Here is my discussion of my attempt to replicate the numerical computations in Mirrlees’s seminal analysis of the optimal nonlinear income tax (Restud, 1971) which can be downloaded here (gated). Although my computations yield reasonable results, they do not exactly replicate those in Mirrlees’s tables, suggesting I’ve likely made a coding error of some sort.
The code for the replication is available at github.com/bblockwood/Mirrlees-1971-Replication.
Here is my replication and discussion of Slemrod et al. (Journal of Public Economics, 1994), which can be downloaded here (gated).
Code for the replication is available at github.com/bblockwood/Slemrod-1994-Replication.
It’s been widely reported that Romney’s effective tax rate is 13.9%. The low rate is largely because he receives most of his income from investments (stock portfolio appreciation and the like), which are taxed at 15% (a far lower rate than earned income).
Greg Mankiw (Harvard economist and Romney advisor) and others have argued that the tax rate on capital returns is actually much higher, since those returns come from corporate profits, which are subject to corporate income taxation (as high as 35%). Romney himself has said that this means his tax rate is “really closer to 45 or 50 percent.”
Economist Rajiv Sethi (Columbia) has argued that this reasoning is totally wrong. The existence of the capital gains tax, he says, was already priced into Romney’s shareholdings when he bought them. The idea is this: suppose you’re bidding on a $10,000 (pre-scratched) winning lottery ticket on eBay (probably not legal, but ignore that for now). Lottery winnings are heavily taxed — say at 50% — so that when the winning bidder turns in the ticket (s)he’ll have to send the IRS $5,000 in extra taxes on the lottery winnings. With this in mind, what would you expect the winning bid to be? Obviously not more than $5,000. Suppose you bid $4,900 and win the ticket. At the end of the year, should we say you paid an extra $5,000 in taxes because of this transaction? Of course not! It’s true that you cashed a lottery ticket worth $10,000 which was taxed at 50%. But that tax was already taken into account by bidders for the ticket, so the $5,000 tax payment didn’t cost you anything. Similarly (this argument goes) we shouldn’t take the corporate income tax into account when calculating Romney’s tax rate, because the prices of his shares were already reduced accordingly when he bought them.
These two stories seem glaringly inconsistent — according to Mankiw, Romney pays a higher tax rate than any of us; according to Sethi, Romney’s tax rate is very low. So what’s going on? I emailed Mankiw to ask for his take on Sethi’s post, and he responded with a one-liner:
If we levied a tax on land, to whom would you attribute the tax burden?
I thought about this a bit and wrote back:
Good point. I would expect land prices to fall immediately at the time the tax is announced, effectively making a transfer from the (then) landowner to the government. Thereafter, land prices would be such that cash flow from the land generates the risk free rate of return.
In the case of securities, I would expect share prices to be such that the post-tax cash flow (net of both corporate and capital gains taxes) equals the market interest rate. So it might not make sense to attribute a corporate tax burden (or a capital gains tax burden) to current capital holders at all, since the burden was born entirely by whoever held the capital when the tax was announced. Is that similar to how you think about this? (Obviously there are GE [general equilibrium] effects as well, since the higher tax means fewer projects will generate positive net returns, and the tax harms those marginal project-holders.)
To which Mankiw responded:
Yes, I think so.
In general, the CBO calculations on tax incidence are static. That is, they assume capital bears the burden of all capital taxes, and labor bears the burden of all labor taxes. That is right in one-period model if capital and labor are inelastically supplied.
But as you point out, there are complicated intertemporal issues, which surely complicate things. To the extent taxes are capitalized into prices, the original owners bear the entire burden.
I get the feeling that you won’t know the “right” answer until the question is more precisely posed. That is, what are these effective tax rates supposed to measure?
Upshot: it’s not really clear what we mean when we say “Jane’s tax rate was X.” Do we mean “The IRS received a check for X*(Jane’s income) from Jane”? The lottery ticket example demonstrates that this is a completely uninformative statement. Someone could have sent the IRS a very large check without incurring any costs. In fact, if the winning bidder had a low enough income, (s)he could have a tax rate over 100%! We probably mean something more like “Taxes imposed a cost of X on Jane”. That seems like a more interesting question — but it also means that we need to take into account price movements caused by taxes. These issues are covered in the tax incidence literature. The calculations depend on the elasticities of demand and supply in the relevant markets.
One final note: in these incidence calculations, both the corporate income tax and the capital gains tax enter in the same way — they create a wedge between the cash flow paid by a security and the net income received by the shareholder. Therefore it’s almost certainly not right to talk about Romney’s 14% tax rate — the range could be anywhere between 0 and 50% depending on how well you think prices incorporate future taxes, but there’s not a clear reason to count the capital gains tax while ignoring the corporate income tax.
Asked for my take on John Taylor’s WSJ opinion piece today. Here was my quick reaction:
I find articles like this frustrating, because they recount a bunch of coincident occurrences and (implicitly) assume causation. “This then that (so this must have caused that, right?)” I much prefer empirical studies that try to establish causation — and fortunately there are loads of such studies on these topics. Obviously there are challenges even there, but they are way more convincing than Taylor’s narrative.
As for the content, I completely agree with the need for a simpler tax system, broader tax base and lower marginal tax rates (corporate, income, maybe capital gains too). Taylor writes as if tax complexity, permanent big government, Keynesian fiscal policy, and expansionary monetary policy all go hand in hand. That’s not right — I oppose the first two, cautiously favor the third, and strongly favor the fourth. Moreover, Taylor gives the impression that because Reagan did well in the 80s, current Republican policy is what we need now.
But in fact I find current Republicans on exactly the wrong side of some of these issues. The right way to interpret Reagan’s monetary policy is that it was smart given the circumstances — not that we should be all-contractionary-all-the-time. In the current environment, smart monetary policy is expansionary. Unlike the contraction in the 80s, which was driven by supply side forces (e.g. high oil prices), much of the current problem is insufficient demand (which explains why inflation is so low), and expansionary monetary policy helps correct that. I think Milton Friedman would agree here. But many Republicans are criticizing Bernanke’s (somewhat) expansionary monetary policy, and rather than taking advice from economists and standing up to those critics, too many Republican leaders are deferring to them. (Here’s an interesting article on Romney suggesting as much.) Gingrich says similar things, and Ron Paul, much as I love his tenacity and independence, is the worst of all of them on this point.
Upshot: yes, let’s go for simplicity and broad-based, low-marginal-rate taxes. But let’s not confuse that with contractionary short-run monetary and fiscal policy, as many current R’s seem to be doing.
The power of value added teacher scores
Raj and Jonah’s new study finds huge and enduring gains from good teachers.
Economist’s View
via "Climate Change – Our Real Bequest to Future Generations".
I made a similar point in my undergraduate thesis.
Interview with Steven Kaplan on the makeup of the top 1%
CEO pay roughly moved in tandem with other, more “arms-length” salaries, e.g. attorneys & athletes. Suggests maybe agency problems are not driving force behind rising inequality.
Salaries of CEOs of fortune 500 companies totaled $4B, top 25 hedge fund managers were made $25B.
Scaling via technology, globalization raise returns to talent.
Interview with Bruce Meyer on middle class, poverty, and inequality.
Says that contrary to popular belief, middle incomes have in fact gone up about 50% since 1980. Inflation is often overestimated, since typical measures underestimate increases in quality of goods; in 1980, 25% of poor had AC, now 67% do (poor = bottom 20% of incomes). Also, measuring changes in consumption yields different results from changes in income (income often misreported, esp among poor, since hard to represent all govt transfers, gifts, etc, but consumption often well reported). And consumption shows more growth than income.
A great talk on inequality with a panel including Larry Katz and Ed Glaeser:
A couple of points I found interesting:
Glaeser:
Worldwide inequality is decreasing (due mostly to gains in India and China) despite rising inequality in the US.
On min wage: leery of any policy that creates barriers to employment for lowest skilled. So would support a tax on top earners used to subsidize wages up to some level, but wary of conventional min wage laws.
Katz:
In 1970, top 1% made 10%, now make 23%.
Lower taxes cause more rent seeking and evasion among high earners, but don’t seem to alter labor supply much. So mostly not productive/stimulative.
