Tuesday, February 12, 2008

Are taxes really distortionary?

The mysterious knzn says:
I've always been skeptical of the importance of the purported bad incentive effects of high marginal tax rates on high income earners.
This view characterizes many left-leaning economists. I disagree, which is one reason I lean more to the right.

Including all forms of federal, state, and local taxes, high income earners face marginal tax rates in the ballpark of 50 percent (and perhaps even higher to the extent that incremental dollars are to be left to one's kids and thus taxed a second time by the estate tax). So here is the question I would ask people like knzn:

Have you ever turned down a money-making opportunity that you would have accepted if it paid twice as much?

For many high income earners, the answer is yes, which means the tax system is distorting their behavior and reducing the size of the economic pie.

Update: Several people have asked, "Isn't the right question whether you would work more if all of your money-making opportunities were twice as lucrative, not just the ones you turned down?"

No, that is not the right question. It is a standard result of economic theory that the deadweight loss of taxation depends only on the substitution effect, which is measured by your response to a marginal opportunity. (That is, for this purpose, you need to use the compensated labor supply curve.) If we taxed your inframarginal work at a lower rate, the income effect would induce you to work less, as long as leisure is a normal good. But that income effect is not relevant for the question of deadweight loss, for reasons explained more fully in this previous post.