The key arguments for high top rates of income tax are political as well as pecuniary

When people complain that neoliberalism is a meaningless concept, I should point them to what has happened to the top rate of income tax since around 1980, not just in the US and UK but elsewhere. (Source HT Marcel Fratzscher)

Here is a chart of the United States top tax rate over the last century (HT Martin Sandbu). Eisenhower had top earners paying a 91 percent marginal rate.

No doubt there are complex reasons for these reductions, but key among them has to be a neoliberal belief that cutting top rates would lead to more dynamic CEOs who would produce more dynamic companies, and the benefits of this would trickle down to the economy as a whole. Low top tax rates would encourage entrepreneurs to take more risks that were socially beneficial and so on. The argument is so familiar, trotted out routinely by right wing think tanks, it hardly needs elaborating. It is a classic example of neoliberals using a bit of simple economics to justify policy that is advantageous to themselves or their paymasters.

Yet the evidence for such an effect is weak, at best. The intuition for why it should be weak is straightforward. Above a certain level of income, other incentives beyond the purely pecuniary become important. Top CEOs, like top footballers, want to be successful at what they do, and more successful than others. They will want success whatever the overall financial rewards of being successful.

Another bit of basic economics that neoliberals hardly ever mention is the diminishing marginal utility of consumption. This implies quite the opposite of low tax rates at the top. It is socially much more beneficial to tax those to whom one dollar is not worth the effort of picking off the sidewalk and transfer it to those who are poorer. A well known paper by Diamond and Saez found that, after allowing for disincentive and avoidance effects, the optimal top rate of income tax in the US should be 73%. [1] [2]

There are two reasons why even 73% might be an underestimate. Piketty, Saez and Stantcheva have argued that giving CEOs lots of money can have negative incentive effects. The CEOs start putting effort into increasing their salary rather than improving their firm. Part of your status comes from what you can afford. When all CEOs are taxed a lot at the margin the size of your salary has little impact on that, but when your salary is not taxed so much you can increase your salary and theefore status by extracting more from your own firm. To use some economics jargon, a low marginal tax rate on top incomes can be a good example of an incentive for rent extraction rather than an incentive for increasing social output. .

But while an extra dollar for a CEO is not going to incentivise them in a positive way very much, you could argue that it incentivises those with talent to aspire to be CEOs. CEOs are always going to be among the richest in society, because a lot of their income will be taxed at lower rates. A paper by Lockwood, Nathanson and Weyl turns that argument on its head. High salaries are associated with activities, like finance and law, that have what economists would call negative externalities, which means that they do much less good for society than the size of the salaries they pay might suggest. A lot of finance, for example, is about trying to take money off other people rather than growing the size of the overall pie. If high post-tax salaries incentivise talented people into those professions, that is negative for society, which would benefit if they worked in different jobs. You can reduce this misallocation of talent by having higher tax rates on top incomes.

Neoliberals have one last line of defence against raising top tax rates in a single country, and that is migration. The argument is that talent, which could be quite mobile, will move to where talent is most rewarded. There is clear evidence that this is true, to an extent. This concern does not mean we leave top tax rates where they currently are or even reduce them, but simply that we might not put them up as high as they should otherwise go while some countries that are attractive to talent continue to have low tax rates on top incomes. Sweden seems to do pretty well with a 70% effective top tax rate.

This danger of a race to the bottom with top tax rates makes it all the more important that the United States raises it’s top marginal tax rate, along the lines recently suggested by Democrat Alexandria Ocasio-Cortez. For various fairly obvious reasons the US does not need to worry too much about a talent drain if it raised top tax rates.

In my view the arguments for higher top tax rates are at least as much non-pecuniary, by which I mean they do not depend on the points raised so far. The evidence that social welfare is higher in more equal societies seems compelling to me. In other words we should increase top tax rates just because that helps produce a more equal society. I have seen a few attempts to debunk the evidence for this in The Spirit Level, but they are not convincing as a collective, while there is even more evidence to support the idea that people are happier in more equal societies..

There is a final argument for high tax rates at the top which seems particularly relevant to the US and UK at the moment. If you have a political system like the US where money easily buys political influence, you will find some of those who earn very high salaries trying to do exactly that (some references here). You can create the kind of plutocracy I discuss here. Because money can also help to buy votes, that plutocracy may also be able to continue with democratic elections without in any way threatening the plutocracy. Even when you have laws limiting the amount that can be spent on elections, the UK shows there are ways for the rich to get around that, particularly if they control large sections of the press.

This is the argument made in this excellent NYT op-ed by Emmanuel Saez and Gabriel Zucman. They write

“An extreme concentration of wealth means an extreme concentration of economic and political power. Although many policies can help address it, progressive income taxation is the fairest and most potent of them all, because it restrains all exorbitant incomes equally, whether they derive from exploiting monopoly power, new financial products, sheer luck or anything else.”

The economist Greg Mankiw, in a short response to this op-ed, says

“most rich people I know would have been happy to spend vast sums of money to keep Mr Trump out of the White House. And many tried. The Trump phenomenon is not an argument that the moneyed elites have too much influence on politics. If anything, it is an argument that they have too little.”

But this misunderstands (as some on the left do) the nature of the plutocracy that super incomes and wealth create. It does not, as I make clear here, create a kind of committee of the very rich that between them decide who rules. It is much more erratic than this. Instead it allows small groups among the very wealthy, who may be quite unrepresentative, to hijack a democratic system. Trump and Brexit are clear examples. Mankiw is right that one way to avoid that would be to create a more representative kind of plutocracy, but a far better way of avoiding disasters of this kind is to deal with the problem at its source, by reinstating high rates of tax on top incomes.

[1] Some intuition on this number. If disincentive and avoidance effects were so large that an increase in tax rates led to no additional income, then there is no pecuniary advantage from doing so. If these effects did not exist, the optimal marginal rate at the top would be 100%. The paper estimates these effects are somewhere between these two extremes, so the optimum tax rate at the top will be between zero and 100%.

[2] For a discussion of these issues in a UK context, see https://www.ifs.org.uk/publications/9678. Note that HMRC calculations that the short-lived raising of the UK top tax rate to 50% did not raise any revenue involve debatable assumptions, and much of the avoidance only worked because the hike was temporary.    

Class interests

This is a small contribution to answering Paul Krugman’s question about why the wealthy want to raise interest rates, even when the economy remains depressed. (See also Steve Randy Waldman, Peter Dorman and Brad DeLong.) The preliminary point to make is that this is not just a US phenomenon. In the UK the right wing Institute for Economic Affairs set up what they call the ‘shadow MPC’, and they were voting for higher interest rates before the recovery began! The highly influential FT journalist Chris Giles, who has become a bellwether for right wing interests, has been championing the cause of an early rise in rates for many months.

I want to start with inequality, and the rising share of the 1% in the US and UK. This began in the 1980s, and is associated with deregulation of the financial sector and large cuts in top tax rates. The dominance of a neoliberal ideology, associated with Reagan and Thatcher, occurred at the same time, and there is no doubt that those who started becoming much wealthier at that time understand the connection.

Both politicians began their administrations during periods of high unemployment - higher than anything seen since the war. Both were the result of tight money: in Thatcher’s case this was a clear political choice, whereas in the US it was the result of the Volcker Fed. Whether intentional or not, this high level of unemployment greatly helped both administrations achieve their neoliberal goals, in part because it fatally weakened the power of organised labour. The period also helped the neoliberal cause because it appeared to discredit the idea that governments could intervene in the economy to achieve full employment.

Is it any wonder, therefore, that the ‘1%’ who started to become much richer in the 1980s should see tight money as an essential condition of their new found wealth? But what about the ‘interests of capital’: surely the owners of business should see that firms will be less prosperous if demand is kept too low through tight money? Here I can only quote Michal Kalecki:

“But 'discipline in the factories' and 'political stability' are more appreciated than profits by business leaders.  Their class instinct tells them that lasting full employment is unsound from their point of view, and that unemployment is an integral part of the 'normal' capitalist system.”

This was written in 1943, and the post war consensus appeared to suggest Kalecki was being too pessimistic. But that was before neoliberalism and the rise of the 1%.

Nowadays we see achieving the ‘natural unemployment rate’ as predominantly the task of monetary policy. Most economists see independent central banks as a better means of achieving this than direct political control for familiar reasons. However if you think that lasting full employment can be unsound for your class interests, then giving monetary control to conservative central bankers would also seem like a good idea.

This sets up two areas of political tension between the interests of the wealthy and, of all people, academic macroeconomists. First academic macroeconomists, and their occasional number who become central bank governors, see monetary policy as a means of achieving the natural unemployment rate and steady inflation. The wealthy see monetary policy as a means of maintaining a degree of unemployment that reduces the political threat to their wealth. Second, when monetary policy stops working in a liquidity trap, most academic macroeconomists want to use fiscal policy to take its place. To the wealthy this not only seems unnecessary, but it also calls into question their ideology about the failure of pre-neoliberal times.

As macroeconomists we know (or think we know) that it is impossible to keep unemployment above the natural rate forever, because inflation will continue to decrease, although there is now a lot of evidence which suggests it may not decrease by much. So if you wanted to critique my (and Kalecki’s) characterisation of the views of the wealthy, you might say that keeping unemployment above its natural rate is not a sustainable strategy (and therefore not rational). To which I would respond maybe, but there could be a reason why now, like the 1980s, is a particularly important time to keep unemployment high for a while.

The reason for this is that the aftermath of financial crisis is extremely threatening to the neoliberal political consensus and the position of the 1%. I remember saying shortly after the crisis that the neoliberal position that government regulation was always bad and unregulated markets always good had been blown out of the water by the crisis. This was politically naive, in part because a crisis caused by unregulated markets was morphed by the right into a crisis caused by too much government debt, or too many immigrants. But that fiction will not be sustainable once a strong recovery has reduced both government debt and unemployment. For the 1%, these are very dangerous times, and they want to be on favourable territory for the battles ahead.  

If minimum wages, why not maximum wages?

I was in a gathering of academics the other day, and we were discussing minimum wages. The debate moved on to increasing inequality, and the difficulty of doing anything about it. I said why not have a maximum wage? To say that the idea was greeted with incredulity would be an understatement. So you want to bring back price controls was once response. How could you possibly decide on what a maximum wage should be was another.

So why the asymmetry? Why is the idea of setting a maximum wage considered outlandish among economists?

The problem is clear enough. All the evidence, in the US and UK, points to the income of the top 1% rising much faster than the average. Although the share of income going to the top 1% in the UK fell sharply in 2010, the more up to date evidence from the US suggests this may be a temporary blip caused by the recession. The latest report from the High Pay Centre in the UK says:

“Typical annual pay for a FTSE 100 CEO has risen from around £100-£200,000 in the early 1980s to just over £1 million at the turn of the 21st century to £4.3 million in 2012. This represented a leap from around 20 times the pay of the average UK worker in the 1980s to 60 times in 1998, to 160 times in 2012 (the most recent year for which full figures are available).”

I find the attempts of some economists and journalists to divert attention away from this problem very revealing. The most common tactic is to talk about some other measure of inequality, whereas what is really extraordinary and what worries many people is the rise in incomes at the very top. The suggestion that we should not worry about national inequality because global inequality has fallen is even more bizarre. 

What lies behind this huge increase in inequality at the top? The problem with the argument that it just represents higher productivity of CEOs and the like is that this increase in inequality is much more noticeable in the UK and US than in other countries, yet there is no evidence that CEOs in UK and US based firms have been substantially outperforming their overseas rivals. I discussed in this post a paper by Piketty, Saez and Stantcheva which set out a bargaining model, where the CEO can put more or less effort into exploiting their monopoly power within a company. According to this model, CEOs in the UK and US have since 1980 been putting more bargaining effort than their overseas counterparts. Why? According to Piketty et al, one answer may be that top tax rates fell in the 1980s in both countries, making the returns to effort much greater.

If you believe this particular story, then one solution is to put top tax rates back up again. Even if you do not buy this story, the suspicion must be that this increase in inequality represents some form of market failure. Even David Cameron agrees. The solution the UK government has tried is to give more power to the shareholders of the firm. The High Pay Centre notes that: “Thus far, shareholders have not used their new powers to vote down executive pay proposals at a single FTSE 100 company.”, although as the FT report shareholder ‘revolts’ are becoming more common. My colleague Brian Bell and John Van Reenen do note in a recent study “that firms with a large institutional investor base provide a symmetric pay-performance schedule while those with weak institutional ownership protect pay on the downside.” However they also note that “a specific group of workers that account for the majority of the gains at the top over the last decade [are] financial sector workers .. [and] .. the financial crisis and Great Recession have left bankers largely unaffected.”

So increasing shareholder power may only have a small effect on the problem. So why not consider a maximum wage? One possibility is to cap top pay as some multiple of the lowest paid, as a recent Swiss referendum proposed. That referendum was quite draconian, suggesting a multiple of 12, yet it received a large measure of popular support (35% in favour, 65% against). The Swiss did vote to ban ‘golden hellos and goodbyes’. One neat idea is to link the maximum wage to the minimum wage, which would give CEOs an incentive to argue for higher minimum wages! Note that these proposals would have no disincentive effect on the self-employed entrepreneur. 

If economists have examined these various possibilities, I have missed it. One possible reason why many economists seem to baulk at this idea is that it reminds them too much of the ‘bad old days’ of incomes policies and attempts by governments to fix ‘fair wages’. But this is an overreaction, as a maximum wage would just be the counterpart to the minimum wage. I would be interested in any other thoughts about why the idea of a maximum wage seems not to be part of economists’ Overton window.