Saturday, May 18, 2013

More Evidence that Conservatives Have the Effects of Tax Cuts Backwards

I remember back when I was a conservative leaning undergraduate having completed a few economic courses how simple the world seemed. Incentives were straight forward way to explain everything. Amazing! Shift the incentives and you get more or less of something. The great depression happened because wages couldn't fall to a market clearing level. Higher taxes disincentivised work leading to lower growth. Tax cuts and deregulation meant the best, brightest, and most successful would have more ability to apply their skills and talents to efficient allocation. It's all so easy! Why are these stupid left-leaning Marxists always getting in the way?

Then I graduated and was able to spend some serious time investigating the questions that mattered to me. Then I went to graduate school where I was really able to refine my analysis and learn to interrogate the simple, logical models taught to me at the undergraduate level. By the time I had reached graduate school I had already realized that the world was too complex to bend to the application of straightforward logical reasoning, no matter how much brainpower one has to throw at it. After completing graduate school I had learned to tackle a problem from multiple angles in order to get at some rough semblance of the truth.

What does any of this have to do with the topic of the post? Well, the kind of logical reasoning that one gets out of Econ 100, from media pundits, presidential campaigns, and the whole range of business books all leads one to the conclusion that higher taxes means lower growth. Why, incentives. Simple, easy to understand, perfect for the busy businessman on the fly who wants to write a check to the candidate of the Chamber of Commerce's choosing (rarely explicit, but there's always a lot of indirect solicitation at these things).

The problem is, this reasoning appears to be wrong. Angry Bear has an excellent post discussing a graduate student's paper on marginal tax rates and economic growth. To excerpt:

Using a panel of 18 OECD countries over the period 1960-2009, this paper finds support in favor of a quadratic top tax-growth relationship. Results are robust to different model specifications and estimation techniques. The point estimates of the regressions suggest that the marginal effect of higher top tax rates becomes negative above a growth maximizing tax rate on the order of 70 percent.

This is consistent with everything recent I've read on the subject. While there were some important papers showing a negative effect of taxes on growth most of these date to the 80s and 90s and use far simpler modeling techniques. It has been apparent for a while that the relationship is non-linear, the interaction of taxes and GDP growth is fairly complex. This should have been obvious, after all the vast majority of people are not solely income maximizing, other things in our lives matter.* Other complexities, like income/wealth targeting, shifting income categories (problematic where rates differ between capital and income allowing reclassification of income to reduce taxation), relative efficiencies of public vs private spending (many economic models assume private spending is more efficient, but this is generally due to either an operational assumption to make models more tractable, it's easier to do the math if you just assume market allocations are efficient even if there is no objective observations to indicate this (is a bridge to nowhere less efficient than a mansion that never gets completed just because one is public and the other private?), or because of ideological priors), along with many others.

Robert Waldman discusses this a bit more in comments:

But mostly the evidence for large growth reducing incentive effects of income taxes is very weak. Growth promoting effects of higher taxes don’t have to be very strong to outweigh the sort of effects one infers from micro data. I am thinking especially of after tax rates of capital income and consumption/savings choices (there is almost no evidence of any effect at all).

In the comments and in the original article mechanisms are discussed in a bit more detail. I have a slightly different take on this, however. In my view, something that is too often forgotten is that markets and capitalism are simply a human artifact, they are not the result of God's natural law. In its simplest, and not entirely accurate, form what capitalist markets do is quantify human wants and resources into a single measure, the price signal. This is an amazing achievement, it allows for a relatively quick and easy grasp of the trade-offs inherent in our actions.

However, a lot of information is lost in this quantification which necessarily relies heavily in a number of largely invisible assumptions which go into the creation of prices. It is simply one way of making a decision and sometimes the information lost in generating the price signal is more important than the information that remains.

In these cases we need a different method of making decisions. That is what democracy is for. The trade off is that democracy, and government, can process a lot of information that is otherwise lost in the market economy but that this information cannot be made directly comparable in the form of a simple cost-benefit analysis. The extent to which allocation should be made by each system depends on both the preferences of the individuals composing the relevant social unit as well as the current state of technology. Taxation is an important way in which the balance between the two predominant resource allocation schemes function, if taxation is either too low or too high allocation will be decided by the wrong system leading to an inefficient allocation. There is no way to determine this rate from priors, optimization is ultimately a property of markets created by social construction that does not exist in the natural state, so we must instead rely on observation. Observation seems to be telling us that the US especially, but other states also, lies on the wrong side of the growth curve in the trade-off between market and democratic allocation.**

The question is how long until the evidence grows enormous enough that people will listen?

* This requires a small caveat. The nature of our economic system is that it rewards people who respond strongly to income. It would be very surprising if the ranks of the most economically successful do not disproportionally share this trait, since these individuals are also those with the most influence over our economic institutions, and less directly our political ones, it would also be surprising if these institutions did not display the same bias. There is simply no reason to believe that monetary incentives have equal effect given a heterogeneous distribution of traits and this likely biases our economic institutions towards motive and away from merit degrading these institutions' effectiveness. On an anecdotal level, I can't think of an interview I've had where the interviewer didn't have to add money as a motivation, since I never mention it, as it has never been a strong motivator for me. Sure it's a motivator, but rather low down on my list of wants, I enjoy reading more than just about anything else and it's a cheap hobby so once my income was above 30K or so I just shrug my shoulders and ask about other factors, which tends to throw the interviewer off and has likely cost me a few jobs since I'm probing for the things I really want like flex time, longer vacations, ability to work from home, career advancement, interesting work, challenges, and other non-monetary factors. Our economic institutions just aren't set up well to deal with people who don't have money as a strong motivator. I also tend to come away slightly offended that employer's feel they can simple assume a minimum time commitment with an indefinite upwards increase given enough pay, my time's not cheap and the value I place on it increases non-linearly as more is asked for given the relative value I place on an additional book read vs. an additional dollar.

** In other words I don't really see how the arguments about whether state or capitalist allocation are better as intelligible. They are simply different. Each form of allocation derives from different priors and relies on different means of making decisions. Each has different strengths and weaknesses and is more or less successful at allocating different things. Optimal policy is to use each where it is efficient and to avoid each where it is not. Arguments about size and scope of government in general are also unintelligible, these arguments have their priors all mixed up and don't display and adequate understanding of capitalism or democracy. The relative share of each in allocation decisions should depend solely on the expressed desires of the public for the array of resources available and the relevant technologies available for these resources provision and distribution. One can only be judged superior or inferior to the other when a specific allocation is under discussion not in the abstract, aggregate sense which dominates the discussion in US politics.


  1. Take the view that people are solely income maximizing. The simplest counter-evidence may be this. What is the income incentive for giving blood?

    You don't get paid to donate blood; in some places it is even illegal for the blood bank to pay. Yet people will spend half an hour giving away a pint of blood. Even though it is uncomfortable (and frequently the needle hurts going in). and they do it over and over for years. Where is the income maximizing in that? (Or the expense reduction?) Anyone who holds that people are solely income mzximizing best come up with an economic explanation . . . and there isn't one.

    1. I generally hear this hand-waved away as simply being that their doing it reveals that this is their utility maximizing choice. Pressed, the hand waving rapidly increases with something along the lines of them getting a good feeling from helping people. And that Mother Theresa is just as selfish as a banker, her utility function is just different.

      I obviously don't take these arguments seriously even in their more serious form.