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The key arguments for high top rates of income tax are political as well as pecuniary

Summary:
When people complain that neoliberalism is a meaningless concept, I should point them to what has happened to the top rate of income tax since around 1980, not just in the US and UK but elsewhere. (SourceHT Marcel Fratzscher) Here is a chart of the United States top tax rate over the last century (HT Martin Sandbu). Eisenhower had top earners paying a 91 percent marginal rate. No doubt there are complex reasons for these reductions, but key among them has to be a neoliberal belief that cutting top rates would lead to more dynamic CEOs who would produce more dynamic companies, and the benefits of this would trickle down to the economy as a whole. Low top tax rates would encourage entrepreneurs to take more risks that were socially beneficial and so on. The argument is so familiar,

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When people complain that neoliberalism is a meaningless concept, I should point them to what has happened to the top rate of income tax since around 1980, not just in the US and UK but elsewhere. (SourceHT Marcel Fratzscher)

The key arguments for high top rates of income tax are political as well as pecuniary


Here is a chart of the United States top tax rate over the last century (HT Martin Sandbu). Eisenhower had top earners paying a 91 percent marginal rate.

The key arguments for high top rates of income tax are political as well as pecuniary


No doubt there are complex reasons for these reductions, but key among them has to be a neoliberal belief that cutting top rates would lead to more dynamic CEOs who would produce more dynamic companies, and the benefits of this would trickle down to the economy as a whole. Low top tax rates would encourage entrepreneurs to take more risks that were socially beneficial and so on. The argument is so familiar, trotted out routinely by right wing think tanks, it hardly needs elaborating. It is a classic example of neoliberals using a bit of simple economics to justify policy that is advantageous to themselves or their paymasters.

Yet the evidence for such an effect is weak, at best. The intuition for why it should be weak is straightforward. Above a certain level of income, other incentives beyond the purely pecuniary become important. Top CEOs, like top footballers, want to be successful at what they do, and more successful than others. They will want success whatever the overall financial rewards of being successful.

Another bit of basic economics that neoliberals hardly ever mention is the diminishing marginal utility of consumption. This implies quite the opposite of low tax rates at the top. It is socially much more beneficial to tax those to whom one dollar is not worth the effort of picking off the sidewalk and transfer it to those who are poorer. A well known paperby Diamond and Saez found that, after allowing for disincentive and avoidance effects, the optimal top rate of income tax in the US should be 73%. [1] [2]

There are two reasons why even 73% might be an underestimate. Piketty, Saez and Stantcheva have arguedthat giving CEOs lots of money can have negative incentive effects. The CEOs start putting effort into increasing their salary rather than improving their firm. Part of your status comes from what you can afford. When all CEOs are taxed a lot at the margin the size of your salary has little impact on that, but when your salary is not taxed so much you can increase your salary and theefore status by extracting more from your own firm. To use some economics jargon, a low marginal tax rate on top incomes can be a good example of an incentive for rent extraction rather than an incentive for increasing social output. .

But while an extra dollar for a CEO is not going to incentivise them in a positive way very much, you could argue that it incentivises those with talent to aspire to be CEOs. CEOs are always going to be among the richest in society, because a lot of their income will be taxed at lower rates. A paperby Lockwood, Nathanson and Weyl turns that argument on its head. High salaries are associated with activities, like finance and law, that have what economists would call negative externalities, which means that they do much less good for society than the size of the salaries they pay might suggest. A lot of finance, for example, is about trying to take money off other people rather than growing the size of the overall pie. If high post-tax salaries incentivise talented people into those professions, that is negative for society, which would benefit if they worked in different jobs. You can reduce this misallocation of talent by having higher tax rates on top incomes.

Neoliberals have one last line of defence against raising top tax rates in a single country, and that is migration. The argument is that talent, which could be quite mobile, will move to where talent is most rewarded. There is clear evidence that this is true, to an extent. This concern does not mean we leave top tax rates where they currently are or even reduce them, but simply that we might not put them up as high as they should otherwise go while some countries that are attractive to talent continue to have low tax rates on top incomes. Sweden seemsto do pretty well with a 70% effective top tax rate.

This danger of a race to the bottom with top tax rates makes it all the more important that the United States raises it’s top marginal tax rate, along the lines recently suggested by Democrat Alexandria Ocasio-Cortez. For various fairly obvious reasons the US does not need to worry too much about a talent drain if it raised top tax rates.

In my view the arguments for higher top tax rates are at least as much non-pecuniary, by which I mean they do not depend on the points raised so far. The evidence that social welfare is higher in more equal societies seems compelling to me. In other words we should increase top tax rates just because that helps produce a more equal society. I have seen a few attempts to debunk the evidence for this in The Spirit Level, but they are not convincing as a collective, while there is even more evidence to support the idea that people are happier in more equal societies..

There is a final argument for high tax rates at the top which seems particularly relevant to the US and UK at the moment. If you have a political system like the US where money easily buys political influence, you will find some of those who earn very high salaries trying to do exactly that (some references here). You can create the kind of plutocracy I discuss here. Because money can also help to buy votes, that plutocracy may also be able to continue with democratic elections without in any way threatening the plutocracy. Even when you have laws limiting the amount that can be spent on elections, the UK shows there are ways for the rich to get around that, particularly if they control large sections of the press.

This is the argument made in this excellent NYT op-ed by Emmanuel Saez and Gabriel Zucman. They write
“An extreme concentration of wealth means an extreme concentration of economic and political power. Although many policies can help address it, progressive income taxation is the fairest and most potent of them all, because it restrains all exorbitant incomes equally, whether they derive from exploiting monopoly power, new financial products, sheer luck or anything else.”

The economist Greg Mankiw, in a short responseto this op-ed, says
“most rich people I know would have been happy to spend vast sums of money to keep Mr Trump out of the White House. And many tried. The Trump phenomenon is not an argument that the moneyed elites have too much influence on politics. If anything, it is an argument that they have too little.”

But this misunderstands (as some on the left do) the nature of the plutocracy that super incomes and wealth create. It does not, as I make clear here, create a kind of committee of the very rich that between them decide who rules. It is much more erratic than this. Instead it allows small groups among the very wealthy, who may be quite unrepresentative, to hijack a democratic system. Trump and Brexit are clear examples. Mankiw is right that one way to avoid that would be to create a more representative kind of plutocracy, but a far better way of avoiding disasters of this kind is to deal with the problem at its source, by reinstating high rates of tax on top incomes.

[1] Some intuition on this number. If disincentive and avoidance effects were so large that an increase in tax rates led to no additional income, then there is no pecuniary advantage from doing so. If these effects did not exist, the optimal marginal rate at the top would be 100%. The paper estimates these effects are somewhere between these two extremes, so the optimum tax rate at the top will be between zero and 100%.

[2] For a discussion of these issues in a UK context, see https://www.ifs.org.uk/publications/9678. Note that HMRC calculations that the short-lived raising of the UK top tax rate to 50% did not raise any revenue involve debatable assumptions, and much of the avoidance only worked because the hike was temporary.    



Simon Wren-lewis
Professor of Economic Policy at the Blavatnik School of Government, Oxford University, and a fellow of Merton College. This blog is written for both economists and non-economists.

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