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.    

The media, the market and truth

I read with interest a recent article by Greg Mankiw about media bias (HT Mark Thoma). It discussed research by Gentzkow and Shapiro on the US newspaper industry. They find that a newspaper’s political slant is governed by the politics of its readership rather than the politics of its owner. Of course television and radio are different from newspapers, and the UK newspaper industry is rather different from that in the US. But what interested me were Mankiw’s own closing remarks:

“These findings speak well of the marketplace. In the market for news, as in most other markets, Adam Smith’s invisible hand leads producers to cater to consumers. But the findings also raise a more troubling question about the media’s role as a democratic institution. How likely is it that we as citizens will change our minds, or reach compromise with those who have differing views, if all of us are getting our news from sources that reinforce the opinions we start with?”

Now even raising this question sounds rather radical, and potentially paternalistic. Should we stop people reading what they want to read, because we think it would be good for them to read something else?

The problem with political bias is that it covers a multitude of sins. At its most innocent, it can simply be presenting facts within a political or ideological context that matches that of the reader. In the UK, a lot of the reporting in the Guardian, or Telegraph, is of this kind. Where it gets more difficult is when this bias determines which facts get reported.

Take this report in the Daily Mail about the UK food banks run by the charity the Trussell Trust. (Or, as some government sources apparently like to describe the Trust, as a ‘business’ seeking publicity.) It is written as an expose, designed to give you the impression that the numbers of people using the Trust (almost a million) should not be taken at face value. It might just work, for someone who wants to avoid the implications of such a large increase in the use of UK food banks. Anyone with a different perspective would either laugh or get angry. (When the article was highlighted on twitter, donations to the charity increased.) You can spot one or two untruths: a headline says their reporter got three days of food ‘no questions asked’, when the article makes clear questions were asked. But mainly this article is biased because of its highly selective choice of facts presented.

(In reality a large part of the increase in demand at UK food banks seems to reflect mistakes made as a result of government changes to welfare, as this Economist article explains, or as John McDermott reports in this excellent piece of journalism. So the bias in this Mail report is not only in the ‘slant’, but the deliberate absence of key facts considered by the Economist and FT.)

At its most extreme bias can involve making things up. At the beginning of this year rules on Bulgarian and Romanian workers coming to work in the UK were relaxed.  Here is a report in the Daily Mail online, indicating a rush of workers taking advantage of this relaxation. As this comprehensive discussion makes clear, the report was essentially a work of fiction. As this report shows, the costs to the newspaper of making things up in this case were minimal. (We have just had the figures for the first quarter: employment of Bulgarians and Romanians went down compared to the previous quarter.)

The traditional view is that slanting news and a highly selective choice of facts is tolerable, but making things up is not. The idea here is that people read newspapers on the understanding that they are based on facts rather than fiction, so including news stories that are made up is the equivalent of misreporting the sugar content on the packaging of some food. So the only thing that should worry us here is that whereas the manufacturer of a food product would presumably be subject to a large fine and damaging publicity if it got its food labelling wrong, a newspaper can effectively get away with it.

Yet this distinction does not address Greg Mankiw’s concern. If people are only told the facts that they are comfortable with, they will never change their minds. And as Paul Krugman observes (via Mark Thoma), if it is only the media read by your political opponents who will cry foul, politicians who just want to ‘play to the base’ are tempted to also distort or manufacture evidence, perhaps leading to descent into a world of fantasy.

Does this selection of facts actually influence people? Fewer people in the US think climate change is a major threat to their country than almost anywhere else (HT George Monbiot). The figure for the UK is also unusually low. This is particularly ironic as a good deal of the science telling us it is a major threat is done in these two countries. A major reason (pdf) why people in the US and UK think this way is that they are allowed the freedom to not to be told about the science, or to be given the opinions of skeptics as if they carried equal or more weight than the vast majority of scientists. (I look at other evidence of influence here.)

So this is an important issue. But can Mankiw be rescued from the charge of paternalism? (No, I never expected to write that line either.) I just want to raise two final thoughts. First, do we know that people are happy not to be told important facts that they might find challenging? If they had a choice between a newspaper that presented all the facts from their own ideological perspective, and another identical paper which only gave them the facts they wanted to hear, would they really choose the latter? Perhaps people do not get that choice. Second, even if they might sometimes choose the latter option, do they want that option? Perhaps it is a bit like being on a diet. We know we might be tempted never to be confronted with facts that challenge our priors, but we know we really should be. So just as those on a diet would rather not be constantly faced with the choice of lots of fattening foods, so perhaps people would not object if they did not have the option of just hearing what they wanted to hear. 

The Liquidity Trap and Macro Textbooks

Over the last eleven days something unusual has happened – I have not only failed to post a blog of my own, but I have not even read anyone else’s posts. Instead I have taken advantage of a sabbatical term to take a break [1] in Umbria, during a time of year when it is still cool enough to walk, but not too cold in the Piano Grande. Before I left I did write a couple of things that I thought I might quickly post while away, but with the help of the Italians’ penchant for starting dinner late and eating four (or more) courses that idea somehow got lost.  

So I’m spending part of today catching up, and reminding myself why Paul Krugman and Martin Wolf are such great writers. (For example, from the former, a masterful analysis of the decent into worldwide austerity, and from the latter, a perfect short account of why when it comes to government debt the Eurozone really is different.) What I want to pick up on here is this Krugman post, where he questions the description in a Nick Crafts piece of higher inflation as a way out of the liquidity trap as being ‘textbook’. (See also Ryan Avent.)

So is raising inflation expectations to avoid the liquidity trap textbook or not? Let’s take the 2000 edition of the best selling undergraduate macro textbook. Here ‘liquidity trap’ does not appear in the index. There is a page on Japan in the 1990s, and in that there is one paragraph on how expanding the money supply, even if it was not able to lower interest rates, could by raising inflation expectations and therefore reducing real interest rates stimulate demand. One paragraph among 500+ pages is not enough to make something ‘textbook’, so it seems as if Paul Krugman has a point.

Yet how can this be? It is not one of those cases where textbooks struggle to catch up with recent events, because the Great Depression was a clear example of the liquidity trap at work. How can perhaps the major macroeconomic event of the 20^th century, which arguably gave rise to the discipline itself, have so little influence on how monetary policy is discussed? Yet it is possible to argue that the discussion is there, in an oblique form. A standard way of analysing the Great Depression within the context of IS-LM, which this popular textbook takes, is to contrast the ‘spending hypothesis’ with the ‘money hypothesis’: was the depression an inevitable result of a negative shock to the IS curve, or as Freidman argued could better monetary policy have prevented this shock hitting output?

A standard objection to the money hypothesis is that nominal interest rates did (after a time) fall to their lower bound. The counterargument – which the textbook also suggests - is that, if the money supply had not contracted, long run neutrality would imply that eventually inflation would have to have been higher, and therefore real interest rates on average would be lower. So in one way the story about how higher inflation could avoid a slump is there.

What is missing is the link with inflation targeting. Because textbooks focus on the fiction of money supply targeting when giving their basic account of how monetary policy works, and then mention inflation targeting as a kind of add-on without relating it to the basic model, they fail to point out how a fixed inflation target cuts off this inflation expectations route to recovery. Quantitative Easing (QE) does not change this, because without higher inflation targets any increase in the money supply will not be allowed to be sustained enough to raise inflation. In this way inflation targeting institutionalises the failure of monetary policy that Friedman complained about in the 1930s. Where most of our textbooks fail is in making this clear.    

[1] Sometimes known as holidays, these are things that we Europeans are forced to take many more of than Americans, leading to great frustration and misery (or maybe not).

Macroeconomists: Scientists or Engineers?

Some comments on my earlier posts discussing microfoundations have mentioned Mankiw’s well known paper on the macroeconomist as scientist or engineer? This is something I’ve also wondered about, so I went back to reread the paper. Mankiw writes:

“My premise is that the field has evolved through the efforts of two types of macroeconomist—those who understand the field as a type of engineering and those who would like it to be more of a science. Engineers are, first and foremost, problem-solvers. By contrast, the goal of scientists is to understand how the world works. The research emphasis of macroeconomists has varied over time between these two motives.”

Mankiw tries to relate this distinction to the debate between Keynesian and New Classical economists. When I first read the paper, and even more so now, I find this link ultimately unconvincing. The attempt to cast Keynesians as engineers and New Classicals as scientists requires too many qualifications: there is probably something there, but it does not seem to be the critical distinction. His argument that New Keynesian theory has had little influence on policy turned out to be premature, as he himself anticipated in his conclusions.

But suppose we use the engineer/scientist dichotomy and apply it to microfoundations, rather than particular schools of thought – will that work? Microfoundations macro is the science, while those pursuing different approaches are the engineers. Is the problem with academic macro at the moment that we have too many who think they have to be scientists, and too few who try to be engineers?

I really have not made my mind up about this. One of the motivations I give in my earlier post listing reasons for departing from microfoundations focuses on policy. We have some empirical finding that at present has no clear microfoundation, but policy cannot wait for theory to develop that microfoundation. We need to explore its macroeconomic implications now. I give price rigidity as a retrospective example – it took at least a decade to develop New Keynesian theories. So we can imagine those involved with policy as the engineers, busy looking at the implications of some empirical finding, while those exploring its microfoundations are the scientists.

Certainly I have found the distinction between scientist and engineer often has resonance with macroeconomists in policy making institutions. They feel the urgency of the problem, and probably have less concern about some of the seemingly more esoteric issues that might be raised in an academic seminar. My post suggesting that the core models used by central banks should not be DSGE models ties in with this. In that context I like the scientist/engineer dichotomy, because I don’t think central banks have the resources to develop alternative modelling frameworks alone. Although we find plenty of engineers outside academic departments, we also need engineers who are academics.

But then, would it make sense to have distinct departments, of pure and applied macroeconomics? Obviously not because there are not enough of us to go round, but isn’t there something more fundamental in that observation? I write papers that build and simulate DSGE models, but I have in the past built models that are not fully microfounded, and the only thing stopping me doing both at the same time is time itself and that a major part of my job is to publish in academic journals. More importantly, in which department would you put Michael Woodford (at least when he writes Jackson Hole papers)?

This isn’t really about people as about ideas. I certainly think that anyone building non-microfounded models needs to have a thorough knowledge of microfounded models to do it well. (That would go for heterodox economists as well.) But equally, I think it is difficult to build good microfounded models without having a good knowledge of the empirical evidence. This is not just a matter of selecting an appropriate puzzle: I think a good deal of the microfoundations game is about selecting particular ‘tricks’ that allow these models to get closer to the real world, as I suggested here. While I can think of some macroeconomists whose productivity is largely unrelated to what is happening in the real world, and others – particularly in policy institutions - who do good stuff without ever seriously thinking about microfoundations, I think the majority of academic macroeconomists need to do both. In other words, to be good scientists we need to be engineers, and to be good engineers we also need to be scientists. 

Giving Economics a Bad Name

Greg Mankiw is known to every economist and economics student, if only because of his best selling textbook. John Taylor is known to every macroeconomist, if only because of the large number of bits of macro with his name on it (Taylor rule, Taylor contracts etc). Both are respected by other academics because of the quality and influence of their academic work.

With two others, they recently wrote this about the Obama administration’s attempts to stimulate the economy through fiscal policy after the recession: “The negative effect of the administration’s ‘stimulus’ policies has been documented in a number of empirical studies.” They then quote from two studies. The first looks at a minor aspect of the stimulus packages, the Cash for Clunkers attempt to bring forward car purchases. There are other studies of this programme which are more favourable. The second study is co-authored by John Taylor, and others have interpreted his findings differently.

No other studies are directly referred to. That might just be because the overwhelming majority suggest that the stimulus package worked. Dylan Matthews on Ezra Klein's blog documents them here. As I wrote in a recent post, the evidence is about as clear as it ever is in macro. Which is not too surprising, as it is what Mankiw’s textbook suggests, and it is what the New Keynesian theory both authors have contributed to suggests.

Now the quote comes from a paper prepared for the Romney presidential campaign. It is clearly political in tone and intent. As both academics are Republican supporters, it may therefore seem par for the course. But it should not be. The Romney campaign publicised this paper because it was written by academics – experts in their field. It allows those who oppose fiscal stimulus to continue to claim that the evidence is on their side – look, these distinguished academics say so.

It is one thing for economists to disagree about policy. It would also be fine to say I know the evidence is mixed, but I think some evidence is more reliable. It is not fine to imply that the evidence points in one direction when it points in the other. I say here imply, because the authors do not explicitly say that the majority of studies suggest stimulus is ineffective. If they chose their words carefully, then you have to ask whether ‘intending to mislead’ is any better than ‘misrepresenting the facts’. Was that the intent, or just an isolated unfortunate piece of bad phrasing? All I can say is read the paper and judge for yourself, or this post from Brad DeLong.

This is sad, because it tells us as much about economics as an academic discipline as it does about the individuals concerned. In the past I have imagined something similar happening in physics. It actually stretches the imagination to do so, but if it did, the academics concerned would immediately lose their academic reputation. The credibility of their work would be questioned.  Responding to evidence rather than ignoring it is what distinguishes real science from pseudo science, and doctors from snake oil salesmen.

What can economics as a discipline do about this sad state of affairs? The answer is pretty obvious, to economists in particular, and that is changing the incentives where we can. However we cannot do much about the incentives provided by politics and the media. I have been pretty pessimistic about this in the past, but in a future post I will try and be more positive and talk about one possible way forward.