Google+
Close

The Agenda

NRO’s domestic-policy blog, by Reihan Salam.

The Long-Run and Short-Run Impacts of Taxation



Text  



As you might already know, Dylan Matthews of the Washington Post has written a very helpful post on how to think about the Laffer Curve. No one disputes that there is a point at which higher tax rates will yield diminishing revenue. Yet there is considerable disagreement as to where the Laffer Curve bends. Dylan asked a number of economists and political commentators for their views. The most insightful comments, to my mind, were from Joel Slemrod and Greg Mankiw, who said different versions of the same thing. First, Slemrod, a noted tax economist at the University of Michigan and editor of Does Atlas Shrug?:

I would venture that the answer is 60% or higher…. The idea that we’re on the wrong side has almost no support among academics who have looked at this. Evidence doesn’t suggest we’re anywhere near the other end of the Laffer curve…. The elasticity of response, which is the key parameter here, isn’t some absolute parameter that we just have to deal with. It depends on policies. Let me be specific. There’s an article about how the IRS has reorganized itself to crack down on tax evasion of high-income people and corporations moving their operations or assets offshore. That’s the kind of policy initiative that can affect the elasticity of response by closing up a loophole. ÐEmphasis added.Ò

Mankiw said the following:

My guess is that that the short-run answer and the long-run answer are quite different. For example, if you raised the top rate from 35 to, say, 60 percent, you might raise revenue in the short run. Over time, however, you would get lower economic growth, so the additional revenues would fall off and eventually decline below what they would have been at the lower rate…. I will pass on offering a specific number, as it would require more time and thought than I can offer just now, but I will opine that I think the long-run answer is actually more important for policy purposes than the short-run answer.

So why are these comments related? Arpit Gupta touched on this in a recent Economics 21 commentary. As recent research by Raj Chetty suggests

micro estimates rely on instantaneous adjustment to higher tax rates, and typically focus on short durations after law changes. However, a variety of factors may combine to make the behavior responses to tax cuts a more long-run effect. People face costs in switching jobs or entering the job force. They may simply be unaware of tax changes or lazy. Any of these plausible frictions are compatible with large long-term effects of tax cuts that are difficult to capture in micro data.

The paper by Saez, Slemrod, and Giertz acknowledges these difficulties:

An important question is whether the clearly visible short-term responses persist over time. In particular, how should we interpret the continuing rise in top incomes after 1994? If one thinks that this surge is evidence of diverging trends between high-income individuals and the rest of the population that are independent of tax policy, then the long-term response to the tax change is less than estimated. Alternatively, one could argue that the surge in top incomes since the mid-1990s was the long-term consequence of the decrease in tax rates in the 1980s, and that such a surge would not have occurred had high-income tax rates remained as high as they were in the 1960s and 1970s. It is, though, very difficult to disentangle those various scenarios with a single time series of top incomes and top tax rates. As mentioned above, cross-country time-series analysis might be a fruitful area to make progress, taking advantage of varying time patterns of tax rate changes. ÐEmphasis added.Ò

Edward Prescott has argued that cross-country differences in hours worked can be traced to durable differences in marginal tax rates [PDF]. I highlighted the passage about diverging trends because I think there are many good reasons to believe that upper-tail wage gains have been driven by forces independent of tax policy, including the rise of “digital organizations.” Labor market polarization in the United States has been driven in large part by the explosion in upper-tail inequality, i.e., the very top has been pulling away from everyone else, and we’ve seen this happen in virtually all of the advanced countries before taxes and transfers are factored in. (I’ll have more to say on this in the future. Briefly, younger cohorts in Europe have caught up with and surpassed younger cohorts in the U.S. in educational attainment. Older European cohorts, however, were well behind older U.S. cohorts. And higher levels of education tend to mean higher levels of wage dispersion.) 

And so it seems likely that the experience of the 1993 tax increase has proven misleading. Because it is so difficult to isolate the impact of tax changes from other factors, many are convinced that the increases in marginal tax rates were costless when in fact overall growth would likely have been higher in their absence. A more interesting debate is over which kinds of taxes will do the least amount of harm.

Matt Yglesias wrote a good post on a related subject that I recommend, as did Karl Smith.

Matthias Trabandt and Harald Uhlig have offered valuable comparative perspective on the Laffer Curve:

We characterize the Laffer curves for labor taxation and capital income taxation quantitatively for the US, the EU-14 and individual European countries by comparing the balanced growth paths of a neoclassical growth model featuring ”constant Frisch elasticity” (CFE) preferences. We derive properties of CFE preferences. We provide new tax rate data. For benchmark parameters, we find that the US can increase tax revenues by 30% by raising labor taxes and 6% by raising capital income taxes. For the EU-14 we obtain 8% and 1%. Denmark and Sweden are on the wrong side of the Laffer curve for capital income taxation.

Lest you interpret this as a case for higher U.S. taxes, the co-authors end their paper with the following note:

We therefore conclude that there rarely is a free lunch due to tax cuts. However, a substantial fraction of the lunch will be paid for by the efficiency gains in the economy due to tax cuts.

So yes, we could increase revenue by raising taxes. But this means sacrificing potential efficiency gains — and this sacrifice, per Prescott, helps explain why the United States is the world’s wealthiest major economy, assuming you accept that Luxembourg, Macao, the UAE, Norway, Singapore, and Brunei Darussalam are not major. 

It’s not obvious that maximizing tax revenue should be our only goal, or even a very important one. There is definitely a reasonable case for slightly increasing the tax burden, provided we also make strenuous efforts to discipline spending. But doing so will make our economy smaller, and poorer, than it could be. That is the reason those of us on the right are so allergic to tax increases.

To be sure, if our goal is only to maximize the well-being of the bottom 10 or 20 percent of the population, a high tax strategy might make sense. As Scott Winship recently observed:

Tim Smeeding’s research based on the Luxembourg Income Study shows that in general Americans have higher incomes than their European counterparts as long as they are in the top 80 to 90 percent of the income distribution. Below that, incomes are more comparable across countries, and the living standards of Americans look less impressive.

My normative instincts tell me that this outcome is perfectly acceptable. Tim Worstall had an interesting take on this way back in 2006:

How we’re supposed to read this is that the USA has a very uneven income distribution, that the poorest 10% only get 39% of the median income, that the richest 10% get 210%. Compare and contrast that with the most egalitarian society amongst those studied, Finland, where the rich get 111% and the poor get 38%. Shown this undoubted fact we are therefore to don sackcloth and ashes, promise to do better and tax the heck out of everybody to rectify this appalling situation.

But hang on a minute, that’s not quite what is being shown. In the USA the poor get 39% of the US median income and in Finland (and Sweden) the poor get 38% of the US median income. It’s not worth quibbling over 1% so let’s take it as read that the poor in America have exactly the same standard of living as the poor in Finland (and Sweden). Which is really a rather revealing number don’t you think? All those punitive tax rates, all that redistribution, that blessed egalitarianism, the flatter distribution of income, leads to a change in the living standards of the poor of precisely … nothing. 

There are, of course, other considerations, including the quality of public goods and how wealth concentration shapes institutions and political outcomes, etc. But overall, I’d say I’m with Worstall.



Text  


Sign up for free NRO e-mails today:

Subscribe to National Review