Matt Yglesias raises an interesting argument regarding taxes and growth. First, he says something I find a bit frustrating:

How, exactly, are higher tax rates supposed to impoverish the country?

Having spent a fair bit of time in impoverished countries, I think it’s safe to say that slightly higher marginal tax rates won’t “impoverish the country,” and I think most people who oppose higher marginal tax rates would agree. Rather, we tend to think that the benefits don’t outweigh the costs in terms of the excess burden of taxation.

One mechanism I find very plausible is distortions. The tax code contains loopholes and deductions that distort the allocation of economic resources. When you make tax rates higher, the extent of the distortion grows. Currently, high-income people over-consume health insurance thanks to its favorable tax treatment and higher tax rates would encourage even more over-consumption of this one commodity. So I completely agree in this regard that it’s better to tax the rich by closing loopholes first and only raising rates later.

We’re in agreement on this point. But why? If raising marginal tax rates is costless, why not raise them as a first resort? I think Matt is acknowledging that there is an incentive effect, which is good news.

The other mechanism that seems to be on offer is labor supply. This makes a lot of sense to me as applied to low-income people. If you work at McDonald’s or drive a taxi then you face a real choice about whether or not to increase your hours worked at the margin in exchange for more money. Driving a cab at 2AM is obviously a huge pain in the ass and not especially lucrative. To the extent that cab drivers face higher income taxes, they have even more reason not to work so late since it becomes even less lucrative. And the availability or non-availability of late night cabs has a variety of downstream impacts on bars & restaurants, drunk driving, etc.

Matthew Rognile has written a very good post describing the burden of implicit taxes, which I recommend. This is a particularly salient issue for low-income workers who are eligible for various means-tested benefits.

My disagreement with Matt (Yglesias) comes next:

But it’s a lot harder to see this at the high end. A very large share of high-income professionals basically have a marginal wage of $0. The CEO of WalMart can’t cut back his hours by 5 percent in exchange for a 5 percent pay cut. What’s more, a lot of high-end work is characterized by zero-sum competition. It’s plausible to imagine higher income tax rates making veteran NBA players more likely at the margin to retire rather than play one more season at the minimum. But what are the downstream economic implications of Mike Bibby retiring? The overall quantity of NBA players is fixed and there are plenty of other people willing to step up and do that job. The average quality of NBA talent might decline, but so what? The players just play against each other. And it’s not just athletes. Fancy lawyers and high-frequency traders are playing against each other. Marginal changes in average quality don’t matter. If anything, reducing the average quality of America’s lawyers and finance guys would be beneficial if it inspired more people to do something else with their time.

How is the CEO of WalMart compensated? From the AP:

The CEO of Wal-Mart Stores Inc. received a pay package in 2010 worth $18.7 million, a 4 percent dip from the year before, according to an Associated Press calculation, as the world’s largest retailer struggled to reverse a decline in a key revenue figure.
Mike Duke, 61, received a base salary of about $1.2 million and a performance-based bonus of nearly $3.9 million for the fiscal year that ended Jan. 31.
His performance-based bonus fell 20 percent from 2009 because the company’s U.S. stores performed below its targets, Wal-Mart said in a filing Monday with the Securities and Exchange Commission.

To be sure, this performance-based bonus isn’t tied to work hours per se, but one suspects that Duke is sensitive to the performance-based component of his annual compensation. Moreover, Mike Duke is 61 years old, and he has made a series of professional choices over decades that have shared his career trajectory and his compensation. As a 30-year-old middle manager, for example, Duke was presumably making decisions about how to allocate his time between work and leisure, and one assumes that his effective tax burden played a role.

And as an executive, Duke is obligated to assemble teams of workers to accomplish various tasks. Tax kinks can create coordination problems for firms. How is that? Raj Chetty et al. built a model explaining how this might work. Under their model,

Changes in taxes induce changes in labor supply not just by making individuals search for different jobs, but also by changing the equilibrium distribution of hours. Because changes in taxes that affect a largergroup of individuals induce larger changes in hours constraints — either through market forces ordirectly through unions — they generate larger observed elasticities. Furthermore, tax changes may affect even the labor supply of workers whose personal tax incentives are unchanged by distorting their coworkers incentives and inducing changes in hours constraints. Finally, the model predicts a correlation between individual responses to tax and responses to taxes induced by aggregation of workers tax preferences through firms or unions. In particular, one should observe larger distortions in the equilibrium distribution of job offers in sectors or occupations where workers themselves exhibit larger tax elasticities. [Emphasis added]

That is, firms have hours constraints that are respond to collective choices regarding the work vs. leisure trade-off. Tax changes will impact these collective choices in a manner that can constrain work effort even if one is indifferent to higher marginal taxes as an individual. A low work effort/high leisure equilibrium will limit everyone’s earning potential, but particularly that of those most inclined to work really long hours. Chetty et al. compared their model to Danish tax records, and found that their predictions were confirmed.

I think of tax kinks as a question of allocative efficiency. Last year, David Schleicher published a fascinating paper on “The City as a Law and Economics Subject.” In it, he argued that tax competition across local governments has a significant cost:

This paper seeks to develop the framework for a modern law and economic method for analyzing local governmental law. Specifically, it claims that there is an inverse relationship between the gains from agglomeration and sorting. Having many small local governments, and enabling individuals to choose their local public policies by sorting among them, affects the organization and density of people in metropolitan areas, creating movement away from economically-optimal location decisions. Sorting thus reduces agglomerative efficiency. Similarly, the existence of agglomerative gains means that individuals are making location decisions for reasons other than matching their preferences for public policies. Agglomeration therefore causes a reduction in the efficiency of sorting. [Emphasis added]

Schleicher is writing about sorting across geographical space, or rather across jurisdictions with the power to tax. A progressive tax schedule creates an economic map of the world, in which lots of people cluster at certain income levels just below a new effective marginal tax rate kicks in. And this clustering does more than shape individual choices: it shapes the way that firms organize themselves to attract and retain workers. All firms are designed to solve coordination problems, and tax-indifferent workaholics can’t really do their work well if tax-sensitive shirkers are off playing golf and not coordinating with them. As a result, everyone downshifts. The appeal of a single-rate tax regime is that we don’t have to worry about this clustering quite as much. Tax-sensitive shirkers suddenly become tax-sensitive workaholics who can lift tax-indifferent workaholics to new heights of productivity, making everyone richer in the process. To be sure, we might also make everyone sleepier and crankier.

I realize that a single-rate tax isn’t in the cards, but I think that there would be significant gains if we moved in that general direction.

Matt’s point about the average quality of NBA players is actually pretty interesting. Why should we care? Well, maybe we shouldn’t care about the NBA, but the NBA isn’t the only domain in which teams of talented people compete. That is also true of the knowledge-intensive services that are a large and growing share of our economy, and success in these domains is self-reinforcing, i.e., it entrenches the success of existing agglomerations, like Silicon Valley, Wall Street, and Hollywood. If the average quality of workers declines in these domains, it might stymie or delay the creation of productivity-enhancing innovations. Agglomerations in other countries will gain a relative edge. There’s nothing necessarily wrong with that — it doesn’t make us any worse off if other countries are richer — but this will have a cascading effect on the service workers who complement our high-wage professionals. We certainly can adjust to a lower work-effort/higher leisure equilibrium — Western Europe is a perfectly nice place. I just don’t think that being poorer than we can be is a good thing.