By Paul Krugman [April 30, 2021]
Friday’s column was mainly about the payoffs to expanded child care, but I also talked a bit about the consistent failure of conservative predictions that say raising taxes on high incomes will lead to economic disaster and introducing tax cuts will lead to nirvana. However, I didn’t talk about why tax rates on the rich don’t seem to have major economic consequences. So I thought I’d devote today’s newsletter to some speculations on that question.
It’s not because incentives don’t matter. Clearly, they do. France’s high taxes haven’t led to low employment of prime-age adults, but generous benefits for those who retire early have led to low employment among near-seniors:
How, then, can we explain the lack of clear responses (other than tax avoidance) to changes in the tax rate on top incomes?
One answer, which I suspect is relevant in the uppermost strata of the income distribution, is that at that level people don’t seek more money so they can afford more things, since they’re already able to afford far more luxury than anyone can enjoy. Instead, it’s about keeping score; that is, their goal is to make as much or more than the people they compare themselves with. And raising taxes on rich people in general doesn’t eliminate the race to out-earn one’s rivals.
Even to the extent that the rich seek income for what it can buy, however, it’s not clear that cutting their taxes will lead to greater effort. Indeed, it could lead to reduced effort, because it becomes easier for them to afford what they want.
Readers who took economics probably realize that I’m talking about income effects as opposed to substitution effects, a distinction that plays a crucial role in understanding how wages affect labor supply.
As most intro econ texts including the best one explain, higher wages have two effects on workers. They have an incentive to work more, because an extra hour gets them more stuff. But they’re also more affluent, which lets them consume more — and one of the things they might choose to consume is more leisure, i.e., they might choose to work less.
Historically, in fact, higher wages have generally led to reduced working hours. Wages have increased enormously over the past century and a half, but the workweek has gotten a lot shorter:
So if tax cuts for the rich are like a wage hike, they could lead to less rather than more effort.
But wait: the top tax rate is a marginal rate, not an average rate. Individuals making, say, $600,000 a year pay 37 percent on the last dollar they earn, but most of their income is taxed at substantially lower rates — and those rates won’t be affected if President Biden succeeds in raising the top rate back to 39.6 percent. So you might think that raising or lowering the top rate is not, in fact, much like changing affluent Americans’ wages.
But here’s the thing: most of the earned income accruing to people in the top tax bracket is, in fact, taxed at the top rate. (Capital gains etc. are a different story.) Why? Because the distribution of income at the top is itself very unequal: there are huge disparities even within the economic elite. According to estimates by Thomas Piketty and Emmanuel Saez, almost half the income of the top 1 percent accrues to the top 0.1 percent, a category that begins at around three times as high a threshold.
Now, high incomes closely follow a Pareto distribution, indeed to an eerie extent. Here’s a plot of high incomes versus the percentage of taxpayers with incomes above that level, both expressed in natural logs:
In such a distribution, the top .05 percent is to the top 0.5 percent what the top 0.1 percent is to the top 1 percent, so what is true of the distribution of income within the 1 percent is also true of the distribution within the roughly 0.5 percent of Americans subject to the top tax rate. This means that, as I said, most of the income accruing to that group is taxed at the top rate. And this in turn means that cutting that top rate is more like an across-the-board wage rise for the elite than you might think — and wage rises don’t tend to increase work effort.
Or to put it a bit differently, while tax cuts for the rich may offer an incentive to work harder, they’re also a big giveaway that encourages the elite to work less.
Of course, the fact that tax cuts at the top are a big giveaway is precisely the reason that belief in the immense economic importance of low taxes is such an unkillable zombie. As Upton Sinclair famously said, it’s difficult to get a man to understand something when his salary depends on his not understanding it.
Paul Krugman has been an Opinion columnist since 2000 and is also a Distinguished Professor at the City University of New York Graduate Center. He won the 2008 Nobel Memorial Prize in Economic Sciences for his work on international trade and economic geography.