Sunday, April 26, 2009

The Tax Debate: Is High Income Due to Effort or Luck?

With hat tip to Mark Thoma, Robert Frank offers us this:

Contrary to what many parents tell their children, talent and hard work are neither necessary nor sufficient for economic success. It helps to be talented and hard-working, of course, yet some people enjoy spectacular success despite having neither attribute. (Lip-synching members of boy bands? Money managers who bet clients’ retirement savings on subprime-mortgage-backed securities?) Far more numerous are talented people who work very hard, only to achieve modest earnings. There are hundreds of them for every skilled, perseverant person who strikes it rich — disparities that often stem from random events.

The role that this observation plays in the debate over how progressive the tax system should be was explained by Hal Varian:

In the simplest version of the Mirrlees model, taxpayers differ only in their ability: how much they can produce with a given amount of effort. One striking result of this model is that those at the very top of the income scale should face low marginal rates. This result emerges from a detailed mathematical analysis, but the intuition is not hard to explain. Let us assume, for the sake of argument, that Bill Gates made $1 billion in 2000, an amount larger than any other American taxpayer. Suppose further that despite the best efforts of his accountants, he ended up paying 40 cents of the last dollar he earned to the Internal Revenue Service. Consider the following thought experiment: drop the marginal tax rate from 40 percent to zero for all incomes above a billion dollars. The I.R.S. won't lose any revenue from this reduction, since no one has an income larger than $1 billion. And who knows -- the lower marginal rate might encourage Mr. Gates to work a little harder in 2001, producing new products that would make him, and the rest of us, better off. Of course, the fact that it pays to reduce the marginal tax rate for billionaires doesn't say much about what tax rates should be like for mere millionaires, a point that has been emphasized by Professor Mirrlees himself and confirmed by subsequent researchers, like Peter Diamond of the Massachusetts Institute of Technology and Emmanuel Saez of Harvard. But the intuitive argument presented above is pretty compelling: if income depends only on ability, those at the very top of the income-ability distribution should face low marginal tax rates. But perhaps this model is too simple. One might well argue that Mr. Gates, as productive as he is, doesn't owe his success entirely to ability: there was a lot of luck involved, too. And, if truth be told, that's probably true even for mere millionaires. So let's consider a different model: one in which differences in income are a result only of luck and have nothing to do with ability. In this case, the optimal income tax may well involve taxing billionaires at very high marginal rates. True, aspiring billionaires won't work quite as hard, since the after-tax reward from hitting $1 billion has been reduced. But the chances of becoming a billionaire are pretty low anyway, so taxing billionaires at a high rate won't really discourage much effort by those hoping to become one. Thus a model where luck is the driving force tends to yield a more progressive optimal tax than a model where ability is the driving force. This is about as far as theory can take us, but it highlights the critical question: How much income results from ability and how much from luck?


Myrtle Blackwood said...

Effort or luck?? Try POWER.

" one bank had a consolidated statement of all the Hunt loans, because Bunker and Herbert had refused to allow them to see one. The Hunt business had been too good for the banks to insist.... Page 234

" Runs on a bank are no longer triggered by individual customers' lining up outside the doors to withdraw their life savings, as they were in the 1930s. (..FDIC..guarantees the accounts of depositors...). Now a run is created by institutional money managers who look at the bank's balance sheet and say: "I'm not going to risk a row with my board if there's trouble at the First of Chicago." The money managers just withdraw their money when short-term loans come due, and it ebbs out of the bank like the tide on a shallow beach. And their was one money manger of consequence who was threatening to do just that. A mutual fund with a balance of half a billion dollars at the First of Chicago..." Page 221

" [the fate of the Hunts] had become inextricably linked with that of the financial system of the United States which was itself linked with that of the City of London, Paris, Frankfurt, and Zurich. In Europe, too, bankers waited anxiously for the latest news from New York and Washington..."Nobody wanted the Hunts bailed out: they're the least favorite characters anyone could dream of." Said Robert Carswell. But the personalities of Bunker and Herbert Hunt were not the issue. Bankers had begun to describe the problem as "systemic" and a decision would have to be taken about the best way to deal with the monumental debts of the Hunt brothers."
page 223

From "Beyond Greed - How the two richest families in the world, the Hunts of Texas and the House of Saud, tried to corner the silver market - how they failed, who stopped them, and why it could happen again." by Stephen Fay. 1982
ISBN 0-670-64497-8

Shag from Brookline said...

With respect to people who are successful financially, an executive of a firm I represented told me of an old Italian saying (this executive was Italian-American):

"If you're rich, you're not only smart, but you're good looking too."

He told me this after the CEO and founder of the firm shot down his marketing proposal.

Anonymous said...

Milton Friedman argued (a) luck is a big factor and (b) therefore taxes should NOT be progressive. Dig back into Capitalism and Freedom and you'll find it. If you win the lottery should your friends be able to force you to share the winnings with them?

It's a crummy analogy--I think progrowthliberal has it right--but it's in the literature and you expect it to be trotted out in discussions like these.

Peter Dorman said...

I find it interesting that theoretical discussions of the sources of income inequality never consider antisocial behavior. No system is airtight; there are always possibilities for unscrupulous individuals to benefit at the expense of others. The Bill Gates example brings that to mind.

Martin Langeland said...

If a dollar has any value above null, is it even conceivable that anyone -- by their own efforts alone -- could earn a million dollars in a year?
I think not.
That's why I call executive pay piracy. How else does one explain its rise in the past fifty years from a two digit multiplier of basic wages to a three digit one?

Bruce Webb said...

Try this thought experiment.

Suppose Mr. Yu made a billion dollars selling adulterated products to mostly East Asian markets with some leakage into Australia and the United States. Suppose the Chinese government dropped all taxation of income over $1 billion. Would Mr. Yu redouble his efforts to produce and sell more product? Well probably. Would that make us all collectively better off?

We can argue specifics of whether Microsoft has made us better or worse off in the long run (because somebody was going to supply that software to IBM) but either way there is a fundamental fallacy in the argument. Economic efficiency should not be a self-validating argument, not that is without considering issues of subsequent distribution and assorted externalities.

If Mr Yu sells a $billion of adulterated pet food overseas in 2008 and $2 billion in 2009 because of lower marginal rates he wins, Chinese tax revenue is unaffected, Chinese GDP is up, as is its trade surplus. Hurray! Everyone is a winner!

Except Fluffy and Bowser.

I know this was not the focus of Varian's piece but he has simply built in the 'income is income' premise in without regard to whether that income derived from enforcement of near monopoly position (Gates) or producing products with deadly externalities (hypothetical Mr. Yu).

Jack said...

How about the government sets tax rates so as to collect enough to pay its expenses and debts. How about the tax system tax those who have gained the most from our economy the highest rates just because they have gained the most from our economic structure. How about economists discontinue the mental masturbation of trying to predict what will be the effect of marginal increases and decreases until such time as those economists gain the ability to read the financial pages one or two decades into the future.

There is too much opportunity to shill for one income group or another when we start to imagine that we actually understand the relationship between taxation and economic decision making. Will we really get any consensus of opinion in regards to the effect of marginal rates on future investment decision making? Not likely. Virtually every economic question that comes up on this and similar discussion sites results in no consensus, but a plethora of similar and dissimilar ideas. Great for discussion. Lousy for the purpose of tax planning. Taxes are for the purpose of paying the cost of good government in a complex society. There's going to be an effect. So, what? We stop collecting taxes? That's real bright, but little different from the nit picking discussions of how much to tax people who have so much money they can't figure out what to do with it all. Let them support the society that has enabled their wealth.

Anonymous said...

Let's base tax rates on luck. We can have a luck committee to review each case, obviously PGL has the stats and ability to judge this. So Shaquille O'Neill will be taxed at a 95% rate because his situation is clearly 99% luck that he possessed the right DNA and grew to his prolific stature.

Never-mind the fact the people that sit around and argue Rawls all day treat people that earn $100,000 in NYC the same as Bill Gates. Do you really understand how dumb you sound?

If you want to tax the 400 richest people at some obscenely high rate, then I do not care. But quit trying to lump everyone in that same economic category based on your "luck" rationalization.

Lastly, you are confusing wealth and income - these are totally different topics from a tax perspective.

Jack said...

"Lastly, you are confusing wealth and income - these are totally different topics from a tax perspective."

An excellent point and obviously a valid one. Let's tax the income as it is earned regardless of how it is earned. Let's call it new and additional wealth. Let's be sure to include salary, bonus, paid in shares of stock or cash or any commodity of any value. Let's not forget to apply that income tax to dividends as well as interest on capital.

Good distinction, income is taxed while it is earned. Then let's tax wealth when the holder of that wealth drops dead. Let's have no inheritance tax to avoid confusion. We'll only tax estates before distribution to heirs. Let's make that tax significant as a means of recouping all the earned income that the wealth holder had avoided in the first place. Let's differentiate the estate tax from an inheritance tax so that the heirs can't complain that their legacy is being unfairly taken. If the heirs have some special claim to an individual's wealth let them establish that claim while the benefactor is still alive to uphold that claim. If the wealthy benefactor is intent to have his/her wealth passed along to some next generation heir let that benefactor share that wealth before the sundown of life. If the heir(s) are special enough to be entitled to share the wealth, then that entitlement should not have to succeed a life time. No more battles in probate court. No more temptation to put the poor bastard out of his/her misery prematurely.

Thank you Anonymous, that distinction between wealth and income was brilliant.

Kevin Carson said...

We need a third category besides hard work and luck: privilege.

It may take a lot of hard work to get the system set up working for you, but once you do you'll get a lot more money out of the system than your hard work alone could have gotten you.

Absent the privilege of "intellectual property," one can only derive income from an innovation until others enter the market and adopt it, and arbitrage the quasi-rents down to zero. Patents and copyrights make it possible, on the other hand, to live a lifetime off the profits of a one-hit wonder.

If it weren't for the state's IP laws, Bill Gates would probably have a comfortable upper-middle class income.

In addition, artificial scarcity of land and capital, and the monopoly rents attending on them, mean that you can do the initial work of accumulating a chunk of wealth, and then let it build on itself via the law of compound interest.

Most of the income of the plutocracy comes either from direct government subsidies (the main function of government is to subsidize the operating cost of big business), or from rents on artificial property rights.