This is Chris Edwards' closing remarks in a larger debate on tax policy.
This is Chris Edwards' closing remarks in a larger debate on tax policy.
The Economist has chosen a provocative advocate for tax increases. But Thomas Piketty's policies are far out of the mainstream, and I don't think policymakers will take him seriously. Indeed, governments around the world have been slashing top income tax rates in recent decades—the opposite of what Piketty is proposing.
In this article, I will discuss recent reductions in income tax rates. Then I will address Piketty's obsession with corporate executives, which seems to warp his view of tax policy. Finally, I will discuss the effect of tax increases on entrepreneurs—a group of people crucial to the economy that are absent in Piketty's worldview.
Tax rates are coming down
Tax rates are coming down
In his statements, Piketty has focused on the labour supply elasticity of high earners. But the economic damage caused by high tax rates relates to the entire taxable income response of high earners. Remember that the individual income tax does not just hit labour income, it also hits capital income, including interest, dividends, and small business income. Capital income is more elastic than labour income, particularly in an era of globalisation. That's one reason why top income tax rates have been cut around the world, contrary to the advice of Thomas Piketty.
The average top personal income tax rate in the 30 nations of the Organisation for Economic Cooperation and Development fell from 68% in 1980 to 42% by 2007.1 Non-OECD countries are also cutting rates. Cuts to top rates since 1985 include: Egypt (45 percentage points), Morocco (43 points), India (27 points), Philippines (28 points), Thailand (28 points), Brazil (33 points), and Peru (35 points).
In response to today's mobility of high earners, countries have also cut other taxes on capital, such as annual wealth taxes. Wealth tax rates have plunged, and many countries have completely abolished these taxes, including Austria, Denmark, Finland, Germany, Iceland, Luxembourg, the Netherlands, and Sweden.
As Piketty is surely aware, France's high income and wealth taxes have led to a brain drain and a wealth drain. Wealthy rock star Johnny Hallyday fled to Switzerland in 2006 to avoid France's high taxes. He said: "I'm sick of paying, that's all ... I believe that after all the work I have done over nearly 50 years, my family should be able to live in some serenity. But 70% of everything I earn goes to taxes."2 Unlike Piketty, I take such complaints seriously both as a moral statement about oppressive government and as an indicator about how high-earners respond to taxes. For French every rock star like Hallyday, there are likely many entrepreneurs and scientists who have also fled high-tax France.
Rather than raising top income tax rates, countries should be cutting them. A basic theoretical point is that the economic damage, or deadweight loss, of a tax rises more than proportionally as the tax rate rises.3 In particular, a doubling of an income tax rate causes the deadweight loss to roughly quadruple. Thus, raising the tax rate on someone in a 40% bracket would create much more damage than raising the rate on someone in a 20% bracket. That is why flatter tax rate structures are more efficient than graduated tax structures.
One of Piketty's key arguments for tax increases is that the market for corporate executives does not work very well. As I noted, the economics literature on this is actually mixed. One problem is that numerous regulations distort the market for executives, such as a 1993 tax law in the United States that encouraged the proliferation of stock option compensation.
So let's repeal the distortions first, then we can have a discussion about fixing other problems in the market for executives. How can we make corporate boards more effective? What is the appropriate level of shareholder control over executive pay? I don't know the answers to those questions, but I would note that it might not be in shareholders' interest to cut executive pay. The average pay of CEOs in 1,400 large U.S. corporations represents just 0.1% of corporate revenues.4 Given the important role of CEOs in leading companies, it makes sense for shareholders to use compensation policies to secure the best executives they can get.
Finally, note that Piketty's solution of a punitive tax on all high-earners is oddly detached from the narrower problem he supposedly identifies with corporate executives. Piketty seems uninterested that his tax policy would hit a wide range of the economy's most productive and entrepreneurial people, not just corporate executives.
The type of people who would be hit by Piketty's 80% tax are on Forbes list of the 400 richest Americans.5 The great majority of these people are not the idle or poorly performing executives that Piketty seems to imagine. Today's wealthy are mainly self-made and entrepreneurial—they are not simply passive inheritors of wealth.6 They start new companies, they fund venture capital, and they launch innovative charitable activities, as Bill Gates does.
I wrote a study a while back about the role of entrepreneurs, and I was stuck by the power of single individuals to generate broad changes in the economy.7 In growing economies, it is often independent entrepreneurs who create new products and industries, not existing large corporations or governments.
Readers of The Economist are familiar with the entrepreneurial stories behind companies such as Apple and Google, but the American model of venture-financed entrepreneurship has been around for decades, even centuries. The Google of the 1960s, for example, was Xerox Corporation. It began as a small photographic equipment firm called Haloid, which struggled for years on a shoestring budget funded by angel investors. It developed an idea for a simpler paper copying machine that had been ignored by the big companies of the day. Haloid struck gold in 1960 when it introduced the world's first modern photocopier. The company changed its name to Xerox and a huge new industry was born. Similar stories of risk capital, struggle, and leadership were behind the companies that revolutionised long-distance telecommunications (MCI Corporation), package delivery (Federal Express), portable computers (Compaq Corporation), and many other industries.
Yet Piketty says that "one should think of taxing the rich pretty much in the same way as taxing pollution activities." Unbelievable! Bill Gates and Steve Jobs are economically equivalent to sludge—now there's an economic theory for the 21st century! Piketty is trying to be provocative, but that sort of thinking is scary to anyone who believes in free markets and economic growth.
Higher tax rates would have a variety of effects on entrepreneurs. I discussed the basic effect of changing their marginal incentives to work less and evade taxes more. With a tax rate as high as Piketty suggests, we would also expect that productive people would head in droves for careers as lawyers and accountants to avoid the risky world of entrepreneurship. Why take risks if the government is going to steal your payoff when you are successful?
Higher taxes at the top end would severely damage savings and investment. Under the Piketty plan, the American who earns $10m would have her tax rate above $1m jump from 35 to 80%, thus reducing her annual earnings by $4m. That would mean less money for consumption, but the more important effect is that it would reduce savings. High-earners save a higher share of their income than lower earners.8 When they save, their money goes to work for all of us because it flows through to businesses for capital investment. For an economy to grow, it needs a large pool of savings that is constantly replenished, but Piketty's tax policy would destroy that pool of savings.
The particular way that rich people save is important. I noted that one of Silicon Valley's strengths has been the active role played by each wave of entrepreneurial millionaires in funding the next round of innovations. Successful high-tech entrepreneurs, such as the founders of Microsoft, Dell, and Oracle, channel their wealth back into high-tech start-ups, creating opportunities for new entrepreneurs. Over the years, Microsoft billionaire Paul Allen, for example, has invested in hundreds of companies in telecommunications, biotechnology, and other areas. Such angel and venture investment is crucial for economic growth, and imposing high tax rates on people such as Paul Allen would destroy the virtuous cycle of risk-financed innovation in many industries.
In closing, I'd suggest that Thomas Piketty get his nose out of the academic literature, and spend more time researching the productive activities of high-earners in the real world. We shouldn't treat high-earners as pawns for social experiments, but instead reduce the tax burdens on them so that they can start the companies and deliver the innovations that make us all better off.
- Chris Edwards and Daniel Mitchell, Global Tax Revolution (Washington: Cato Institute, 2008). The data includes both national and subnational tax rates. Tax rates are also available from the OECD at www.oecd.org/ctp/taxdatabase.
- Quoted in Doreen Carvajal, "Swiss Tax Deals Lure the Superrich, but Are They Fair?" New York Times, January 14, 2007.
- Harvey Rosen, Public Finance, 6th Edition (New York: McGraw-Hill, 2002), p. 292. To be precise, deadweight losses rise by the square of the increased tax wedge between pre- and post-tax income.
- Ira T. Kay and Steven van Putten, "Executive Pay: Regulation vs. Market Competition," Cato Institute Policy Analysis no. 619, September 2008, p. 5.
- Matthew Miller and Duncan Greenberg, "The Forbes 400," Forbes, September 17, 2008.
- Luisa Kroll and Allison Fass, "The World's Billionaires," Forbes, March 8, 2007. See also Merrill Lynch and Capgemini, "World Wealth Report," 2006.
- Chris Edwards, "Entrepreneurs Creating the New Economy," Joint Economic Committee, November 2000.
- See data here www.bls.gov/cex/2007/Standard/higherincome.pdf and here www.federalreserve.gov/pubs/oss/oss2/scfindex.html.