David R. Henderson  

John Cochrane on Taxes

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Now wait a minute here...The top graph is a tax rate, the percentage of income paid, while the bottom graph is total dollars. To say this is comparing apples and oranges is an insult to fruits.
This is one of the many nuggets in John Cochrane's recent blog post on taxes. He titles it "How to Lie With Statistics." There's too much in it to summarize, but I'll hit a few high points. If you want to understand better what I'm summarizing below, go to his post and look at the figures he's referring to. My one criticism is that, like most people who engage in this debate, whatever side of it they're on, Cochrane uses the word "rich" where he should use the term "high-income." There's a high correlation between wealth and income, of course, but it's not 1.0. I have a multimillionaire friend, a dyed-in-the-wool Democrat, who cheered when Clinton was elected: she knew that his tax increase on high-income people would keep her in the 15% bracket.
The important point, for the Times is that graph has basically nothing to do with Federal income taxes. All of the action comes from Saez and Piketty's assigment of corporate taxes and estate taxes. They assume all corporate taxes are paid by stockholders and bondholders. This is conceptually right -- it is not true that "corporations" bear any tax burden. Someone is paying, through higher prices, lower salaries, or lower returns to investors. Saez and Piketty assume it's all the latter.
It may be fine for Saez and Piketty's purpose, but I doubt any New York Times reader had the faintest idea they were looking at a graph that primarily said "rich people were hurt by taxes in the 1960s because we assume corporate income taxes drove down the rates of return on their investments!"
The actual individual income tax line has not changed much at all, other than to fall slightly for all income groups. Almost all of the Times' fabled taxes the rich were happily paying in 1960 comes from Saez and Piketty's assignment of corporate taxes to wealthy people and their calculations of estate taxes! (Estate taxes are notorious for the games the rich pay to avoid them.)
And now a nugget I've NEVER seen elsewhere. I still have to think through whether he's right, but I think he is:
It also appears to me that Saez and Piketty are a bit off here: If you charge corporate income tax against the rich, don't you have to divide that tax by an income measure that includes corporate income?
And finally:
Now, look at the nefarious pairing of the decline in (statutory) tax rate with the change in income on the right hand side of the top graph. We cut rich people's taxes and look how they got richer!

Here, the Times got too clever by half. The cause and effect insinuation here is actually a supply sider's dream, if you can read and add. The insinuation is, the rich got richer because they got to keep all that income that they're not paying to the government. Even that doesn't add up: a 528% rise is much more than (1-0.34)/(1-0.71) = 2.28 = 128% rise in after-tax income.

But the tabulated rise is in pretax income. (At least the labels are honest.) As tax rates came down, people went out and made an enormous amount more income in the first place.

71% x $100 = $71.00. 34% x $528 = $179.52. So, using the New York Times' numbers, we would infer that lowering the tax rate on the top earners corresponded to tripling the tax revenue earned [sic] from that group! The rich are, apparently, paying much more in taxes than before.

If you take the Times' numbers seriously, Art Laffer's wildest dreams came true.


HT to Jeff Hummel.


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CATEGORIES: Taxation



COMMENTS (5 to date)
GD writes:

Great post.

Trivial point, but of interest nonetheless:
The expression is 'dyed-in-the-wool', not died.

When a color is "dyed in the wool," the wool itself is dyed before being spun into threads, so the colour is less likely to fade or change.

MG writes:

I think that Cochrane's nugget relates to the inapprorpiateness of showing trends in tax rates (class warrior analysis won't usually show taxes paid) which are defined as taxes paid (which would impute taxes "paid" from a 100% share of corporate taxes) divided by income (which may leave out 100% share of corporate income). We do know that class warrior analysis of trends in income inequality understate the income the top 1% or so paid in the 60's and 70's as a lot of its income used to be reported as corporate income, before changes in tax law encouraged most of this income to be reported as personal income.

Milton Recht writes:

"There's a high correlation between wealth and income, of course, but it's not 1.0."

Actually, there is a common misperception among the public, the media and economists that wealth and income have a high correlation.

For example, in a study published by the Minneapolis Fed Res Bank, "Updated Facts on the U.S. Distributions of Earnings, Income, and Wealth" by Javier Díaz-Giménez, Vincenzo Quadrini, José-Víctor Ríos-Rull and Santiago Budría Rodríguez, Summer 2002, the authors found that US wealth and labor income have a 0.27 correlation coefficient, i.e. income explains about 7 percent (0.27 squared) of wealth and vice versa.

When they included business income derived from business ownership and capital income, the correlation coefficient of income and wealth jumps to 0.60, table 3, (36 percent explanatory).

The weak linkage between income and wealth is one of the reasons income inequality measures (like GINI or 90/10 income ratios) overstate, and are misleading measures of, overall US inequality.

David R. Henderson writes:

@GD,
Thanks. Correction made.
@Milton Recht,
I had thought it was about 0.7. Thanks for pointing out that it’s 0.6, which is lower than I thought.

Costard writes:

"It also appears to me that Saez and Piketty are a bit off here: If you charge corporate income tax against the rich, don't you have to divide that tax by an income measure that includes corporate income?"

Corporate income not distributed to shareholders should be reflected in share price, and then in capital gains income. However, it is not just the very wealthy who own stocks, and I'm not sure how Saez and Picketty accounted for this. Did they take into account pension funds and 401k's? Corporate income also funds new hires, and capital expenditures that go at least in part to payroll at other firms. I think in this case the answer depends on how deeply you're willing to look, which in turn depends upon the point you're trying to prove.

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