In his latest Bloomberg View column, Peter Orszag references a familiar phenomenon: the volatility of incomes at the top of the distribution. My Economics 21 Chris Papagianis has discussed this volatility on a number of occasions.
One implication of this volatility is that jurisdictions that depend on steeply progressive tax codes experience considerable revenue volatility, a subject we’ve addressed in this space. Last year, Robert Frank of the Wall Street Journal wrote an article on the fiscal consequences of a heavy reliance on high-earners:
The working class may be taking a beating from spending cuts used to close a cavernous deficit, Mr. [Brad] Williams said, but the root of California’s woes is its reliance on taxing the wealthy.
Nearly half of California’s income taxes before the recession came from the top 1% of earners: households that took in more than $490,000 a year. High earners, it turns out, have especially volatile incomes—their earnings fell by more than twice as much as the rest of the population’s during the recession. When they crashed, they took California’s finances down with them.
Mr. Williams, a former economic forecaster for the state, spent more than a decade warning state leaders about California’s over-dependence on the rich. “We created a revenue cliff,” he said. “We built a large part of our government on the state’s most unstable income group.”
New York, New Jersey, Connecticut and Illinois—states that are the most heavily reliant on the taxes of the wealthy—are now among those with the biggest budget holes. A large population of rich residents was a blessing during the boom, showering states with billions in tax revenue. But it became a curse as their incomes collapsed with financial markets.
Arriving at a time of greatly increased public spending, this reversal highlights the dependence of the states on the outsize incomes of the wealthy. The result for state finances and budgets has been extreme volatility.
In New York before the recession, the top 1% of earners, who made more than $580,000 a year, paid 41% of the state’s income taxes in 2007, up from 25% in 1994, according to state tax data. The top 1% of taxpayers paid 40% or more of state income taxes in New Jersey and Connecticut. In Illinois, which has a flat income-tax rate of 5%, the top 15% paid more than half the state’s income taxes.
Yet Orszag draws an entirely different conclusion:
[O]ne of the best ways to damp income volatility is to make the tax code more progressive, cushioning the blow from declines in income, while limiting some of the upside from gains. The tax system in the U.S. is highly progressive at the bottom of the income distribution — which is why the betas on after-tax income for families at the bottom are substantially smaller than those on pretax income.
This might indeed be an excellent way to damp the volatility of taxable income. Individuals who achieve windfalls in any given year will presumably go to considerable lengths to increase deductible consumption or to engage in other forms of tax arbitrage. What a more steeply progressive tax code certainly won’t do is make the revenue base less volatile. Rather, it will do the opposite.
Moreover, it’s not clear why we would want to damp income volatility at the top, if making the revenue base more stable is not at issue. Earlier in the piece, Orszag quotes Erik Hurst:
Erik Hurst, an economist at the University of Chicago, says higher incomes could even be viewed as compensation for the additional volatility: “Households with very high incomes may have anticipated the increase in risk,” he writes, “and if so one would expect them to have demanded compensation for bearing that risk.”
This seems like an entirely reasonable outcome. Given that high-earners are well-equipped — due to their relative financial sophistication, etc. — to manage income shocks both positive and negative, it’s not obvious why we’d want public policies aimed at protecting high-earners from these shocks. Peter Orszag may well have devised the strangest argument for a more steeply progressive tax code, i.e., that it will damp income volatility for the rich.
In fairness to Orszag, it could be that he is more concerned about using the tax code to damp income volatility for the non-rich, in which case it might make more sense to consider a return to “income averaging,” a provision of the tax code that is still used for farmers and commercial fishermen. I wouldn’t recommend that course of action, but it does directly address the underlying concern.
If we accept that volatility of high incomes is not intrinsically problematic, particularly if state and local governments turn to taxes bases that are more stable, the rest of Orszag’s column seems a bit unusual:
For the very top of the income distribution, however, the tax code is not progressive. In 2009, taxes rose as a share of income up to about $1 million or so. At that point, according to Internal Revenue Service data, the effective income-tax rate stabilized before declining a bit for families with incomes of more than $10 million. Introducing more progressivity into the tax code above $1 million would help to reduce after-tax income volatility at the very top.
Again, why would this be a high priority? It makes perfect sense for the federal government to protect non-rich households against severe negative income shocks. But it seems perfectly sensible to leave high-end income smoothing to high-earners themselves, and to focus our tax reform efforts on encouraging growth and meeting revenue goals.
Finally, if anything, high-earning households should be the ones most in favor of aggressively boosting the economy in the short run — and not just out of benevolence. Yet I suspect, without definitive proof, that support for additional stimulus declines as one moves up the income scale.
Essentially, Orszag is asking, “What’s the matter with Greenwich, Connecticut?” That is, why aren’t high-earning households supporting fiscal stimulus measures that will boost short-term growth? One obvious possibility is that these voters, like many voters earning more modest incomes, are engaging in “sociotropic voting,” i.e., they are more sensitive to aggregate outcomes than to personal outcomes. At least some affluent voters may have concluded that while fiscal stimulus can contribute to the buoyancy of financial markets, etc., in the short-term, thus increasing their incomes, the long-term growth prospects of the U.S. depend on a credible commitment to fiscal consolidation and that the champions of fiscal stimulus have not demonstrated a credible commitment. This view isn’t necessarily right, but it is certainly coherent.
I imagine it is true, however, that high-earning incumbent firms have been enthusiastic about fiscal stimulus, particularly firms that depend heavily on sales to and subsidies from the public sector.