Economy & Business

Let’s Not Kid Ourselves about 70 Percent Tax Rates

(Jonathan Ernst/Reuters)
Their only justification is to confiscate others’ money.

My op-ed in Tuesday’s Wall Street Journal argued that academic justifications for 70 percent marginal tax rates, such as Peter Diamond and Emmanuel Saez’s, are nothing more than a veneer intended to deceive a wider audience that doesn’t know better. Saez’s expansion of his justification for confiscatory taxes in the New York Times does little to prove otherwise.

Diamond and Saez’s original argument for a 70 percent tax rate –  that it would enhance both tax revenue and social welfare – ignores the long-term consequences of high tax rates on growth. They assume that taxing, redistributing, and consuming income that taxpayers would otherwise invest doesn’t reduce investment. While admitting that taxes discourage work, they similarly assume that a reduced supply of properly trained talent has no effect on the willingness of investors and entrepreneurs to take risks that grow the economy. Nor, in their model, does lower pay reduce the number of students willing to pursue tedious and arduous fields of endeavor that grow the economy — e.g., accounting, engineering, and computer programing — or the willingness of talented workers to immigrate to America. Nor do reduced amounts of investment, talent, and risk-taking slow the rate at which the economy builds growth-magnifying institutions such as Google, which exposes workers to cutting-edge knowledge that spawns innovation, and Silicon Valley in general, which facilitates the commercialization of new ideas. They also ignore the effect of slower growth on tax revenues more broadly. Honest analysis that endeavors to estimate these effects finds welfare-maximizing tax rates of 30 percent or less.

Saez’s op-ed in the New York Times avoids all his far-fetched economic assumptions, abandons his prior economic justifications for higher taxes and now claims America needs higher taxes to prevent “oligarchical” control of the government, a topic on which he has no expertise. Like his sometimes partner Thomas Piketty, Saez implies that success is largely ill-gotten and so policymakers can tax it without slowing growth. And he uses disingenuous historical examples, such as high tax rates in post-WWII Japan – a nation of savers who merely needed to copy the hard-earned success of the U.S. to catch up rapidly, circumstances that have little, if any, application to America today — to provide evidence that tax rates don’t slow growth.

To make the case that minimizing the threat of oligarchical control of the government is the most important objective of tax policy, Saez must compare this objective to other relevant alternatives. In an economy like ours, where federal debt has risen from 33 to 75 percent of GDP since the financial crisis, where the Congressional Budget Office expects debt to rise to 150 percent of GDP as Baby Boomers retire, and where an emerging China could threaten Western democracy, growing the economy may be a more important objective at this time. Lacking any argument that 70 percent tax rates would serve this end, Saez simply focuses on “oligopolistic” control of the government instead.

To justify such high taxes in the face of the harms they would cause, Saez must also show not merely that oligarchical control of the government is suboptimal, as of course it is, but rather that greater influence of the richer minority over the poorer majority necessarily endangers democracy and threatens prosperity at the margin. As Churchill taught us, democracy is the worst form of government except for all the others. Yes, special interests will endeavor to influence lawmakers – but at the same time, most citizens will be easily misled by propaganda; the poorer majority will eagerly tax the richer minority, no matter the consequences; and political parties will offer voters more, no matter how much it costs. Given these flaws, influence by investors is valuable. Saez provides no evidence to adjudicate whether more or less investor influence than we have today is optimal.

During Saez’s exalted period from 1950 to 1980, for example, when high marginal tax rates ruled America, growth of total factor productivity — the portion of growth driven by innovation, which is the chief source of growth today — fell from nearly 3.5 percent per year in the decade prior to the 1950s to less than 0.5 percent per year by the 1970s. America reduced marginal tax rates during the 1980s, and total factor productivity growth doubled to about 0.75 percent per year. That hardly makes his case that lower marginal taxes, higher income inequality, and greater influence by successful investors over the government necessarily endanger democracy and threaten prosperity.

And it’s not just democracy, but also capitalism, that governs society. Capitalism too has strengths and weaknesses. Competition forces a single-minded focus on serving customers more effectively. Even liberal economists agree that investors must create five dollars of value for others — namely customers and employees — to put a dollar in their pockets. And unlike politicians who seek to control society, investors must focus on serving customers. That’s reassuring. When they seek to influence the government, investors often fight their competitors to a draw.

But competition also leads to ruthless efficiency that sometimes hurts individuals. It can allocate scarce resources to the richest customers. And some success is ill-gotten. Given these flaws, many leaders advocate more government control over business without careful regard for the consequences of expanding democracy’s flaws.

Rather than address these complex tradeoffs, liberal economists like Saez merely insist the vast majority of success is unearned despite evidence to the contrary. This assumption is also essential to Saez’s far-fetched assertion that higher taxes don’t slow growth by reducing the payoffs for work, investment, and risk-taking. Without Saez’s extreme assumption, it’s hardly obvious that confiscatory taxes and giving more control over business and success to politicians and an uninformed electorate necessarily optimizes prosperity.

Optimal tax policy should extract the maximum value from mankind’s randomly distributed talent. Free markets do this by bidding up pay to a price just high enough to motivate talented workers to work harder and take the risks necessary to produce innovation that grows the economy. This is especially important for America, where, for example, half the share of men score at the highest levels on international tests compared with Scandinavia, according to the OECD, but where Scandinavian-Americans produce 35 to 40 percent more GDP per capita than their Scandinavia-residing counterparts. The notion that the economy’s pricing mechanisms are so miscalibrated that confiscatory marginal tax rates will have small economic effects, as Saez and others claim, is farfetched.

Don’t be fooled. If Saez had better arguments, he’d make them. He can’t because he doesn’t.

Edward Conard is an American Enterprise Institute visiting scholar, a former Bain Capital partner, and author of The Upside of Inequality: How Good Intentions Undermine the Middle Class.

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