and a good way to boil down otherwise technical material, though we can all disagree about how he borrows from the literature.

    On the other hand, his policy discussions seldom are as captivating. He knows one story: rich people rig the system in their favors. That rent seeking exists and that you can't assume blue colar Joe to be lobbying for high end tax cuts is obvious. Yet, the world is not solely a hobbesian field pitting groups of people against each other based on income, let alone skin or gender. One fundamental reason is that 'the rich' is a vague term and, no matter how you cut the income or wealth scales, membership changes. Another reason is that we vary on a plethora of dimensions (as individuals, we are unique) and we should always keep in mind any bundling is bound to be approximately correct at best.

    And I say this as someone who is not very libertarian ideals, so it is not exactly political dissonance that makes me critical of Krugman.

    By the way, professor Cochrane, it is refreshing to see someone do some justice to the people whose idea they criticize. It gives me some hope that education and a genuine interest in talking about problems can get us somewhere.


Comments are welcome. Keep it short, polite, and on topic.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.