Labor Supply and Taxes

I have a post at The Agenda on the impact of taxes on labor supply:

While many recent discussions of tax policy are motivated by using taxation for the purposes of economic stimulus or for addressing income inequality, the really important long-term impacts of taxation center on labor supply. Higher taxes induce people to cut back on hours worked (what economists refer to as the intensive margin), as well as to drop out of the workforce entirely (the extensive margin). Figuring out how much taxes induce household labor behavior along these dimensions has been a major area of economic research, and the implications for government policy are sizable... 

Broadly, macroeconomists like Ed Prescott, studying the behavior of economies in the aggregate, tend to prefer large labor supply estimates; while microeconomists like Saez and Diamond, studying groups of individuals, tend to support smaller estimates. This empirical dispute has fairly far-reaching consequences on the structure of government policy. If Diamond and Saez are right, then even large hikes in taxation, though they may affect after-tax income, will not impact labor supply or GDP. If Prescott are company are right, then hikes to marginal tax rates will hit labor supply, and through that GDP, and so damage a key source of competitive advantage for the US economy... 

In the midst of continuing economic woes, there is little appetite to raise taxes on anything but a tiny fraction of Americans. Yet, eventually, politicians will face difficult fiscal choices. Raising taxes may avoid difficult cuts to social spending programs; yet there is a sizable body of research that suggests higher taxes may have long-run consequences on the long-run success of the economy — which will in turn make it more difficult to balance Debt/GDP. This may still be a choice worth making. Yet it is important to keep in mind the tradeoffs that higher taxes imply. At the very least, it’s a reason to pursue tax reform that lowered marginal tax rates by broadening the tax base, which would improve economic efficiency with few economic costs.

The Buffett Op-Ed

Others have already tackled this Op-Ed by Warren Buffett, in which he basically calls for higher capital taxes. Buffett's argument revolves around fairness -- he doesn' t seem to be taxed very much on a personal basis relative to the administrative staff in his office (why he continues to have administrative staff is another story -- one imagines that he could just learn to use Google Calendar, email, and then fire everyone else). The take on the other side is that we ought to set taxes on capital and corporations in ways that make sense for society as a whole, not for reasons of fairness.

And Buffett is absolutely playing this for personal PR purposes -- the more he ostensibly calls for greater "sacrifices" from himself; the more he alleviates any potential sources of envy against his wealth. Buffett may well end up doing better in a world of higher capital taxes, which would place enormous burdens on his competitors. Add to that his own ideological biases, the fact that Buffett doesn't pay many taxes anyway due to the fact that he's donating the vast bulk of his wealth, etc. and you end up with a not-particularly compelling case.

But then you also have some seemingly factual howlers.

Some of us are investment managers who earn billions from our daily labors but are allowed to classify our income as “carried interest,” thereby getting a bargain 15 percent tax rate. Others own stock index futures for 10 minutes and have 60 percent of their gain taxed at 15 percent, as if they’d been long-term investors.

This doesn't seem right at all. I'm sympathetic to eliminating carried interest rules; but it just seems wrong as a factual matter to argue that short-term investment gains are taxed at the long-run rate for those institutions -- or so I glean from Avik Roy. See the new update.

Then there's this section, which is something that Buffett repeats over and over:

Last year my federal tax bill — the income tax I paid, as well as payroll taxes paid by me and on my behalf — was $6,938,744. That sounds like a lot of money. But what I paid was only 17.4 percent of my taxable income — and that’s actually a lower percentage than was paid by any of the other 20 people in our office. Their tax burdens ranged from 33 percent to 41 percent and averaged 36 percent.

Leave aside Buffett's estimation of his own tax liability, which primarily reflects capital gains. How are his other office employees taxed at those rates? After all, one only enters the 35% income tax bracket after $250,000; and even there the average tax liability of a person will be much lower (something like 27% in my calculation). Is his comparing his average tax liability with the marginal tax liability of his employees? In the past, he's frequently claimed to have a higher tax rate than his secretary making $60,000 a year. Yet the marginal tax rate for a single person with that income is 25%. That's of course higher than the 17% he quotes above; but is far lower than the range he provides there (with an average tax liability that is far lower too).

There's much more here that's absurd. For instance:

I didn’t refuse, nor did others. I have worked with investors for 60 years and I have yet to see anyone — not even when capital gains rates were 39.9 percent in 1976-77 — shy away from a sensible investment because of the tax rate on the potential gain. People invest to make money, and potential taxes have never scared them off.

Why don't we just go all the way up to a tax rate of 90% then if the tax rate doesn't matter? If you think it matters at 90% on some margin, who is to say it doesn't matter at 39.9%? Why on earth do we think that asking investors will yield better information than thinking through data or theory? There's just no reason to think that making lots of money endows someone with insight in public policy or a comparative advantage in Op-Ed writing.

Update: From James Choi, someone with an Adjustable Gross Income of ~$60,000 pays 12.9% of their taxable income as income tax, and 8.5% of their AGI as income tax. Sure, you can add in payroll taxes, etc. in here -- but it's difficult to see exactly where he's getting the "my secretary pays so much more in taxes than me" statistics from.

Update 2: Steve Waldman has more in the comments regarding the tax treatment of futures. Buffett was right about this and I was wrong. It's still somewhat misleading in the sense that it presents an extreme example of short-term trading, when only 10 percent of the gains accrued by partners are taxed overall at the short-term rate. The particular rule behind the mentioned 60/40 split seems reasonable. Buffett's real concern anyway is not with the long/short run taxation of capital; but with carried interest rules and capital taxes generally. And I'm somewhat with him on the carried interest rules.

Do Taxes Matter?

Elsewhere, I’ve written about the long-run negative consequences of taxes, and the possibility that the top of the Laffer Curve is not so far off. Karl Smith takes exception to these arguments, when looking at this graph:

The supply of working-age people into the labor market seems to be largely driven by changes in monetary policy, rather than changes in taxes. For Karl, this seems to imply that the choice to enter or exit the workforce is largely pre-determined, and responsiveness to to taxes must be pretty low (he has another recent post that makes the same argument; though it is only shows up in my Google Reader).

I’m pretty skeptical of this line of analysis. Rather than eyeball aggregate data like this, I’d rather look at evidence that spans different countries over time, carefully calibrated analyses of specific tax cuts, or modeling based on economic data. All three methods seem to suggest that the responsiveness of people to taxes is pretty high. Even Saez, who recently won a MacArthur genius award and is generally regarded as being on the left on these issues, has a recent paper that argues the impact of taxes can be sizable, especially for those that itemize deductions and higher-income folks (his paper also suggests that the impact of taxes is taking place through channels other than simple labor supply). I think this is all evidence we should take seriously, regardless of what aggregate data suggest.

But none of this directly answers his chart. Well, here are a few more charts:

This one shows the average federal tax/GDP ratio of the American economy going back a few decades. Across a wide variety of tax regimes that have drastically changed average and marginal tax rates, the average tax/GDP ratio has stayed within a fairly tight band. It seems to be driven far more by changes in the business cycle (especially the stock market) than changes in statutory tax rates.

I wouldn’t subscribe to this interpretation entirely: but one plausible reading is that the long-run Laffer curve maxes out for a pretty low value. Successive tax cuts from the high rates of the ‘50s have been accompanied by economic expansion. Tax hikes from the ‘80s have been accompanied by economic slowdown. A tax/GDP ratio of 18% is, if not optimal, close to a maximum of what can be obtained without seriously affecting work incentives. European countries get higher tax/GDP ratios primarily by lowering GDP, not through higher tax revenue.

Here’s another graph in support of that interpretation:

Somewhat surprisingly, America gets about the same tax income per capita as Western European countries with far higher tax rates. That’s because America’s lower tax rates balance out Europe’s lower income almost exactly. I don’t like generalizing about “Europe”, which contains a variety of different systems, including the low-tax, high economic freedom Switzerland. But a simple reading of this graph would reinforce the conclusion that higher tax rates primarily lower economic output, rather than raising tax revenue.

Back to Karl's original graph — note that labor force participation rates are lower than Europe, at least normally. This was not the case several decades ago, which suggests that “culture” is not the reason. The culprit, depending on the country, seems to be a combination of rather high rates of taxation, high rates of people on disability, and the disincentives of social security provision.

I’ll add finally that this debate plays into whether or not we have a sustainable fiscal future. If you look at this CBO graph:

You’ll see that they project rapidly rising entitlement spending, driven primarily by Medicare and to a lesser extent by Social Security. You’ll also see that they project a rapidly rising tax/GDP ratio under the "baseline scenario", which will increase tax/GDP ratios far above historical norms (though this scenario would call for a full repeal of all of the Bush tax cuts, and so is not probably the path we will take). If the CBO is right, we can easily achieve massive increases in tax revenue without seriously affecting work incentives. If this story above is right (and, again, I’m not sure I’d agree with it entirely), a sharp rise in taxes/GDP would not be accompanied by large rises in tax revenue, but rather by stagnant growth in GDP.

The point here isn’t that we can raise tons of tax revenue by cutting taxes — I think the opposite is true. Also, I suspect labor force participation is pretty fixed for a large chunk of the population. But I think the aggregate data cut both ways, and the best evidence we have suggests that taxes have pretty bad effects.

To make a petty partisan point, I’ll also add that though the Republican plan for dealing with deficits in their Pledge has gotten a lot of flack, I don’t quite see how the Democrats are targeting this issue either. After slamming Bush for a decade for his irresponsible tax cuts, they now plan to extend almost all of them — except for those that may actually grow the economy, as the CBO suggests. Meanwhile, they are rolling out new expansions of healthcare entitlements and plan to hold the line on Medicaid, state and local spending, and Social Security. Conflict efforts in Afghanistan will ensure that large military cuts are not forthcoming either. How exactly is this supposed to be affordable? I really hope Karl is right on this one.

Capital Gains Tax

The CBO has a bit up on the changes in revenues from individual taxes over time. They find that the revenue from taxes went way up in the Clinton years due to events unconnected with Clinton, rather than changes in the tax code, while tax revenues did change in the Bush years due to new laws. Of the non-legislative gain in tax revenue during the Clinton years, capital gains taxes on the sale of investments constitute about half. Clinton also drastically cut capital gains on housing, so the housing bubble resulted in relatively little in the way of capital gains revenue. This change may be responsible for the rise in house prices; more on this later, data willing.

There's some debate over the ideal capital gains tax rate is. Charles Gibson and a WSJ editorial I once read make the supply-side argument that lowering this rate increases revenue. I'm skeptical, but in any case the variation in taxes gives Clinton an undervedly good reputation for managing the economy and Bush a worse reputation than he deserves. In reality, the rate of economic growth and the pace of tax revenues vary more or less randomly and place huge constraints on what Presidents can do. This fact tends to be ignored by people who expect elected officials to both not overstep their Constitutional boundaries and wield absolutist power to revive the economy.

Basically, I want to stop reading pointless articles on how some things are correlated to other things, because the world is basically random and few people have any influence on or understanding of the events that go on. Okay, that's a little extreme, but at least come up with a defense that (though it may raise an interesting point connecting inequality and women's relative wages) justifies blatant political pandering.