Taxes, incentives & the long-run

Tim and Richard are debating that old question, would higher taxes on the rich, as demanded by Compass (pdf), actually raise tax revenue, or would the rich emigrate, work less or fiddle their taxes with the result that less income would be raised?
Economic theory is absolutely no help here, as there are two competing effects. The income effect predicts that higher taxes might lead people to work harder, in order to maintain their post-tax incomes. The substitution effect says that if work becomes less remunerative, we’d do less of it and spend more time with the guitar or golf clubs.
It is an entirely empirical question as to which one dominates - in other words, as to where the Laffer curve is.
Here, though, is the problem - the empirics are also uncertain. Take, for example a recent paper (pdf) from IFS economists. It says:

If the richest 1% see a 1% fall in the proportion of each additional pound of earnings that is left after tax, then the income they report will rise by less than half that - only 0.46%. Although a tentative estimate, this suggests that the government would maximise the revenue it collects by imposing an overall marginal rate on the highest earners of 56.6%, very close to the 53.0% currently charged.

Victory to Tim, you might think.
No. For one thing, as they say, the estimate is tentative. Allowing for this gives us another interpretation. This is that the revenue-maximizing top tax rate is 95% likely to be in the range 45-75%. This encompasses Tim’s and Richard’s views.
And it could be that Richard is nearer the truth. The IFS’s estimate is for the top 1%. But these are those most likely to respond  to higher taxes by reducing labour supply. The well-paid hedge fund manager can relocate to Bermuda. The CEO can stop work and take up some non-executive directorships. And guys who have made a few million can afford to retire.
However, those lower down the top decile - the ones Richard wants to tax more - have fewer such options. They might be tied to work. Remember, an income as low as just over £46,000 gets you into the top decile (table 14 of this pdf) - and you can‘t retire on your savings from that.
Indeed, other IFS evidence (pdf) suggests that, for male workers in general, “hours of work are almost completely irresponsive to changes in work incentives.”
So, am I siding with Richard? Not entirely. Here, I’ll invoke one of my favourite rules of thumb, namely:

Elasticities are smaller than expected in the short-run, but larger expected in the long-run.

To see what I mean, put yourself in the shoes of someone on, say, £100,000 a year facing Richard’s higher tax. He might well figure: “I’ve got an ex-wife and kids to support: I’ve got to keep  earning. And I’m not qualified to do anything else anyway. But I hear that some senior partners are thinking of retiring now they have to pay more tax. If I work hard, I might be able to get one of the jobs they leave.” 
But now, think of a university student. He figures: “I was toying with the idea of going into the City. But why should I work 80 hour weeks in a dullish job to hand over most of my money to the government? I’ll do a less well-paid job that I enjoy instead.“
Now, in the short-run - which might be many years - the £100,000 a year man’s response is the most important one. But in the very long-run - decades - it’s the student’s response that determines our macroeconomic fate.
What I’m getting at here is a point made by Assar Lindbeck (pdf, p323) - that the short-run response to incentives can be dampened by habits, social norms and other path dependencies. It is only as these fade away, over decades, that the full effect of disincentives is felt.

Comments

[botogol]

there's a third possible effect - to up sticks and go somewhere else. For the very rich this is comparatively easy.

[Luis Enrique]

The IFS paper you cite says the participation decision for women appears to be particularly sensitive to tax rates.

The importance of female participation is often ignored. Check this paper out:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1501986

[and]

"But now, think of a university student. He figures: “I was toying with the idea of going into the City. But why should I work 80 hour weeks in a dullish job to hand over most of my money to the government? "

Possibly because, if I was an average uni student, I would be amassing a potentially life ruining level of personal debt, which would leave me scant choice but to chase such a job ?

[Jim]

If you think its morally right for the State to forcibly take 95% of someone's income, however much they earn to start with, you need locking up.

Once the State starts taking more than 50% of my marginal efforts, that's the day I down tools. I am not the State's slave. Why should I work hard and see the fruits of my labour redistributed to a bunch of lard ar5ed layabouts? (and that's just the State employees, not the ones on the Social).

This country is screwed.

[Mark Wadsworth]

Jim, depending on who your employer is and/or whether the service you provide is VAT-able or not, your marginal tax rate is already well over 50%. And if you're entitled to Working Tax Credits, it's probably about 80%.

There is also a line of thought that says in practice the revenue-maximising rate for lower earners is higher than for higher earners (because the lumpen proletariate are less internationally mobile and less able to fiddle the system).

[Phil]

"why should I work 80 hour weeks in a dullish job to hand over most of my money to the government?"

Never understood this. "My money" doesn't exist until I earn it - and I earn it under conditions which *always already* include income tax. Gross income is a completely notional figure. I mean, if income tax was abolished tomorrow, do you suppose that next year a new starter doing my job would take home 100% of my current gross income? Perhaps if my workplace had a *very* strong union - but the people deploying the "government takes my money" argument tend not to be in favour of those for some reason.

[Vino's Political Blog]

Well said, Phil. It does strike me that people seem to be rather naive in the assumption that gross incomes will remain unchanged if income tax is cut. In fact, a political situation where income tax is cut, is probably a similar political situation to one where capital gains at the expense of labour - and so there will be downward pressure on wages.

Also, it strikes me as odd that people assume that the gross pay the rich get is "earned". After all, it is only because people are living in advanced capitalist countries with the rule of law and with developed financial systems that a lot of these people are able to "earn" that much. Warren Buffett, who is a lot wiser than a lot of the cheerleaders for plutocracy, once said as much. He acknowledged that a large part of his wealth was due to the accident of when and where he was born - and the fact that the US had a strong economy and a well-developed financial system. If he had been born a century earlier, or in a poor country - he would not have been able to "earn" as much case. The right-wing myth that the super-rich "earn" their money ignores the role of social institutions and wider economic circumstances.

[Tim Worstall]

Glad you weighed in on this. For I do indeed make most of the points you do.

"Remember, an income as low as just over £46,000 gets you into the top decile"

No, he's talking about household incomes, not individual.

And after further prodding he says that it will be "second partners" in high earning households that will go out to work to maintain the income.

"The IFS paper you cite says the participation decision for women appears to be particularly sensitive to tax rates. "

Quite, he's assuming what we know to be untrue.

[Jim]

@Phil: that's why PAYE exists, it's to con people as to the reality of how much of their efforts the govt steals in tax.

If all employees had to pay their own taxes in retrospect (as the self employed do, of which I am one) there would never be another tax increase, probably much lower tax. But people never see the tax cash, they just concentrate on the takehome element. Just as they don't see the VAT element in stuff they buy. In the USA prices in the shop often are before tax, so you see the tax element. IMO the same should be done here.

[Luis Enrique]

Jim,

I think you're quite wrong to only see the confiscatory aspect of tax and not see the political settlement and public services that, among other things, help you run your business.

But you may be right that people feel differently about (and respond differently to) taxes they can "see"

Check out the two papers about "salience" here (bottom of section on taxation on individuals)

http://obs.rc.fas.harvard.edu/chetty/

[Neil]

Following on from Phil, if income tax was abolished tomorrow, I'm sure the first result would be absolutely terrifying price inflation.

[jameshigham]

Tim and Richard are debating that old question, would higher taxes on the rich, as demanded by Compass (pdf), actually raise tax revenue, or would the rich emigrate, work less or fiddle their taxes with the result that less income would be raised?

The latter of course.

[GeoffH]

I don't know why anyone should even think there's a debate here.

Forget hypothesising and look for real world evidence.

I am recently in receipt of my State Pension. I have a company pension. I also do some freelance work.

Being over 65 I receive an enhanced tax allowance giving me a larger tax-free income BUT at around £20k gross income that allowance is reduced by £1 for every £2 earned above that limit.

So, I'm a pensioner privileged to pay a 30% band of income tax that those in employment do not. Nice.

Additionally being self-employed I have to pay class IV NI. 8% of profits, even though I am over 65. This will continue for a further 8 months until the end of my freelance business reporting year. Eight months of a further 8% tax that recently-retired ex-PAYE pension does not pay on any extra earnings. Nice.

I already modulate my work level to balance the utility of additional earnings which are now taxed at, effectively, a confiscatory rate with the real benefit of free time to do pleasurable things.

I take steps NOT to maximise my earnings and would certainly do so more actively if tax rates were to rise yet again.

Murphy is a fool.

[Vino's Political Blog]

James Higham seems to assume that we are already at the revenue-maximising level of taxation. I disagree. I doubt that people would turn down a job earning £200k just because they would have to pay a marginal rate of 50% on the last £50k of it. If there is such a person, i would be happy to swap jobs with him ;)

[Vino's Political Blog]

Re the argument that the rich will emigrate, I am sure that will be true in some cases, but that is not a reason to give in to their blackmail that taxes should be kept low just to keep them in the UK.

The ability for them to continue their businesses/work overseas etc is only possible because, since 1979, there have not been capital controls. City boys would find it a lot more difficult to emigrate and work in Zurich or Hong Kong or Dubai or wherever if it were made clear that to do transactions on the UK stock exchange, bond markets etc you have to be an org based in the UK. The free movement of capital and the flow of "hot money" around the world often does as much harm as good.

[GeoffH]

"I doubt that people would turn down a job earning £200k just because they would have to pay a marginal rate of 50% on the last £50k of it"

This is where you simply don't understand.

Such an offer only comes to those earning close to £200k now. And with additional workload/responsibilities/stress etc.

Already earning, say, £160k and such an offer looks unattractive at a marginal tax rate (inc NI, loss of allowances etc) of over 50%.

Of course, to the student revolutionaries on little more than minimum wage the idea of trading time and peace of mind against higher earnings and higher tax is unimaginable.

That's probably why Vino, you get few readers and no comments.

[reason]

GeoffH,
let's assume there is some truth in what you say. Then what will happen to the job? Will they raise the salary offered, or will they consider younger people with lower salary expectations for the position? Just because you decide it isn't worth it (and if the decision was marginal - maybe that really is the case) doesn't mean the job won't be adequately performed. The "rich" have such inflated views of their own importance.

[reason]

I also argued elsewhere, that there may be another effect to consider - early retirement. It can well be that in the short term lower marginal rates increase work effort - but not lifetime labour supply, because the people will save most of the additional income and retire earlier. This may be hard to see in the data if you don't look for it carefully.

[Ugg london]

Never frown, when you are sad, because you never know who is falling in love with your smile.