The Agenda

Philip Levy on the Irrelevance of Inframarginal Taxpayers

A short while ago, I made the case against giving Warren Buffett’s opinion concerning the appropriate distribution of the federal tax burden any special regard. But Philip Levy of AEI has outdone me by a wide margin, and in the process he clarifies a number of issues that are difficult for many of our fellow citizens to understand:

I really like bananas. Great way to start the day. Tasty and nutritious.

Wegman’s sells them for 49¢ a pound, but I would pay more than that. At 99¢ a pound, I’d still get them. I’m happier paying less, but I could afford the higher price.

So why doesn’t my grocery store take advantage of this? It could double the price of bananas and still keep my business. One reason might be that the nearby Safeway would start flaunting its lower prices and lure me away. But another argument is that I am not typical in my passion for the fruit. There are certainly other customers who are much nearer to indifference. At 49¢, they’ll pick up a few bananas; at 59¢, they’ll go with the melon. In economic parlance, the folks most likely to switch away when the price goes up are the marginal buyers. I, with my ardour, am an inframarginal buyer. For price setting, it’s the marginal buyers that grocery stores think about. At 99¢ a pound, I’d still be buying, but the store’s overall banana sales would fall sharply.

I bring all this up because of billionaire Warren Buffett and his friend President Obama. Buffett likes the investing work he does and he has been very successful at it. He has argued that he would keep doing that work even if he were taxed more heavily. I believe him. He already chooses to pay himself far less than he might—reportedly $100,000 per year, a large part of the reason he is not in a higher tax bracket. But it is unlikely that Buffett is typical—others might work less if taxed more.

As Levy goes on to argue, it is taxpayers at the margin who are of greatest interest:

Imagine for a moment that Buffett’s sentiments are fairly common and that even 19 out of 20 employers would just pay the higher taxes and only one would throw in the towel. What does it matter if there were only one tax-sensitive outlier in the bunch? That would be a mere 5 percent; should it really drive the whole conversation?

To put this in perspective, a small percentage can make a big difference. Civilian employment in the United States peaked in November 2007 at 146.6 million jobs. In August 2011, there were 139.6 million jobs, a drop of 4.75 percent—seemingly small percentage changes can cause significant pain.

We do not have good evidence on how the willingness to invest and employ varies from entrepreneur to entrepreneur. There is evidence, however, that as income taxes go up, willingness to hire workers goes down. Whether this is because all employers are cutting back a little, or because a few are cutting back a lot, the net effect is an unhappy one.

In addition, I would add — speculatively — that there seems to be a subtle cultural shift among workers at the right end of the bell curve from an emphasis on market income to psychic income. If this is true, and that is admittedly hard to know conclusively, two scenarios spring to mind: (1) high-earners are among the most tax-sensitive workers among the brainy, which suggests that the impact of an increase in marginal tax rates will have a stronger incentive effect than we’ve come to expect, or (2) high-earners are actually less tax-sensitive than is commonly understood, because market income is a bauble symbol of what really drives them, which is a desire to achieve distinction in their work. In either scenario, I continue to believe that the question that must be asked is this: how exactly will the additional revenue be spent?    

I’m reminded of Arnold Kling’s recent discussion of a wonderful essay by Jeffrey and Shterna Friedman. The following is Kling’s characterization of two of their arguments:


Q: Why are so many intellectuals hostile to capitalism?

A: Because many intellectuals do not have first-hand knowledge of economics. They have heard that “incentives matter,” and this confirms their impression that capitalism is based on greed. Even intellectuals with training in economics take away from “incentives matter” the message that “we” (meaning intellectuals making policy) should manage, or at least tweak, everyone else’s incentives.

Q: How would you break down that hostility to capitalism?

A: By de-emphasizing “Incentives matter” and instead emphasizing that “unintended consequences matter.” That is the message of Adam Smith. It is the message of Hayek. Once we embed people in complex economic and political systems, selfish intentions can turn out well (because of competition), and good intentions can turn out badly (because of imperfect knowledge).

This is particularly salient in debates over taxes and the distribution of the tax burden. It is hardly surprising that social democrats want to emphasize the fairness of the tax burden rather than how tax dollars are spent. A large majority of taxpayers embrace the basic principle of a progressive and indeed a highly progressive tax burden. Yet as Doug Schoen recently reminded us, taxpayers prefer spending cuts and public sector compensation reforms to tax increases, presumably because they believe (or one might say recognize) that the U.S. public sector is not defined by a high level of efficiency. 

The key to political debates is defining the terms of engagement, or rather where our attention lies. It makes sense of the left to emphasize questions of justice and fairness. It makes sense for the right to emphasize how public sector institutions work in practice and whether increasing spending is always the best strategy for improving them, or if other institutional reforms might prove more effective.