This is Chris Edwards' rebuttal to Professor Thomas Piketty in a larger debate on tax policy.
In his opening statement for the tax debate sponsored by The Economist, Thomas Piketty argues that we should impose a very high tax rate of about 80 percent on the top income earners in society. The following rebuttal of this idea addresses Piketty's philosophy of income, and it discusses problems with his political, economic, and historical reasons for tax increases on high earners.
Piketty's Philosophy of Income
Piketty's understanding of the nature of income is very European. He implies that there is a fixed income pie, such that any income that high earners receive must come at the expense of others. Because the share of income earned by the top 1 percent has increased, he says that there has been "an income transfer of about 14 points of national income" to the top group. But high earners did not take that money from other people, they generated it by their own efforts.
In a market economy, there is no central pile of money that is distributed out to the citizens. Each person produces value and earns income by voluntary exchange in a decentralised fashion. Compensation follows from people producing items of value to others. Of course there are exceptions, such as those high-earning CEOs who perform poorly, but it doesn't make economic sense to impose exorbitant tax rates because of the exceptions.
Those at the top end—the entrepreneurs, doctors, and others with unique skills—often generate benefits that are greater than their reward in compensation. One reason is that there is scope for innovation in top-end jobs like heart surgery that there isn't in lower-income jobs. The trash collector's wage matches his contribution, but when the surgeon invents a new medical technique, it can create long-lasting benefits for the rest of us that will only be partly reflected in compensation.
I have people like Apple's Steve Jobs in mind when I think about designing tax policy for the top 1%. But Piketty seems to think that those at the top end did not earn their compensation, rather their high pay came from amorphous forces such as "gains from globalisation." However, let's say Piketty is right, that the innovators behind firms like Apple just happened to be lucky that their products became global bestsellers. It still makes no sense to impose high taxes on them because those entrepreneurs are more likely to use the cash productively than the government. Indeed, from the beginning of Silicon Valley, wave after wave of millionaires have funded the next wave of business successes through angel financing and venture capital. Obviously, that would not have been possible under Piketty's 80% tax rate.
A final note on income is that Piketty's calculations on the rising income share of the top 1% are much less precise than he pretends. Piketty's work is based on income as reported on tax returns, but there have been huge changes in the American tax system since the 1970s that make measuring income over time very difficult. My colleague Alan Reynolds has tackled some of these problems with the Piketty data.1 One issue is that the top federal income tax rate fell from 70% in the late 1970s to 35% today, with the result that high-income taxpayers are avoiding and evading taxes less, and reporting more income on their returns.
If you look at Piketty's data showing the share of income received by the top 1% since the 1970s, you will see sudden upward spikes after major tax rate cuts. That suggests that a portion of the income gains at the high end are not based on structural factors, such as globalisation as Piketty suggests, but are simply expected responses to changes in tax law. In a 2009 paper, Emmanuel Saez and co-authors confirmed that, noting:
"It is striking to note that the share received by the top 1% of income recipients started to increase precisely after 1981—when marginal tax rates started to decline. The timing of the jump in the share of top incomes from 1986 to 1988 corresponds exactly to the sharp drop in the weighted average marginal tax rates from 45% to 29% after the Tax Reform Act of 1986. These correspondences in timing...provide very compelling evidence that high incomes are indeed quite responsive to marginal tax rates." 2
Piketty's Political Arguments
Mr. Piketty argues that if we don't impose very high taxes on the rich "there is a serious risk that citizens will ask for much more damaging, anti-market policies." The Economist debate proposition similarly suggests that we need to buy "social peace" by imposing high tax rates at the top. I think the reality is exactly the opposite. The more arbitrary and punitive government intervention becomes, the more that politicians and the public will get used to it, and the more likely that further punitive measures will be imposed. The government that persecutes certain people with 80% tax rates will find it much easier to expropriate the property of other groups it deems to be a menace. The more that politicians try to centrally plan the end goals for society, the less they will focus on making the general rules of government equal and fair.
Piketty's Economic Arguments
This is a strange statement by Piketty: "The idea that heavy taxes on very top incomes would entail huge economic distortions is purely ideological and is based on zero empirical evidence." I don't understand how a public finance specialist could say that, unless he is hiding behind the word "huge." Are the distortions "large" Mr. Piketty?
One mistake Piketty makes is to suggest that tax distortions are caused only by changes to labour supply. But the economic distortion caused by high tax rates is related to the total taxable income response, not just to changes in labor supply. Martin Feldstein, one the top public finance experts of recent decades, has stressed that point repeatedly. Feldstein's empirical work shows that the economic distortions caused by high marginal rates are large. Increases in marginal tax rates set into a motion a whole range of behavioral responses, all of which add to deadweight losses. Piketty's own co-author, Emmanuel Saez, has found that behavioural responses are substantially greater at the top end, indicating that the top tax rates are the most distortionary.3
In the United States, half of all business income is reported on individual returns, not corporate returns, and a lot of that business income is reported by people at the top end. If you raise individual income taxes at the top end, you hit a large amount of small business income. And empirical research has shown that small businesses are sensitive to income tax changes. A series of studies by economists Robert Carroll, Douglas Holtz-Eakin, Mark Rider and Harvey Rosen explored, for example, the effect of marginal income tax rates on small business hiring, investment, and growth.4 They found substantial effects, such as that a five percentage point cut in marginal tax rates would cause a 10% increase in capital expenditures.
But Piketty doesn't mention entrepreneurial businesses. Instead, he repeatedly implies that the only people who earn top incomes are shady corporate executives, who operate a "crude skimming model" rather than earning their pay. Actually, the literature on executive compensation is mixed in its conclusions regarding the extent to which executive pay is based on market forces. Scholars Kevin Murphy and Jan Zabojnik, for example, argue that there are market reasons why CEO compensation has risen quickly in recent decades.5 As in any market, the market for corporate executives makes mistakes that are corrected over time, which is something we cannot say about governments. These days, corporate executives operate in a very stressful and risky environment, and they are subject to very high firing rates—a much different climate, for example, than tenured university professors.
Piketty's Historical Arguments
Piketty thinks that "confiscatory marginal rates applied to the very high incomes of the 1932-80 period were a pretty good policy." That is quite a claim, but let me just note that the world has vastly changed since the mid-20th century. I co-authored a book last year, "Global Tax Revolution", which documented the worldwide movement to cut tax rates on skilled workers, entrepreneurs, and corporations since the 1970s.
During Piketty's golden era in the 20th century, most industrial countries had fixed exchange rates, which allowed them to seal their borders to capital flows and to keep tax rates high. But nations started floating their currencies in the 1970s and dismantling their exchange controls, with the result that cross-border capital flows have exploded. Virtually every advanced nation has responded with dramatic cuts to top rates on those taxes that have the most mobile bases. Even socialist Sweden recently abolished its wealth tax because it was scaring away too many productive people, such as Ingvar Kamprad, the founder of IKEA, who moved to Switzerland.
High tax rates in the mid-20th century were not good for the economy then, but they would be a disastrous today. In recent years, Europe has seen the most intensive tax competition for skilled workers and businesses anywhere in the world, so it is surprising that Piketty doesn't understand that.
- Thanks to Alan Reynolds for pointing out this study
- Jonathan Gruber and Emmanuel Saez, "The Elasticity of Taxable Income: Evidence and Implications," National Bureau of Economic Research Working Paper 7512, January 2000.
- See the following National Bureau of Economic Research papers by Robert Carroll, Douglas Holtz-Eakin, Mark Rider, and Harvey Rosen: "Entrepreneurs, Income Taxes, and Investment," NBER Working Paper 6374, January 1998; "Income Taxes and Entrepreneurs' Use of Labour," NBER Working Paper 6578, May 2000; and "Personal Income Taxes and the Growth of Small Firms," NBER Working Paper 7980, October 2000. See also William M. Gentry and R. Glenn Hubbard, "Success Taxes, Entrepreneurial Entry, and Innovation," NBER Working Paper no. 10551, June 2004.