Garett Jones  

Can Progressive Taxation Survive Exit?

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The other day I tweeted:

Under a Tiebout federal government, I posit the rich would pay more in dollars than the middle class, less as a percentage

Tiebout is shorthand for "voting with your feet," and it's a way to think about local governments competing against each other.  If citizens and firms could relocate easily, governments that offered low value for the tax dollar would lose citizens, and those that offered good value would gain citizens.  

Highly progressive taxation seems like a bad deal for high earners, so I wouldn't expect it to survive competition.  If McDonald's started a progressive pricing policy, I'm guessing high earners would switch to another restaurant pretty quickly.  The same probably would be true for competitive governments.  

So, is my hunch right? U.S. state governments might be a decent proxy for Tiebout governments--it's fairly easy for most people to move across borders if they don't like the price/service bundle they're receiving.  Fortunately, public finance researchers have estimated these numbers repeatedly.  Here's a graph from a report by the Institute on Taxation and Economic Policy.  The light blue sums up all state and local taxes, not just income taxes: 

stateprogfromWhoPaysADistlAnalysis.JPG

An academic paper (gated) by Chernick with similar findings for other years is here

I should note though, that while state taxation is regressive in percentages, it's progressive in dollars.  And that's the point of my tweet: Higher earners pay more than lower earners even though they could leave.  Perhaps some of that is altruism, but I suspect-without-proof that most of it is just that the rich (and middle class) buy more and better government services than the poor.  

It's possible that progressive income taxation could coexist with voluntary competitive government. Maybe the high-skilled need to be near each other to produce a lot, so the locales preferred by the rich can tax that demand for proximity.  The (not very progressive) New York City income tax comes to mind.  

But at the national level, I suspect that the reason the rich pay higher total tax rates is mostly because it's hard to leave the nation.  Easy targets.  

At least for the U.S., when people can shop for their own social contract the equilibrium tax system is usually progressive in dollars and regressive in percentages. It's worth keeping this concrete collection of social contracts in mind when hypothetical social contracts are being debated.  

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COMMENTS (20 to date)
Greg G writes:

The problem with this idea is the same problem with most libertarian ideas. It relies on conditions and options that the real world stubbornly refuses to provide.

Brandon Berg writes:

The use of single-year snapshots exaggerates the regressivity of consumption taxes as a percentage of income. A rate of seven percent implies that members of the bottom quintile are spending virtually all of their income on taxable goods and services, which obviously isn't true.

What we're actually seeing, I suspect, is consumption smoothing. Retirees spending down their savings, for example. This allows them to spend more than their income, which creates the illusion of a very high tax rate.

8 writes:

Property taxes in the northeast can be 10 times property taxes in the south. Most people only need so much house. A lot of people move from the north to the south.

Garett Jones writes:

@Brandon Berg:

The lifecycle point is well-taken. If someone knows of a study or studies that account for that, please link here in the comments....

tjames writes:

Exit is not only about geography. High earners, in particular, can enter/exit tax regimes without moving. It would seem this complicates the problem, since high earners and the wealthy can potentially shift their income into low tax regimes, while living in an area that has high taxes, high services.

Joe Cushing writes:

Unless you live in a border twin city like Grand Forks/East Grand Forks or Cincinnati/Florence, Moving from one state to another is not that easy. It means you have to leave your family and friends behind. It means you have to find new work. It means there must be industry in the new state that matches your skills. You have to like other things about the sate, such as the land and weather. North Dakota has very low unemployment right now but I don't see people flocking there to find work.

This system would work better if only local municipalities could collect taxes. It's easy to move from one township or suburb to another and still maintain everything else in your life.

MG writes:

What you are testing is more than intra-state progressive taxation, but the inter-state alternatives to move to a lower rate (however progressive the alternative curve may be). As many point out, it is complicated and probably not cost-effective, to arbitrage an equation such as: (Income Opportunity in High Tax State - Income Opportunuty in Low Tax State)*(High Tax Rate - Low Tax Rate) + Differences in (Cost of Living + Value of Public Goods + Other Non-Income Taxes +...) + Transaction Costs. And do this year in and year out.

However, there is decent evidence that at high enough level it will happen by income domiciling, and at lower levels by seeing where people tend to move as empty nesters and retirees. By the way, the arbitrage equation is not static, and the more tax benefits you get for moving to a low tax domicile the higher the cost of living for that income bracket will get -- real estate, prop taxes, luxury goods and services, etc. think Monaco, Switzerland, etc.

Mike W writes:

But at the national level, I suspect that the reason the rich pay higher total tax rates is mostly because it's hard to leave the nation. Easy targets.

Maybe that is changing. The bonds of structural conditions and cultural preferences that have made that so in the past may be weakening so as to make it easier to consider leaving...especially for not just the wealthy but also for the merely well-off.

If US tax rates on the well-off go to European levels why would the heavily taxed not shop for a lower tax residence? (Do Europeans?) That would especially be the case for those whose income is not tied to a specific location...e.g., pensioners, investors & non-managing business owners.

The Murray-ish cultural separation of the upper and lower classes as well as a lessening of the need (maybe even the desire) for family in close proximity could make consideration of a full-on nationality change easier to contemplate.

And on the supply side, tax and amenity competition by countries for well-off residents...similar to the competition here in the US between the states for businesses...could make the decision easier. (Like maybe a post-Castro Cuba...with close proximity to the US and a desire to tweak America's nose.)

What "more and better government services" are the well-off able to buy with their taxes that another country could not match? And if the increase in taxes in the current home country is mostly due redistribution and not to more and better government services why would those most impacted by these additional taxes not look for a tax residence that does not impose that redistributionist increment?

MatthewH writes:

A couple of years ago I worked on a project related to this. We looked at the choice of living location for high earners in the Louisville, Cincinnati, and Clarksville metro areas. We used IPUMS data and ran it through a taxsim program which estimated state tax burdens for households.

We didn't find anything which disproved, per se, the notion that rich people move to minimize their taxes, but the effect seemed to be swamped by the desire to be in the downtown.

Rich people in all MSAs chose to live on the side of the border where the downtown was located, regardless of tax rate.

Now, this was complicated by the fact that the top quintile in Clarksville is the middle quintile in Cincinnati.

Anyway, something to contemplate regarding the "place matters" hypothesis. Lead researcher was William Hoyt at University of Kentucky. He might have published something more extensive since I left the project.

Joe Cushing writes:

MatthewH,

I'm surprised people would choose to live in the downtown of Cincinnati instead of in Florence. I think the view of downtown from Florence is way prettier than the view of Florence from Downtown. There are some very nice houses in Florence where you can see the whole of downtown Cincinnati from.

John Fast writes:

All of the following seem pretty common-sense to me, and I might be overlooking something:

1. It is a bad idea for governments to charge anyone less than the cost of services that they actually consume. (I mean "bad idea" from a theoretical public finance standpoint, as opposed to the cynical public choice standpoint that expects governments to give unfair special benefits to the politically powerful at the expense of the less-powerful, or of the public as a whole.)

2. In a competitive (e.g. Tiebout) situation, it is a bad (i.e. net money-losing) policy for governments to charge anyone *more* than the value of the benefits they provide to that person (because such people will relocate to places where they will not be exploited as much).

3. Some taxpayers consume more services (measured by cost) than others. Perhaps the poor receive more welfare and require more police intervention than the rich; perhaps the rich consume a lot of luxury services such as Coast Guard rescue when their yachts sink, or bailouts when their banks and investment brokerages sink.

4. Some governments provide more value than others -- not just in terms of specific services, but in terms of the environment. For example, I consider the War on Minority Drugs to be something harmful even if it didn't cost any government funds to pay for its enforcement. Ditto with our current immigration policy. Ditto with most regulatory policy. So government which provide more economic growth, or less crime, are providing greater benefits than other governments, ceteris paribus.

"Solve for the equilibrium."

Brandon Berg writes:

The use of single-year snapshots exaggerates the regressivity of consumption taxes as a percentage of income. A rate of seven percent implies that members of the bottom quintile are spending virtually all of their income on taxable goods and services, which obviously isn't true.

What we're actually seeing, I suspect, is consumption smoothing. Retirees spending down their savings, for example. This allows them to spend more than their income, which creates the illusion of a very high tax rate.

Brandon Berg writes:

Sorry about the repeated comment. Several hours after posting the first one, I refreshed the page, clicked through to one of the linked papers, then used my browser's back function, at which point it thought it would be a good idea to resubmit my comment.

Various writes:

I agree with MG. Furthermore, I think your attempt to determine the Tiebout effect at the state level is hampered by the different average marginal tax rates at the state and federal level. For example, in a world in which the average state rate was 1% of income, I think few people would bother moving between states on account of the income. The taxes at the federal level would dominate the decision. However, if state income taxes represented a larger portion of the total tax pie, and fed taxes a smaller portion, I'm guessing the Tiebout effect would be significant or very significant. A good argument for shifting more power away from the federal government and to the states.

Floccina writes:

I think that one reason that most local governments support slow growth policies is that they tend to drive out poor people. Lack of poor people is amenity that people look for. High taxes might also tend to drive out poor people.

blink writes:

How about progressive taxes as a kind of mandatory income insurance program? We should remember that year to year there many be considerable mobility among quintiles, so some progressive taxation can be viewed as transferring money to oneself across good-luck and bad-luck states. Since the government is already collecting income taxes, it is a low-cost provider of such insurance. Hypothesis: Voters will prefer more progressive taxation in locales where incomes are more volatile.

Alexei Sadeski writes:

Interesting theory, Garett.

A supporting piece of evidence is that the US has a more progressive national taxation system - far more progressive - than most / all European nations, and it is far far easier to exit the European tax regimes than the US federal regime.

Indeed, it is neigh impossible for a wealthy individual to exit the US regime.

Paul writes:

@Joe Cushing

At least when I lived there, rich people didn't live in downtown Cincinnati, but rather lived in old mansions and homes in the hills surrounding downtown. Another thing to remember is that Cincinnati has a public middle school and high school that is a feeder to the Ivies. I went to elementary school at the same prep school as the children of P&G executives and about half of the students in the school would switch to Walnut Hills between sixth and seventh grade.

Also, don't forget that in Cincinnati, no matter how wealthy you are, if you live in the wrong part of town, people will call you white trash. So that is a very strong disincentive for the wealthy to move to Kentucky. I guess for some people higher taxes are the price they pay for not being called a hillbilly all the time.

Rick writes:

The only way to exit the federal government taxes is to renounce your U.S. citizenship but remember if your net worth is over $2 million you must pay your expatriation tax.

http://www.irs.gov/Individuals/International-Taxpayers/Expatriation-Tax

No easy escape from the taxman, but plenty of Americans are renouncing their citizenship now, paying the tax and never coming back.

Thomas Boyle writes:

I think Floccina is right.

I'll go farther: I believe that California's anti-business policies are a similar phenomenon. Anti-business policies preferentially drive out the low-value-add businesses that employ lower-income people. A lot of people are leaving California, primarily because there are declining numbers of lower-middle-class jobs (even more than because of the stupefying, above-European-level tax rates). Those people are moving to Texas, Arizona, Nevada, etc. - reducing the cost of providing schools and social services, and the pressure on crowded freeways.

When only the rich pay taxes, the State will eventually want to get rid of everyone else.

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