Bryan Caplan  

The Presumption of Elasticity

Poor Choices... Austrian Economics in Business...

Did tax cuts in the '80's spur Internet entrepreneurship twenty years later? I can't prove it. But it seems very plausible, and no one's proven otherwise. After all, when marginal tax rates are 70%, the dream of striking it rich in business seems pretty hopeless, and you'd expect ambitious kids to look for other ways to excel.

Most economists get uncomfortable when I make arguments like this. But Greg Mankiw is not most economists:

I also don't know of any evidence for the impact of taxes on educational attainment. On the other hand, producing evidence would not be easy, as current taxes are less relevant for educational choice than expected future taxes. That is, in deciding how much to invest in skill acquisition, a young person would have to consider expected tax rates that would apply over the next several decades of working. Eddie's [Edward Lazear's] view that taxes matter for human capital accumulation seems like a plausible hypothesis. Reasonable people can disagree about the likely magnitude of the effect.

This situation exemplifies a common conundrum for policy advisers like Eddie. In the absence of hard evidence, should he act as if there is no effect, as Larry [Lawrence Katz] seems to be suggesting here? Or should Eddie rely on the general principle that people respond to incentives and make an educated guess about the magnitude?

Bottom line: If the best empirical methods probably aren't good enough to locate an effect if it exists, we're back to introspection and common sense. There's no escaping it.

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COMMENTS (7 to date)
talboito writes:

In what world is 70% (the worst case estimate) of Bill Gates wealth not equal to "filthy rich"?

pontus writes:

Then you should find similar tax-cuts in other countries where internet entrepreneurship also spurred.

Will you? I doubt that.

dearieme writes:

There's also the thought-experiment. When you face a marginal tax rate of, say, 98%, do you risk all to make a high income?

Justin writes:

"Bottom line: If the best empirical methods probably aren't good enough to locate an effect if it exists, we're back to introspection and common sense. There's no escaping it."

Wow, that sounds pretty Austrian of you Bryan... are we coming around??

bartman writes:

Most economists, including me, get uncomfortable when other economists start talking about "proving" things. I can understand that sort of thinking from a layman, but it is unacceptable in a professional.

Matt writes:

Ireland has been pretty successful with budget airlines and software, and they cut taxes big time well before the boom hit.

With regards to calculating future taxes, how many people have actually considered the future impact of Medicare and Social Security on taxation? I've had conversations with peers about moving or conducting business in a more favorable tax jurisdiction should the solution to the problem be higher taxes (and I've met people alread doing it because they are Western European), but I have to think we're in the substantial minority.

I think most people extrapolate the present into the future. There is a time lag because it takes several years before the economy fully restructures and adjusts to the change. The Republicans passed the tax break on capital gains on the home in 1997. The real estate mania didn't emerge until 2003, although home building had increased. Similarly, the tax cuts in the 1980's may well have spurred entrepreneurship in the 1990's, but students didn't become comp-sci majors en masse until the late 1990's. Similarly, there weren't many students in 1995 pouring into finance classes and business school because the capital gains tax cut was about to unleash a bull market. They waited until 2000 and 2001.

spencer writes:

The thesis that the tax cuts of the 1980s caused the boom of the 1990s has two major problems.

You might also note that Larry Kudlow made this argument several years ago.

First, the primary driving force of the 1990s boom was a massive drop in the cost of computing power.
This was a technological development that had been developing for some time and that came into full bloom in the 1990s. What impact did government policy have on this development? I find essentially no evidence that tax policy had anything to do with it. The government policies that contributed mighty to this was the tremendous subsidies government provided for years to scientific research and the education of engineers--largely through the land grant university system. The internet portion of the boom could not have occurred in the 1990s without the Pentagon developing and building the original framework that the private took advantage of in the 1990s. It is hard to find a single area of the 1990s technology boom where government subsidized research did not played a major role.

The second part of the argument that the tax cuts contributed to the boom is that lower personal tax rates increased individuals willingness to take risk. However, even though we talk about the role of individual entrepreneurs like Bill Gates, essentially all the the 1990s high tech capital spending boom occurred within the corporate sector where individual income tax rates do not enter into the equation.

Actually, in the 1990s the role of small business in the economy fell sharply as the successful high tech firms morphed into very large corporations. Typically, small business were the last to participate in the high tech revolution. It was long after large firms with large scale computer departments worked the bugs out of the systems and made the software very simple before small firms were able to take advantage of the new computer systems.

If you look at the data on the share of firms with over 500 employees in the 1990s you find that their share of total employment rose sharply in the 1990s.

In the US gdp accounts nonresidential capital spending stems from three sources: one, corporations, two, nonprofits, and three partnerships, s-corps, individuals, etc that are subject to the individual tax code. If your thesis is correct that individuals tax cuts played a significant role in the 1990s capital spending boom is correct you should have seen an increase in the share of investment accounted for by the third group that is subject to the individual tax code.

I bet you do not have any idea how much of US nonresidential investment is financed by this third group, corporations, and nonprofits and what happened to their share of investment in the 1990s.

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