David R. Henderson  

Romney Tax Cuts: Income and Substitution Effects (Wonkish)

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By keeping average taxes the same, while reducing marginal tax rates, it is possible to encourage people to earn and report more income.
This is from Alan Reynolds, "Marginal Tax Rates," in the first edition of The Concise Encyclopedia of Economics, and it relates to the discussion yesterday of my post on the Romney tax-cut plan.

When the government cuts a marginal tax rate, and that's all it does, that cut has two effects in opposite directions: a substitution effect and an income effect.

The substitution effect is to make leisure more expensive. If you're facing a 35% marginal tax rate (MTR), for example, and the rate is cut by 20% to 28%, your "price" of leisure rises by (72 - 65)/65, or 10.8%. When the price of a normal good rises (and leisure is a normal good), you buy less of it. So people work harder.

The income effect is to make you buy more leisure. The cut in marginal tax rates increases your real income and therefore you demand more leisure. That is, you work less.

Empirically, the substitution effect tends to outweigh the income effect slightly for men and strongly for married women. This means that cuts in MTRs alone will tend to increase income somewhat for men and a fair amount for married women. That was the effect of Reagan's cuts in MTRs in the early 1980s.

But what happens when the government doesn't just cut MTRs but also broadens the base by limiting deductions and exemptions? Let's say the government does so to make static after-tax income (before the effect of the higher incentive to make money) the same as before. Or another way to say it is that the government cuts MTRs but keeps average tax rates constant (in a static sense.) Then there is no income effect. That means that the only effect is the substitution. That's how you can get a big boost in taxable income. Of course, that also means that the average tax rate in equilibrium will be lower (because of the added income), but the average high-bracket person will pay more income tax (because the static amount of income tax was the same and the person is paying more tax on the additional income.)

Of course, as I understand it, it's unlikely that the Romney tax cut would get rid of so many deductions that people would pay the same average tax rate (in a static sense.) Still, if the tax cut substantially reduced deductions and exemptions but didn't go all the way to making income taxes paid (in a static sense) constant, there would still be an income effect. But it would be attenuated compared to the situation where the only thing that changed was the MTR. So the odds are still that the substitution effect, even for men, exceeds, and probably strongly exceeds, the income effect. Result: more income to be taxed.

There is one fly in the ointment. Because Romney wants to limit deductions and exemptions more for higher-income people than for lower-income people, he would need to phase out those deductions and exemptions with income. That is, past some income level, as people's income increased, their deductions would decrease. Over the income range in which this happens, there is an added implicit MRT. So, for example, if he allowed $25,000 in deductions for people with income up to $100,000 and $0 in deductions for people with income of $200,000 or more, and if he phased it out linearly, as is commonly done, then someone in the income range from $100K to $200K would find himself losing 25 cents in deductions for every additional $1 in income. If the tax rate in that region of income is, say, 20%, then the person pays an additional 5 cents in tax for every additional $ of income. That's like an additional 5 percentage points added to the MTR in that region of income. And, of course, that causes an added disincentive to make income.


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CATEGORIES: Tax Reform , Taxation



COMMENTS (20 to date)
Shayne Cook writes:

Dr. Henderson:

I was wondering if you've ever heard the phrase, "Jeez, I can't believe they actually pay me to do this!"

The first time I heard it, I was conducting a flight test. I, and a few other folks were measuring radiation patterns of an F-15. The "Zipper Suited Sun-God" (fighter pilot) was flying the jet, and we were directing him to perform various maneuvers in order to present various aspects of the F-15 to our antennae. I asked the pilot to perform a particularly "fun" maneuver, and, while he was executing it, I heard the fighter pilot's voice over the radio - "Jeez, I can't believe they actually pay me to do this!"

I'm wondering how that phenomena is accounted for in the accountancy of the balance of accounts, accounting for the substitution account versus the leisure account.

As a matter of fact, I'm beginning to wonder if economics isn't just accountancy.

Tom writes:
But what happens when the government doesn't just cut MTRs but also broadens the base by limiting deductions and exemptions? Let's say the government does so to make static after-tax income (before the effect of the higher incentive to make money) the same as before. Or another way to say it is that the government cuts MTRs but keeps average tax rates constant (in a static sense.) Then there is no income effect. That means that the only effect is the substitution.

Perhaps someone smarter than me can explain this. I understand that the income effect disappears when you keep the average tax rate constant by eliminating deductions - an individual must continue working the same amount to obtain the same after-tax income. There's no longer an incentive to work less and consume more leisure. But why doesn't this same logic apply to the substitution effect? Lower marginal rates make leisure more costly or, put another way, make working harder and longer more profitable. But if you eliminate deductions and exemptions such that after tax income remains the same, why is there still an increased incentive to work harder?

Sorry for the simple question.

Jim Ancona writes:

Tom,

You asked:


But if you eliminate deductions and exemptions such that after tax income remains the same, why is there still an increased incentive to work harder?

The reason you still have an incentive to work more is because the marginal rate changed. Let's try an example:

Imagine a tax system with a single rate of 50% on income after deductions. You make $1000 a year and have $500 in deductions. Therefore your tax is:


(1000 - 500) * 50% = 250

Romney is elected and his new tax system has a single 25% rate and no deductions. Now your tax is:

1000 * 25% = 250

If your income stays the same nothing has changed. You pay $250 (25% of your gross income) in either system. And, to David's point, there is no incentive to work less because your after-tax income hasn't increased. But consider your incentive to work more. Before if you worked overtime to earn an extra $100, you would have paid an extra $50 in taxes for a net of $50. (Remember, your deductions are fixed, they don't increase when you work more.) Now if you work the same overtime you get to keep $75 and only pay $25 dollars in taxes. If the extra take-home pay causes you to work the overtime rather than take it as leisure, that's the substitution effect in action.

Hope that helps!

David R. Henderson writes:

@Tom,
What Jim Ancona said. Thanks, Jim.

David R. Henderson writes:

@Shayne Cook,

Yes, not only have I heard it but also I've said it. To read about a day when I said it to myself and then wrote it up in the San Francisco Chronicle, see my "Mr. White House Counsel, Meet the Constitution." Coincidentally, both your and my stories involve the military.

Having said that, I don't quite understand your question/comment. Would you explain?

MG writes:

Another great post on taxes. I think the "fly in the ointment issue" you refer to is what tax wonks call "a bubble". We lived with it (until I think last year) since the Clinton tax hikes of 1993 introduced something similar. I always thought this as not a "fly in the ointment", but rather a clever way to exact higer effective MTRs with very little transparency. (How often have your heard that the highest MTR under Clinton was 39.6%, versus the more technically correct figure, which I think was around 42%). However, in Romney's case, I think he would see such as scheme as a bug, not a feauture, and that's why they would do something like cap deductions, not phase them out.

A couple of unrelated points. I would love to see the women's versus men effect studies redone to account for changing conditions. I suspect that the disincentive to work for the second (let's say female) spouse to work given an adverse change in MTR to (a) be greater the higher the ratio of women already in the work force; (b) greater the higher the wealth of the couple; (c) greater the higher the age of the couple. I think all these factors would suggest more of a disincentive for higher earners to work in 2010 than in 1990.

I also suspect, and dread the debate, that the intellectually rigorous path to squaring the circle will be for a VAT to be part of tax reform. This is a proposal which economists will cheer, but realpolitik will debate at the extreme because where tried it has been abused.

Methinks writes:

Wow, Jim Ancona. That was short, sweet and crystal clear. If you find I've cut and pasted "Jim Ancona's explanation" somewhere else on the internet, will you mind?

Alex Godofsky writes:

There's a second reason that income effects don't matter: even if the tax change reduces revenues, as long as we live in the long-run-budget-constraint world that must reduce government spending and government spending is also income. This is moderated a bit by the degree to which the spending is on useful-ish things, but is still important.

Shayne Cook writes:

Dr. Henderson:

First, thank you for your work and your colleagues' work here.

Indeed, I have heard (read) you say it before. I also recall Dr. Kling mentioning his concern that the discipline of economics seemed to be descending into a "thing of arithmetic" (my expression, not Arnold's). That is my concern as well.

It strikes me that, particularly now, the world needs economists, not accountants. What you, and other accomplished economists know, and what accountants can never know (they are constrained by the rules of their discipline), is that money is NOT wealth. You know money isn't wealth precisely because you are an economist.

Tax "cuts" are not cuts if they are revenue neutral - they are tax changes, not tax cuts. I appreciate your analysis, using economics terminology as well as arithmetic. And I give Mitt Romney credit for being at least semi-honest in noting his proposed "cuts" are revenue neutral. (I already knew there had to be a Pony in there somewhere.)

But I was dismayed, first by your reference to them as tax cuts (rather than tax changes), and second by your neglecting to heavily caveat your arithmetic results/conclusions with the exclusively economics-based concept that people are NOT solely motivated by money. In many cases, people are not even motivated by money. I guess that was part of the point of my comment.

So these proposed tax changes may in fact have no or very, very tiny incentivizing, wealth-producing or wealth creation inducing economic effects at all. You know, as an economist, that the difference between wealth and money is a remarkably immeasurable variable. It is also the enormously powerful variable, and as such often confounds even the most arithmetically elegant policy goal.

I guess I would have you scream that at the top of your lungs, as an accomplished economist, each and every time - without fail - after you have completed and explained your arithmetic.
"Money is a metric, not a goal."
"GDP is a metric, not a goal."
"And money is NOT wealth!"

The U.S. economy is NOT a "GDP factory", borrowing Arnold's phraseology. First, last and foremost it is a "Wealth Factory".

Paul Heyne never wrote a book titled, "The Accounting Way of Thinking."

Adam Smith never wrote an essay entitled, "On the Nature and Causes of the GDP of Nations." And I'm fairly certain certain he never envisioned his "invisible hand" toiling away at a keyboard performing Pascalian double-entry arithmetic.

Please explain that each and every time you do what you do. I believe the U.S. economy could use a strong, sobering jolt of economics. It already suffers from a super-abundance of accountancy.


Related, but somewhat off-topic, I know you teach at the Naval Postgraduate School in Monterey. Next time you run across a Naval Aviator (Air Force types are referred to as "Zipper Suited Sun Gods"), ask her to explain to you the aviation concept of the "coffin corner". You might find it a useful analogy with regards the current state of the U.S. economy. It's part of the conceptual framework that leads me to believe there is an acute requirement for the foundational concepts of your discipline just now.

Tom writes:

@Jim Ancona:

Thank you! I really appreciate the step-by-step explanation. I mistakenly assumed a simultaneous increase in deductions with each extra dollar earned.

Jim Ancona writes:

Thanks for the kind words everyone. Methinks, if I run across that I'll be honored!

Rereading this post makes me onder why more progressives don't support a flat tax with a large exemption. By broadening the base, and setting a relatively low marginal rate, you can:

  • Keep taxes non-existent or low for low-income folks
  • Raise more money from high-income folks
  • Increase growth from the effect of low marginal rates

In other words, the way to make sure that Warren Buffet pays an average tax rate higher than his secretary is to make them pay the same marginal rate, no deductions and give both of them an exemption that's large relative to a secretary's income and trivial relative to Buffet's.

(Thanks to Meir Kohn who first explained that to me in an undergraduate economics course thirty-some years ago.)

Henry Milner writes:

I think the "fly in the ointment" is a serious problem for your argument. In Jim Ancona's example, the total tax increased for people with income less than the example taxpayer, and the total tax decreased for people with income greater than the example taxpayer. As you pointed out, you shift around the impact if you have multiple marginal rates, but you can't avoid it entirely. Basically, if you want to lower an MTR while keeping tax revenue constant, and you're not on the wrong end of the Laffer curve, someone has to get hit with a higher MTR, or else you have to assess a lump-sum tax on everyone, which is regressive.

However, I think you can still get a free lunch by closing loopholes, but not in the way you described. The point is that we've been assuming that all taxpayers are treated the same. But what you really want is to assess a lump-sum tax tailored to each person's underlying ability to produce. (This isn't my idea - this is my amateur understanding of standard optimal taxation theory.) In the ideal case you figure out what everyone would have earned without taxes and then assess that as their lump-sum tax. Everyone's marginal rates would be 0, so the incentive effect disappears (which is great) but their tax liability stays the same (which is also great).

Of course, you can't actually do this. But what you can do is look for characteristics of people that correlate with income and are hard to change, and tax people accordingly. Greg Mankiw had a half-tongue-in-cheek paper about taxing tall people, the idea being that height is positively correlated with income and is basically immutable:

http://scholar.harvard.edu/mankiw/files/Optimal_Taxation_of_Height.pdf

Maybe the ability to exploit loopholes is like height, and the kinds of people who will take advantage of loopholes are more likely to be ruthless individualists, who are also likely to have high incomes. If you believe that model, closing loopholes is like adding a lump-sum tax on these loophole-users who are likely to also be wealthy. I admit the model isn't necessarily true, but it's plausible to me.

Jason writes:

This gets the award for the simple common sense post that everyone in the world should read and understand of the month. Great job.

Mike Hammock writes:

David, I am curious what you think of this Matthew Yglesias post on the possibility of a 100% marginal tax rate (under certain conditions) in Romney's tax plan.

David R. Henderson writes:

@Jason,
Thanks.

Ron Maimon writes:

This analysis is completely ridiculous. The high taxation one is talking about it for absurdly high incomes, of $250,000 or more, which are approximately 5 times the market average. These incomes can't be controlled by competition, since otherwise there would be people coming in off the street and saying: "That guy get's paid THAT MUCH! Dude, I'll do what he's doing twice as hard for half his salary." It only requires a small surplus of capable individuals to drive the wage down to market levels, around $40,000-$60,000 for individuals.

The fact that occupations exist which have $250,000 or higher salaries means that these positions are not filled competitively, they are filled by non-market political forces, like rising through the ranks of a closed organization. The political factor is most important, and accounts for the vast majority of these high wages. Political wages are a form of class-based reward, they have nothing to do with market forces, and you could tax 100% of income beyond this with _no effect_ on leisure or work choices, since the substitution rational-choice nonsense you are talking about only is relevant to agents in a competitive wage situation, which is workers not the folks here. The folks here only work hard enough to keep their job, and to move to the next tier of the heirarchy, not to increase salary. They work to impress their peers in a show of political showmanship, not to get things done. Generally, the highest-paid workers are the stupidest, the most talentless, and the least productive. Their talent is schmoozing and hand-shaking, and not offending anyone in the organization. They are also good at bad-mouthing others who might also be in line for a promotion, they are masters of office politics, and nothing else.

There are other high-paid individuals, who actually have some skills, although this is rare. Those are the professions who have managed to erect professional barriers to entry, enforced by law, the doctors and the lawyers.

In addition to these workers, there are a few high salaries justified by sporadic work (actors), or by very short career-span (professional sports players). When taxes are adjusted properly to confiscate the non-market salaries of the corporate world, these folks unfortunately get screwed over. One way to fix this is to allow them to place their sporadic income in a special tax free account that then doles it out to them over a period of time a normal salary in small yearly increments, which are then taxed at a lower rate.

Free market theory does not theoretically allow the kind of salary differentials you see in American markets, and if they are not corrected by confiscatory taxation, the predictable result is ruinous depression. The high-class folks get rich, the working class gets less of a share of income during a growth period, and when the purchasing power of the workers slips below what the market requires to purchase all the goods produced, this leads to slacking demand, loss of jobs, and a cycle that ends in ruinous depression. This can never happen in an ideal free market, but it is easy in a market where people in high positions siphon income into their own pockets in the absence of true market competition, which is the world we unfortunately live in today.

This used to be standard wisdom in the Keynsian era, it is supported by theory (the above) and experiment (high-income marginal tax rates and growth rates are slightly correlated in historical data, not anti-correlated), but it is politically inconvenient for the rich people that run the show.

Methinks writes:

Uh-huh. Very interesting, Ron.

I'm in that group that makes more than $250K per year. I'm self-employed and I eat what I kill. I built the company from a tiny initial investment of money which I scraped and scrimped to save.

You are, of course, correct that my exceptional rate of return (oh yeah, it's the return on investment, not the absolute amount that counts - or didn't they teach you that in the Keynesian Era?) can be competed away by others. And if it is, so be it. I'll have to find something else to do. You're welcome to try.

Thing is....I don't see you there. And my competition keeps going under. I survive - and without subsidy or leaning on political connections.

My key employees are paid well more than $250K as well. You know why? Because there are very few people who are that good at making this much money for my firm and, as a result, they suffer no shortage of bidders for their labour. Believe you me...as self-interested as I am, I don't pay them a penny more than I have to keep them working for me.

What did the "Keynesian Era" teach you about that?

Ron Maimon writes:

Methinks, I tend to think that what you say is sincere, but I can't imagine what kind of company you run that is able to stay ahead of the competition so easily. Usually you get competed to lower levels of compensation very quickly.

My guess would be that you are in the fiancial sector. Here there are structural issues due to market fluctuations, and monopolies, even natural ones can easily produce distortions.

Perhaps not. Maybe you are in a company that exploits the already existing class structure in the US, which is caused by the noncompetitive nature of high class positions. Maybe you have a consulting firm that goes to companies and makes recommendations for who to hire to high managerial positions. Such a company is effectively exploiting the market distortions elsewhere to piggy-back on.

But it is also possible that you are just a really smart and really creative fellow who was able to provide a serious service that people need that wasn't forseen by others. I doubt it, because this is extremely rare.

In any case, there is nothing that your top employees could possibly be doing which is particularly difficult, at least not in comparison to programming a computer which is my baseline for a brain demanding job. There are difficult things, like learning how to schmooze with high-class people, but these things are only difficult because of already existing market distortions.

If your income is confiscated and redistributed, you should celebrate, since this is just your contribution to the overall health of the economy, and it still leaves you with plenty to live a happy and productive life.

Methinks writes:

So, let me get this straight: There is no way my company can exist in nature and I should be throwing a party if I stress myself out, take risks, and work long hours (forgoing other, more enjoyable activities) so that strangers can enjoy the fruits of my labour as I toil in the mines. Ha ha ha ha!

When you meet a person like that, let me know!

Ron Maimon writes:

yes, you should. In fact, you must. It would be practically impossible for you to be making such a high income in anything resembling a true free market, so count your blessings that you live in a society that tolerates the level class separation and market distortion that allow you to accumulate a large amount of wealth. This wealth is not something that is owed to you, it is only a relatively recent thing that people tolerate this kind of wealth accumulation.

I doubt that you work harder than any PhD student working on a dissertation, a homeless man collecting cans for shelter, the 89 yr old veteran building manager in my building who lifted 60 lb garbage bags until a week before he passed away, or a 20-something struggling in two jobs. From your flippant responses, I am starting to doubt that you are heading any sort of company at all.

If indeed you head a company and pull in $500,000 incomes, it is almost certainly because you are doing something weird. It is not something other people can do, and this is not because of some unique talent on your part, but because of social structures that close off this path to others. If you need to pay your top folks $500,000 to keep them, it is only because there are market distortions that allow them a too-high income elsewhere.

It is contrary to the basic principles of free market theory that there should be differentials of more than a factor of 5 or so in compensation, it makes no sense theoretically, competition should remove the excess income, and it has never been sustained empirically in any truly competitive profession, nor in any truly competitive market, so no, I would not shed tears if 80% of your highest income were confiscated.

The goal of confiscatory taxation is not to punish you, it is to make sure that the distortions of social class and political heirarchy do not wreck the operations of the market, so as to prevent a depression from loss of purchasing power from those not in your social class. This isn't a game, and it isn't a war, it's a matter of approximating a free market as well as possible.

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