David R. Henderson  

Krugman on Supply-Siders and Incentive Effects of Tax Cuts

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Recently, I "welcomed" Princeton economists Alan Blinder and Paul Krugman to the "supply-side." I had the idea that they had not admitted that high marginal tax rates reduce the incentive to work and invest. I was wrong.

I don't have Blinder's book handy--I'm on a flight--but here are some excerpts from Krugman's 1994 book, Peddling Prosperity.

If you try to tax people, they will try to find ways to avoid paying. Some people will resort to simple fraud--hiding their income and cooking their books. Some will resort to elaborate legal evasions, arranging for paper losses to offset real gains. But in the United States the main way that people try to avoid taxes is by avoiding doing things that are taxed. Unfortunately, these things include working and investing.

Economists, left and right, have always agreed that the tendency of people to change their behavior to avoid taxes--in the jargon of economists, the distortion of incentives associated with taxation--represents a hidden, extra cost of government. This is a basic truth. (p. 66)


[S]uppose that the government decided to spend an extra $10 billion--1 percent of national income. [He's dealing with a hypothetical economy whose national income is $1 trillion.] You might think that it could pay for this spending by raising the tax rate 1 point, from 30 to 31 percent. But in fact, this would certainly not be enough, because a rise in the tax rate would induce at least some people to work less hard or work shorter hours. (p. 67)

Furthermore, the reduction in the incentive to work is somewhat more than this number would suggest, because the U.S. tax system is designed to be somewhat progressive, that is, to make high-income people pay a higher share of their income in taxes than lower-income people. This seems reasonable on social grounds, but has the side consequence that the "marginal" tax rate--the rate you pay on the last dollar of your income--is higher than the average tax rate. If the economic program proposed by Bill Clinton in early 1993 passes, very high income individuals will pay a marginal federal tax rate of 46 percent, plus a few extra points for state and local taxes. This is not trivial: without any question, the negative effects of taxes on incentives are significant. (pp. 68-69)

So why did I think that Paul Krugman denied that the incentive effects of high marginal tax rates on high-income people are potentially large? Because when he talks about the supply-siders, the people who essentially brought this insight about incentive effects to the forefront in the economic debates of the late 1970s, he is so hostile to them.

You can't, for example, agree with the quotes above and, at the same time, deny the Laffer Curve. As I've written earlier, the Laffer Curve is necessarily correct. But in this same 1994 book, Krugman writes:

[T]he sophisticated public finance arguments of Martin Feldstein were eventually to give way to the crude and silly Laffer curve. (p. 56)

The Laffer Curve is crude: so are demand and supply curves. But they're all awfully useful. So it's not silly.

Indeed, later in the book, Krugman recognizes that the Laffer Curve is not silly. He writes:

Nobody questions that something like the Laffer curve exists; but even the supply-siders are skeptical about whether the U.S. economy is really in the "backward-sloping" section. (p. 95)

This is an interesting admission on Krugman's part for two reasons. First, he recognizes, as one must, that the Laffer curve exists. Second, he admits that supply-siders don't kid themselves that we are in the backward-bending portion, the part where an increase in tax rates reduces government revenues and a decrease in tax rates increases government revenues. I so miss the Paul Krugman of the 1990s.


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COMMENTS (10 to date)
Eric Falkenstein writes:

'Insurance works by pooling like risks.'

Funny that Stiglitz, who's signature papers includes a paper on how markets break down when agents with different risk are pooled, is a huge fan of Obamacare. It's a market failure when low risk people flee an indiscriminate market, and his solution is not to find better signaling, but rather, to simply coerce people to pool.

Randy writes:

Some thoughts from a boomer who has retired early;

1. A small pension with very low taxes is worth almost as much as a median income job with median taxes.

2. That workers nearly always create greater value for the company than they are paid constitutes an often unrecognized tax on work.

3. For those who do real work, work is mostly cost.

4. The first of these did not occur to me while I was working, but had a big impact on my planning once I started to realistically consider retirement. That is, for those who must work the incentive effects are likely quite small, while for those at the margins who have other options the incentive effects are likely quite large.

Mike Hammock writes:

I think "I so miss the Paul Krugman of the 1990s" could be an entire book.

Greg Zerovnik writes:

I, too, miss the 1990s Friedman. I used to enjoy reading his NYT column and would even provide a link from time to time to my management or marketing students. But not anymore. He seems to have become very politicized and quite reactionary. Pity.

Even better--worse from Paul Krugman's current viewpoint--is that later in the chapter David is quoting from, he admits that not only Social Security has perverse effects on economic activity, but so does Unemployment Insurance!

He wrote that, alleviating the pain of unemployment had a 'hidden cost to this laudable goal' (citing Martin Feldstein's 'cutting edge' work).

Which reminds me of that Landsburg guy's quip that it is amazing how much economics Krugman had to know to earn his Nobel Prize, but it's equally amazing how much economics he has to forget to be able to write his New York Times columns.

Of course I'd be remiss not to mention that there's an even more embarrassing chapter in Peddling Prosperity; #9 'The Economics of QWERTY'.

It took Lee Gomes of the WSJ four years to track down (and pin down) Paul and get him to admit there 'wasn't much to it' after all.

The damage still bedevils us though, as a few weeks ago Michael Mann was using 'path dependence' as a reason not to build the XL Pipeline. Didn't want us to repeat the typewriter mistake;

There are two main issues at stake in the Keystone XL decision: path dependency and US leadership. Path dependency is the term use to describe the fact that once a policy is put into place, it then constrains future options to those within that policy framework. More simply, the choices we make now determine what choices we get to make in the future.

A classic example is the "qwerty" keyboard layout. Even though this layout may not be the most efficient, it was the first one, and so it became the standard. New keyboard layouts would have to compete with an established format, meaning consumers would have to adapt to a new system they had no experience with. On the basis solely of legacy, inferior standards or policies remain in place, more or less out of inertia.
Andrew_FL writes:

I have a very old version of Blinder's textbook from the 80's, when my Parents went to college. I could look to see what it says, if you think it would be worthwhile.

emerich writes:

I read "Peddling Prosperity" and other Krugman books in the 90's and remember thinking they were smart and made sense. To this day I can't comprehend how someone could have written those books and today be as predictably shrill and partisan as Krugman now is. It's as though he suffered a stroke that incapacitated portions of his frontal lobe and much of what's called the "executive function," i.e., what enables us to rein in the wilder impulses of our id.

Mike W writes:

"I so miss the Paul Krugman of the 1990s."

So do I. I've been using his books "Pop Internationalism" and "The Accidental Theorist" in a class I'm doing to help explain Milton Friedman's "Free to Choose".

Halcyon writes:

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