Tuesday, October 12, 2010

Response to Queries

My recent Times column generated more email and blogosphere commentary than usual.  While it is impossible for me to answer all the questions raised, I thought it might be useful to address three of the more common ones.

If no one is proposing eliminating taxes, why compare the Obama policy to a world without taxes?  Economists understand that, absent externalities, the undistorted situation reflects an optimal allocation of resources.  It is crucial to know how far we are from that optimum.  To be somewhat nerdy about it, the deadweight loss of a tax rises with the square of the tax rate.  Thus, increasing or decreasing a tax rate by 1 percentage point has a small effect on economic well-being if the initial tax rate is low, but it has large effect if the initial tax rate is high.  For the margin of adjustment I was discussing (work more now, let your kids consume the proceeds in 30 years) the distortion is very high once all taxes are taken into account.  As a result, every change in this tax wedge has a large impact on the size of the economic pie.

Aren't there ways to avoid some of these taxes, such as IRAs and life insurance trusts?   Yes, and I use such tax avoidance mechanisms to the extent they are legal and practical.  But there are limits to how much they can be used.  Thus, while they lower my average tax rate, they do not affect my marginal tax rate.  That is, for any incremental income, I cannot do more, so I am facing the full tax bite.

Aren't you motivated by more than money?  Of course. I have never suggested that money is my, or anyone's, sole motivation in choosing a lifestyle.  In economic models, we often simplify things by assuming that there are only two activities: work and leisure.  Work has a pecuniary benefit, whereas leisure has a non-pecuniary benefit.  Reality is more complicated.  I face a choice among a wide range of activities, each of which offers some combination of pecuniary and non-pecuniary benefits.  Absent taxes, I would choose an optimal mix of these activities.  When the government taxes pecuniary benefits, I spend more time on those activities that yield non-pecuniary benefits.  Some of those activities may look like leisure, but others may be better described as "fun work" rather than "income-producing work."  Blogging, for instance, or writing op-eds that particularly inflame the left-wing blogosphere.