Thursday, September 30, 2010

Still having the wrong debate

The New York Times today picks up on the ongoing debate about whether the top bracket should uniquely be left out of extending the expiring Bush tax cuts for individuals. The article refers, inter alia, to the Todd Henderson-Brad DeLong et al brouhaha on which I briefly weighed in last week.

To give one of my main points from last week a bit more emphasis, one of the big problems here is the fundamental mismatch between the rhetoric being used to support letting the top bracket rate cuts expire and the underlying fiscal situation. Extending ANY of the tax cuts is crazy given the looming U.S. fiscal gap, leaving aside only the points that (a) better-directed stimulus than extending the tax cuts may be politically unavailable, and (b) if base-broadening were on the table politically, one might prefer that to letting the rates go up. But again, given that rational alternative courses are unavailable, it verges on insanity to extend any of the tax cuts (other than in the scenario of a temporary extension that the relevant actors agree will be allowed to expire).

The Obama Administration has decided, from the defensive crouch all Democrats have adopted for at least the last 25 years, to support extending all the tax cuts below the top bracket. In other words, Rove's gambit back in 2001 worked: he was able to shift the political baseline to one of permanent tax cuts without having to count the out-year revenue loss. Plus, he got to exercise agenda control 10 years in advance to the Republicans' predictable advantage. But making an exception just for the top-bracket group has encouraged the Obama Administration to trot out rhetoric about billionaire bankers and the like, which genuinely is a poor fit with $250,000 a year even if that income amount is well into the 99th percentile.

So now we have people like Senator Webb of Virginia saying that the cutoff for raising the top rate above the current 35% should be something much higher than $250,000, leading to yet more revenue loss than under the Administration's position if it happens.

Leaving aside the issue of overall revenue loss, however, Webb has his finger on something that merits attention. The issue of billionaire bankers, or more precisely the fact that the very top of the income distribution has pulled far away from everyone else over the last 20 years, clearly is important even if it doesn't support making the long-term fiscal gap even greater by limiting tax cut expiration to the very top of the top. But no matter what the rates are, and no matter how well or poorly one has addressed the fiscal gap, the question of whether tax rates should be higher at the billionaire level than for those merely at the lower end of the 99th percentile deserves thorough analysis.

I should note, however, that, in the optimal income tax (OIT) literature dating back to the rightly Nobel-awarded work of U.K. economist James Mirrlees, there's a result contrary to raising the rate at the very top. The OIT literature seeks to illuminate the proper consequences for tax rate structure of balancing distributional concerns against efficiency concerns (adaptable to any view one has regarding how best to trade them off against each other). But it tends to suggest that tax rates should be relatively flat and indeed eventually declining at the very top - even if one values progressive redistribution a lot.

This OIT-based view has enormous, indeed compelling, logical force within its assumptions. But these assumptions can potentially be challenged. For example, the approach typically treats utility as depending only on one's own consumption. Thus, if someone gets ten times richer while everyone else stays the same, that person wins and no one loses. There might be a strong case for redistribution away from that person, but this would be based purely on the assumption that, due to the declining marginal utility of wealth, other people would get far more utility from a given dollar than he or she would. Simply burning one of that person's dollars (in the sense of causing him to forego it without getting to transfer even a penny to anyone else) can only be bad, under these assumptions, given that everyone's utility counts positively in the social welfare function.

Suppose there is a case that the top 0.1 percent's astonishing pullaway has had bad social consequences, to which one should object in straight utilitarian terms even if one opposes assigning any independent, non-welfare based, weight to equality for its own sake, to non-welfarist "fairness" concerns, etcetera. Then taking away a dollar at the top could potentially have good social welfare consequences even if no piece of it is successfully transferred to anyone else. This would have to be a claim about externalities. It's very contrary to the way economists (and their fellow-travelers such as myself) generally like to think about these issues - and this reluctance is usually quite justified - but, in this setting, potentially compelling albeit needing specific elaboration.

Other stories might also undermine the standard OIT view about flat and eventually declining tax rates at the top. For example, if being at the 99.99th income percentile correlates with enjoying rents, or with being more concerned about positional jockeying versus one's peers than about the consumption that each extra dollar permits one to afford, there could be further support for rising tax rates at high levels. But this is a set of issues that academics ought to be looking at more, whether just because knowledge is good (as they say at Faber College) or in the hope that findings - and yes, it's not just about self-expression - could eventually influence the political process.

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