Monday, August 01, 2011

Epstein on the Flat Tax

Richard Epstein has an article arguing for a flat tax on two grounds. First, progressive taxes generate wasteful tax avoidance. If you've ever talked to someone in asset management for wealthy people you'll know that the most pressing issues have nothing to do with picking good pre-tax investments, because moving income across time or some artificial category has a much bigger after-tax return. Secondly, when taxes are shared pro-rata the discussion on the size of government is more rational because everyone internalizes the cost. Currently only half of working Americans pay income taxes and so don't have to consider the tax effects on their income.

These are good arguments, but I'd add the following. James Mirrlees won a Nobel prize for his work on optimal taxes (see his seminal 1971 paper, An Exploration in the Theory of Optimum Income Taxation). In these models the optimal tax rates depend on assumptions about the distribution of income earning ability, the rate at which the marginal utility of income declines, and how much the tax rate deters income producing.

It is easy to see the utilitarian argument for progressive taxation: rich people don't value $1 as much as the poor, so they should be taxed more on that final dollar, but there is a powerful countervailing force which is less obvious. Given income earning opportunities are lognormally distributed, the highest earners generate much more wealth than the middle income earners. Thus, under most parameterizations you find that lower tax rates on the high earners are better because these earners are wealth-producing machines. Higher tax rates on the most productive people affects these people first, which is the exact opposite of what you want, which is to affect them the least--as far as maximizing total wealth created.

I find this literature compelling because I'm a libertarian, which is really just a dynamic utilitarian: I like to count up happiness over time in a world where people choose their actions in anticipation of certain payoffs, unlike simple utilitarians that assume output is given. Further, we tend to take for granted the unintended benefits of wealth in terms of science, art, and general human camaraderie; Marx's 'idiocy of rural life' comes from never having time to think.

Unfortunately, I think the problem is worsened by the practical fact that people are more concerned with relative than absolute income; we are more envious than we are greedy. It is a hard thing for most people, especially intellectuals, to acknowledge benefits from their rich moral inferiors who never so intended it, people who seem to enjoy it without any sense of extra obligation. Such 'progressives' see progressive tax rates as a good thing no matter how much wealth is destroyed because preventing one dollar more going to the Koch brothers is worth $10 dollars less going to a bunch of working stiffs, especially because these stiffs would probably in some way be doing business with such a bastard.


This is why the Mirrlees model is now so quaint. No one really cares about quantifying the trade-off in wealth vs. equality, because for people who care about relative wealth, aggregate wealth doesn’t matter, and what drives their confabulations is bringing down those above them (see above). No one wants to look at trade-offs because admitting there is one highlights the fiscal multipler isn’t greater than one. Better to focus on aggregate GDP, which assumes government spending and investment are perfect substitutes, and argue about the multiplier in the context of insufficient aggregate demand, a fancy both defensible and sterile.

Envy, while natural, is a vice to rise above and not a virtue to celebrate under the pretext of equality and justice.

18 comments:

Anonymous said...

A land value tax makes far more sense to me. Large tax base; no constraint on the supply of the thing being taxed.

http://en.wikipedia.org/wiki/Land_value_tax

Anonymous said...

Taxes are roughly flat when you include all taxes (state, local, sales, etc.).

http://www.ctj.org/pdf/taxday2011.pdf

Eric Falkenstein said...

To the extent actual tax incidence is well-below marginal income tax rates merely highlights the effectiveness of tax lawyers, one of Epstein's arguments, which as I mentioned I think is a good one.

Anonymous said...

What it means is that a flat tax would not be flat at all but rather regressive.

Anonymous said...

your argument assumes that the additional wealth created by the "wealth producing machines" benefits the entire distribution. However, it's easy to imagine that it just widens the distribution indefinitely. It also assumes that these people will stop producing wealth if their tax rates are higher than those earning much less, but that's also not obvious.

I say this as a supporter of a flat tax, which I support largely because of your initial point that more complex tax codes create wasteful tax avoidance and because they create wasteful enforcement and opportunities for politicians to dole out favors to donors via the tax code.

Further, the flat tax can be quite progressive. If you exempt, say, the first $40k in earnings for a family of four, then tax each additional dollar at 25%, those earning $75k have an effective rate of 11.7% while those earning $150k pay 18.3%, e.g. That's progressive, but its capped at 25%.

Anonymous said...

If by "rich" you mean the Bill Gateses and Steve Jobses of America, yes, this makes a lot of sense. I think entrepreneurs should be richly rewarded. But it is less clear that the super-wealthy who make a living in finance are contributing much, and it is harder to sell the idea to the public in light of this.

stephen said...

Tax rev. becomes more volatile the more the base is weighted towards higher earners, and the percentage of tax payers decreases. This is one of those things that’s not too important (or no one cares) until it is too late.

Its seems that dealing with tax revenue shortages by increasing exposure to the volatile incomes of high earning folks is a little like loading up on high yield assets cause your savings are inadequate.

Dan said...

The notion that 50% of the population pays no taxes is false. They pay social security and employment taxes which have grown substantially as a % of total taxes collected by the government. The poor do no receive as much benefits (they have a lower life expectancy), so you have to look at total taxes paid - total benefits received. Also the uber-rich make most of their money from cap gains which are taxed at 15%. I remember Warren Buffet challenging anyone making $1bn + to show that they actually pay higher marginal taxes then their secretaries.

Kotlikoff has done some research taking all this into account. What you have is a system of regressive taxation. The solution is to replace all income and corporate taxes with a national sales tax. It'd be fair, simple and would encourage savings and investment

Eric Falkenstein said...

SS taxes are tricky. They aren't, technically, 'income taxes', rather, contributions to your old-age SS benefits. Given the money isn't saved, that's a fiction, but that's a different issue.

The many loopholes to the progressive tax structure highlights it is 1) futile and 2) wasteful (lots of activity is done to achieve these results). That's Epstein's main point, which I agree with.

JB said...

You mention the fact that utility is more determined by relative as opposed to absolute income and then skip over the obvious implication of the premise - that high marginal tax rates have small deterrent effects on income production. If utility of the very rich is simply ordinal (i.e. I have more money than the other guy, irrespective of the absolute levels) then it really doesn't matter if we're both taxed at 50% or 70%. That is certainly a more plausible implication than the idea that 'progressives' would literally prefer the tradeoff of $10 less to workers in exchange for $1 less to the Koch brothers.

Eric Falkenstein said...

JB: good point! Didn't think of that. Most research looks at the aggregate preferences, which are for higher progressivity in relative environs, as opposed to what this implies for the really rich.

tx.

Anonymous said...

It may be ordinal to a point, but you tax the "super rich" at a true 70+ percent (not a fake one with loopholes), they are going to quit/shrug, not compete for who can donate the most to government.

bjk said...

They should get you on bh.tv. Talk about your book.

Anonymous said...

What is the level at which a marginal tax rate causes the super rich to say, "f*ck it?" It sounds like an optimal to me.

Anonymous said...

Why is the f@ck it point optimal?

Because you stupidly think we are better off if they shrug?

Or because you thievingly want to steal the maximum?

Leo said...

"Envy, while natural, is a vice to rise above and not a virtue to celebrate under the pretext of equality and justice."

Nonsense. You simply don't know anything about poverty. A small fraction of the intellectual effort and curiosity you put towards finance should get you some basic understanding. How can you tolerate that more than 8 million children in the US are uninsured?

You think that the search for equality and justice can be reduced to envy? I think your pitiful attempts to debase people with ideals far superior to yours are motivated solely by your desire to enjoy your cushy life without guilt.

Eric Falkenstein said...

Leo: It's telling you point out the uninsured, as opposed to health care being too expensive. Health care reform would lose its interest from the Left if it were revenue neutral; the redistribution isn't a side benefit, its the main point.

Insurance is very egalitarian, and by law mandates that everyone gets the same risks covered regardless of preference (STDs?). We could increase health coverage very easily by simply increasing the number of activities that could be performed by nurses and physician's assistants: prescribing antibiotics, simple stitches, etc. No one really cares about that because that elides the real driver of health care reform: redistribution.

How much of this new insurance coverage would come from you? Much less than 0.001% I'm sure. So you are very much in favor of spending other rich people's money on other poor people. How big of you! Like public schooling, will probably just create a vast network devoted to serving the providers, not the customers, all while talking about rights, justice, and root causes. Spare me your moral righteousness.

Anonymous said...

Leo, what's more telling is you think that 8 mm "uninsured children" is somehow the fault of anyone doing ok. You are a socialist through and through. I wish you people would just admit to the term, then let's have the argument.

And Leo, how do you get through your day living whatever lifestyle you do when there are children DYING in Africa left and right (forget insurnace). You are one sick immoral bastard living like you do when this is going on...