Robert Frank Responds to Greg Mankiw

When Greg Mankiw saw Robert Frank's Economic Scene article in the New York Times saying that trickle-down theories don’t hold up against actual evidence, he responded "Frank needs to read more widely":

Frank needs to read more widely, by Greg Mankiw: In today's NY Times, Robert Frank says there is little point to cutting marginal tax rates of high-income individuals:

Trickle-down theorists are quick to object that higher taxes would cause top earners to work less and take fewer risks, thereby stifling economic growth. ... On close examination, however, this claim is supported neither by economic theory nor by empirical evidence.

Apparently, Bob has not read this survey by Stiglitz and come to grips with this theoretical conclusion...:

Pareto efficient taxation requires that the marginal tax rate on the most able individual should be negative.

The reason for this conclusion is that a negative marginal tax rate on the most skilled worker induces him to work more, and if skilled and unskilled labor are complementary inputs, the wage for unskilled labor rises in general equilibrium.

Nor does it seem that Bob has read this empirical work by Gruber and Saez:

A central tax policy parameter that has recently received much attention, but about which there is substantial uncertainty, is the overall elasticity of taxable income. We provide new estimates of this elasticity...We estimate that this overall elasticity is primarily due to a very elastic response of taxable income for taxpayers who have incomes above $100,000 per year, who have an elasticity of 0.57, while for those with incomes below $100,000 per year the elasticity is less than one-third as large...

Bob is perfectly free to believe whatever he likes and to advocate increasing the top marginal tax rate. But to suggest that there is neither theory nor evidence to support the beneficial effects of lower marginal tax rates on high-income taxpayers indicates a lack of appreciation of the academic literature in public finance.

Bob also makes this argument:

If lower real wages induce people to work shorter hours, then the opposite should be true when real wages increase. According to trickle-down theory, then, the cumulative effect of the last century’s sharp rise in real wages should have been a significant increase in hours worked. In fact, however, the workweek is much shorter now than in 1900.

This seems just wrong to me, if the goal is to analyze tax policy. When comparing work hours today versus a century ago, you have to consider both income and substitution effects of wages on labor supply, which are offsetting to a large degree. But, according to standard theory, the distortionary effect of taxes depends only on the substitution effect. The evidence cited suggests that income effects are larger than substitution effects, not that substitution effects are small.

I'm guessing Frank had read the Stiglitz essay (after-all, it's not exactly new, the working paper Greg links is dated 1987), but in any case my reaction was that the Stiglitz paper comes to a theoretical conclusion while the claim Frank makes is mainly about the empirical evidence, i.e. his assertion is that the evidence doesn't support trickle-down claims. Frank wasn't denying that there are theories that allow for the possibility of supply-side effects, though he did point out that the theoretical predictions depend upon the magnitude of responses, i.e. the sign of the response to a change in taxes is not determined unambiguously by theory and hence it is an empirical issue. His point is that the empirical evidence doesn't support the claims made by those promoting supply-side policies. I'm not sure how citing Stiglitz rebuts the claim that there is no evidence for the theory [though to be fair it was offered to rebut that theory does not support supply-side policy, though I interpreted Frank as saying theory doesn't speak unambiguously on the matter, not that there is no valid theory supporting trickle-down effects].

My other reaction was that the criticism was a bit unfair. If you are going to accuse someone of not being aware of or lacking appreciation for research in the area, you owe it to us to cite more than one or two papers yourself and hopefully work a little more current than 1987 and 2000, especially if you were Chair of the CEA where public finance issues are at the forefront giving you a strong incentive to be familiar with the cutting-edge work in the area (and not under a word limit). I expected a summary of the research on both sides of the issue, some analysis about why one set of results ought to be preferred over the other, etc., but citing a single paper from 2000 as though that settles the empirical issue doesn't do it, at least not for me.

Graciously, Greg has offered Robert Frank the opportunity to respond to his objections [I cut Frank's response down a bit, Greg has the full response]:

Bob Frank replies, by Greg Mankiw: A few days ago, I expressed here my skeptical view of a recent column by Bob Frank. I offered Bob an opportunity to respond. Below I am reprinting, in its entirety, what he sends along. There is much that one could debate here, and I am sure the commenters will, but I will refrain. Since I picked this fight, and since I have ample opportunity in this forum to express my perspective, in fairness I will let Bob have the last word--at least for now.

First, my thanks to Greg for his gracious invitation to respond... Here I’ll attempt to explain why Greg’s defense of trickle-down theory falls short.

Greg discounts the significance of the negative relationship I cite between wage growth and the average workweek over that last century...

Greg is right about what this particular piece of evidence shows. But ... the argument I advanced in my column had nothing to do with whether taxes on the rich are distortionary. ... My only point in the column, however, was to question a very different claim—namely, that higher taxes on the rich would reduce work effort. ... In other words, it’s a claim about the combined impact of the income and substitution effects. So the fact that the workweek declined over the last century in the face of substantial growth in real wages is directly supportive of my argument.

A necessary and sufficient condition for trickle-down theory’s argument to the contrary is that the elasticity of supply of labor with respect to real wages be significantly positive. The most comprehensive recent econometric study of labor supply elasticity in the United States will be published in the next issue of The Journal of Labor Economics. The authors, Fran Blau and Larry Kahn, estimate that the labor supply curve for men has been essentially vertical for many decades. The clear implication is that higher taxes on top earners, most of whom are men, will not significantly reduce work effort.

Greg also mentions research suggesting that higher taxes on the rich may reduce the amount of income they report to the IRS. Perhaps so, but that by itself would not imply any reduction in output. And with even the supply-sider Bruce Bartlett now conceding that tax cuts for top earners don’t boost total tax revenues, it’s important not to exaggerate the problem of unreported income. But irrespective of its magnitude, why isn’t the best solution to this problem a simpler and more strictly enforced tax code rather than tax rates that are too low to sustain minimally adequate public services? ...

As evidence for his claim that I need to do additional reading, Greg cites a 1988 paper in which Joe Stiglitz argued that the socially optimal marginal tax rate on the most productive person might actually be negative. ... In the abstract, this is an interesting claim. (Is it any more than that? Stiglitz, for one, never thought to offer tax policy proposals on the basis of it.) But if we’re going to discuss externalities, then complementarities between skilled and unskilled labor are surely not the most important ones to consider.

For present purposes, by far the most important externalities are those stemming from the link between context and evaluation. As decades of behavioral evidence clearly demonstrates, virtually every evaluation is heavily shaped by local context. As Richard Layard put it, “In a poor society a man proves to his wife that he loves her by giving her a rose, but in a rich society he must give a dozen roses.” ... The upshot is that almost every consumer choice generates significant context externalities. Consider, for example, a job applicant’s decision about how much to spend on an interview suit. His goal is to make a favorable impression. But his ability to do so depends far less on the absolute quality of his suit than on how it compares with those worn by other applicants. And when he spends more on a suit, he shifts the context within which other candidates will be evaluated.

Context externalities are pervasive. ... The dependence of evaluation on context lays waste to any presumption that individual decisions about how many hours to work or how much to spend on interview suits will be socially optimal. ... For the discussion at hand, the relevant finding is that evaluations of leisure tend to be far less context-sensitive than evaluations of income. The implication is that individual valuations of leisure tend to understate social valuations. Thus people work longer hours in the hope of moving higher on the income ladder, only to discover that when others do likewise, their position remains unchanged.

It would be unfair to single out Greg for ignoring context externalities. After all, most of the standard economic models ... make no mention of these... But even absent explicit mentions of context externalities, most practical policy analysts already seem to recognize that trickle-down theory’s portrait bears little relation to the behavior of people in the real world.

My point is not that people don’t care about money. On the contrary, when the pay in one occupation goes down relative to others, fewer people enter that occupation. ...

But trickle-down theory is about what happens when after-tax pay falls not just in some occupations but for top earners generally. In a largely meritocratic society like the United States, most top earners are extremely driven people. And as recent studies have shown, most of them will never spend more than a small fraction of their earnings. The trickle-down theorist’s insistence that they will begin slacking off in response to a small increase in their marginal tax rates strains credulity.

While serving as chairman of the Council of Economic Advisers, Greg actively supported the Bush tax cuts targeted at top earners by arguing that the cuts would spur them to work harder. Greg would have been astonished to observe such a response from his colleagues at Harvard. Does he have a behavioral model that leads him to expect different behavior from high achievers in other occupations? Or does he have one that explains why any such differences consistently fail to reveal themselves in the data? In the absence of a plausible behavioral model backed by persuasive empirical evidence to the contrary, I stand by my conclusion that trickle-down theory is supported neither by economic theory nor by empirical evidence.

The tax cuts that were sold by invoking this theory did little to promote the well-being of even the well-to-do Americans who were their ostensible beneficiaries. ... In light of what we know about the empirical magnitude of context externalities, the principal effect of such spending was simply to redefine what counts as adequate. As in the familiar stadium metaphor, all stand to get a better view, yet none sees better than if all had remained seated.

Greg titled his response to my column “Frank Needs To Read More Widely.” On that point, he is surely right. I don’t know Greg well enough to presume to know what he needs. But he would almost surely offer better policy advice if equipped with an economic model that better fits current scientific knowledge about human behavior.

Again, my thanks to Greg for inviting me to respond to his critique of my column.

I hope Greg will make his case at some point and I encourage him to do so because, as I noted, he hasn't made it yet. It would be very useful to hear an unbiased, professional presentation that summarizes and evaluates of the vast work on both sides of this issue rather than an attempt to prove a point.

Comments

[evagrius]

Elasticity. Does that mean that the rubber band just breaks or that it hits you in the face when it does?

[ken melvin]

If it be that wealth flows down from these very hard working at the top of the economic order then let us procure whips and drive them as they have never been driven and thus make everyone of us richer than ever we've dreamed. If it should be that wealth flows up to these via greed and avarice, then it be better that we staunch the flow or take some of it back. Examples abound all round of wealth flowing down from above, do they not?

[Tom palley]

It's "taboo" to say these things but I believe Greg Mankiw's views reflect his self-interest. Greg is a wealthy individual with a high income who benefits from lower marginal taxes and I suspect that influences his views. If you work in Washington DC, it is easy to see how self-interest drives policy advocacy. However, we (economists) are in "denial" about how self-interest can also drive academic work.

[muckdog]

As a person who shut down his CA business 5 years ago, I can tell you that because of fees, taxes, and regulations it just became too much of a hassle. Who wants to spend their weeks worrying about that stuff. It was just getting worse... and worse... and worse.

[chris]

This is great stuff!

Was Mankiw the Bush guy who contradicted his own textbook?

[howard]

chris: yes.

muckdog: that's not the issue at hand here.

as for the general topic at hand, it's my understanding that mankiw is regarded as a good economist (i wouldn't know), but frankly, as far as i can tell, if that used to be the case, he sold his economic heritage for a mass of bush administration potage.

we've had, over the past quarter century, enough empirical opportunities to evaluate whether tax cuts at the margin for high-income earners generate some broader economic gains. as the bartlett/krugman/galbraith discussions recently featured here demonstrate, the very best you can say is that there might be some tiny, ambiguous evidence in favor of that proposition, while there is a lot of unambiguous evidence that doesn't.

[eightnine2718281828mu5]

question:

Does Greg Mankiw believe he was less diligent as chairman of the CEA than he was when occupying positions offering higher compensation?

I'd love to hear his thoughts on the topic.

[calmo]

Frank writesTrickle-down theorists are quick to object that higher taxes would cause top earners to work less and take fewer risks, thereby stifling economic growth. ... On close examination, however, this claim is supported neither by economic theory nor by empirical evidence. I don't know how close you have to stick your nose into this croc or visit the scholarly works that Mankiw cites to make a scholarly determination about which economic theory is supported and to what extent.
Plonking Type I, people.

It takes some density (and gall if you are wealthy) to make the claim that the wealthy are shouldering too much of the tax burden. It takes some density to note that absence of economic growth since 2000 [Kash at The Street Light] and growth of the few wealthy (don't mind my preference for "top earners") who have no interest in the nation's economic growth...so can we skip these crocodile tears for "stifling economic growth"?

Plonking Type II: We have a stifled economy from looting by the wealthy...gushing, not trickling.

[reason]

My take is less aggressive, it is just that monopoly stinks. But the game of monopoly would be very short without pass go and collect $200.

Lets remember where economic theory starts - what is the aim of the economic system - to most efficiently satisfy the needs and wants of consumers given limited resources. But who are the consumers? Answer those with money. Who SHOULD be consumers? (Answer everybody with needs). It NEED BE tax and spread TO MAKE the SYSTEM RESPONSIVE to NEEDS.

I think the James Kroeger take on this is the best.
http://nontrivialpursuits.org/Tax_Policy.htm

It is (because of exactly the sort of context externalities that Robert Frank talks about) not even clear that the rich benefit from low taxes. (In fact taxes do not become much lower they are just differently distributed as essential infra-structure services still need to be paid for.) A richer general population creates more opportunities for entrepeuners than a richer elite does. Trickle down has had about 25 years to show its value, somehow I don't think it has proved its case. Time to move on.

[Frank]

The theoretical optimal tax literature yields important insights but does not, in its self, policy recommendations. The optimal income tax literature is based on simplifying focus on a single issue - asymmetric information which keeps government from taxing potential income and restricts it to taking actual income). This is well understood by public finance economists who work with many insightful but highly simplified models and know that policy must be based on a combining insights from simple models. Read a pop piece by Hal Varian (http://www.ischool.berkeley.edu/~hal/people/hal/NYTimes/2001-05-03.html) for a discussion of the dramatic consequences of introducing another important factor in income determination (i.e including luck not just ability).

Also the empirical labour supply literature is massive and diverse with a wide variety of methodologies employed. Given economists believe incentives matter (and thus a potential publication bias) the compensated labour supply elasticities are remarkably small.

[robertdfeinman]

The Walton family inherited their $80 billion. Explain to me exactly which tax policy makes them work harder? How about Paris Hilton?

There are a few people like Bill Gates who are self made men, but the bulk of the big fortunes are multi-generational and, if these people work, more money is not the incentive. People can work for status or power or for a feeling of contributing to society or just to have something to do. Economists see everything in terms of money.

It is also worth noting the close correspondence between an economist's views on social policy and the theories he cites to "prove" his beliefs. You tell me which party he supports and I can tell you his views on trickle down.

Some of you may be interested in this Canadian study of the relationship between tax rates and the level of well being in society. To spoil the ending, the higher the tax rate as a percentage of GDP the better off the population is in terms of health, education, etc.

The industrialized country with the lowest rate? The US. The country with the poorest measures of well being? The US.

Spending half the discretionary budget on militarism comes with a cost.

Benefits and Costs of Taxation (PDF)

As an aside is it worth mentioning that whenever a conservative truism is attacked the response is an ad hominem attack on the person raising objections?

[Scott Ferguson]

reason: Indeed, the aim of a Democracy is to benefit its members, not to carry water for laiser-faire capitalists. If the citizen's don't feel that unfettered corporations are contributing to their well-being, then it's time to get out the fetters. So many of these Mankiw-types seem to think that the sole purpose of democracy is to support capitalism.

robertdfeinman: Thank you for pointing out that when Economics restricts itself to monetary issues and ignores the other complex psychological factors it reduces itself to sophistry.

[kharris]

Surely, Mankiw could do better than the snide implication that Frank is ill-read. Surely, Mankiw knew there were studies more recent than those he cited which had advanced or at least refined our knowledge of the issues at hand. He chose instead to cite studies convenient to his own position, even in the reasonable apprehension that Frank would be able to cite newer studies that would make obvious the weakness of his own effort.

I am not surprised that Mankiw has a devotion to the views he was paid to espouse during his time at the White House. On this point, I tend to disagree with Tom P. Cognitive dissonance is, I think, harder to overcome than non-essential self-interest. (By non-essential I mean that Mankiw's life, health, family and home are not threatened by a higher tax rate.) Mankiw is very probably unwilling to admit to himself that he said what he said because doing so was a condition of his employment. He has to come up with an alternative explanation. The alternative in cases like this is often to adopt strongly a position that you would have found equivocal prior to supporting it as a condition of employment. It probably doesn't hurt that Mankiw is in the top bracket, though.

Again, what surprises me is that Mankiw has done such a poor job of criticizing Frank. Why show up at all, if he is going to expose himself as unprepared? Routine trips to Mankiw's blog will show that his efforts are often as leaky as this one. Take a gander at the three-guys-in-a-bar metaphor from a while back for a great example of Mankiw showing up for the test in his underwear.

says...

"a great example of Mankiw showing up for the test in his underwear."

Great? Disturbing, would have been better suited :)

[John H. Morrison]

What would the economic effect of 90% tax on income over three million dollars? In other words, a top marginal rate of 90%?

A modest proposal: Let's create a narrow tax bracket ($100 wide -- from $150,000 to $150,100) with a 5% tax rate. What would be the consequences?

[2slugbaits]

A couple of points.

1. My recollection is that the theory about a zero or negative tax rate for the most productive individual literally applies to an (i.e., one and only one) individual at the very top. Mankiw is suggesting that it applies to a class of top earners.

2. Mankiw referenced a paper by Saez and Gruber. Funny that he didn't reference a slightly later paper by Saez, "Using Elasticities to Derive Optimal Income Tax Rates," NBER Working Paper 7628, March 2000. In that paper Saez argues that the optimal rate should be a lot higher than Mankiw would like. Here is from Saez's summary:

"Using elasticity estimates from the empirical literature, the formula for asymptotic top rates suggests that marginal rates for labor income should not be lower than 50% and may be as high as 80%."

[James Kroeger]

I've been baffled for quite a while at the failure of 'Democrat economists' to respond with some conviction to the spurious assumptions re: human motivation that Supply Side theorists have promoted to a status of semi-legitimacy. Thank you, Bob Frank, for pointing out the all-important fact that "trickle-down theory’s portrait bears little relation to the behavior of people in the real world."

Supply Side theory is fatally flawed because the assumptions that Mankiw, et al., make about the 'incentive power' of a tax cut are precisely the opposite of the truth. Reductions in disposable income provide individuals and entrepreneurs with a greater incentive to work more, not a reduced incentive. If the same work effort you gave last year will suddenly provide you with much more disposable income this year simply because your tax bill was reduced, it will inspire you to work less and not more. Not only is there no empirical evidence to support the fanciful claims of Supply-Side theorists, neither is there any logical stream of reasoning that will support them.

Economics students are still being taught in classrooms today the nonsense that the supply curve is upward sloping because business owners/managers have a greater incentive to produce more output when the per-unit price they can get from the marketplace is higher. Balderdash. Business owners/managers are going to try to produce and sell as many units of their product that they can, even if they are only making a penny per unit of net profit. Profit is profit and you are going to try to maximize it however little per-unit you might have to settle for. Guaranteeing business owners a greater net profit via a tax reduction is not going to give them any greater incentive to sell more than they presently have. They want to sell as much as they can, period.

(The real reason why the supply curve of particular markets is upward-sloping is because a higher price---assuming prices in all other industries are unchanged---makes it possible for owners/managers to pay higher prices for input resources, enabling them to 'steal' resources from other industries by outbidding them. The 'incentive' claim has absolutely no validity.)

When do firms need special incentives to motivate them to invest in new capital goods? The answer is never. In modern market economies, competition provides firm managers with the most powerful motivation to continually invest that they will ever need: FEAR. They ultimately face both the fear of bankruptcy and the fear of lost opportunity. If your competition lowers its costs by investing in new equipment, or improves the appeal of its products by incorporating new innovations, then you’d better do the same or you will soon find yourself driven out of business. With only a few exceptions, additional government-provided financial incentives are nothing more than an unnecessary waste of tax dollars.

Entrepreneurs do not need special additional incentives provided by the government to encourage them to assume the risks of creating a new business. True risk takers believe that their ideas will succeed in the market. They have so much of their identities invested in their ideas, they really don’t care if they receive any return at all on their invested time and money, sometimes for several years, so long as they have some hope of eventual success. The problem for entrepreneurs is not that they lack motivation; it's that they can't find someone who is willing to provide them with a loan and that only happens if banks, venture capitalists, and angel investors find their plans too risky. How is the promise of a larger after-tax profit going to fix this problem for the entrepreneur?

Of course, this only addresses the question of incentives for business owners. The suggestion that individual income earners need some kind of special incentives is even more specious...

[reason]

JK...
In principle I mostly agree. But the issue with Investment is more nuanced. Tax rates DO affect the marginal investment decision, depending on how the decision is made and how depreciation is handled. Changes in net income will change the break-even interest rate for investment decisions. Whether changes in interest rates would offset that is another (complex) issue (complex because of floating currencies).

[James Kroeger]

Tax rates DO affect the marginal investment decision...
I don't disagree with you, Reason. The only reason it might appear that I do is because Supply Side economists have been so successful in conflating the investment decisions of firm managers/owners with the amount of time that wealthy income earners decide to spend on their efforts to make more money.
If we want to enact a policy that will result in an increase in total firm investments, it makes little sense to provide some 'extra incentive' to all those firms that have already decided to invest for the competitive reasons I mentioned above. If you want to inspire marginal firms to go ahead with investment decisions that they would otherwise be reluctant to pursue without the promise of a higher net return, then it would make sense for Congress to offer targeted investment tax credits or perhaps government guarantees on private loans granted to marginal firms. Note that these kinds of initiatives make sense, not because they provide an incentive to invest that didn't exist before, but because they provide funds to marginal firms that would not have been available to them otherwise.
The question that Democrat economists need to start asking their Republican colleagues repeatedly is why they always recommend incredibly inefficient methods of stimulating increased private investment instead of more efficient methods? Instead of offering tax credits to firms that actually spend more on investments, they promote the insane idea of throwing tremendous amounts of extra disposable dollars at wealthy savers (through reductions in their income tax rates) in the hope that their extra savings might somehow make their way into the hands of firm managers.

[James Kroeger]

I unintentionally posted the above before I had intended to. Here's the rest......the insane idea of throwing tremendous amounts of extra disposable dollars at wealthy savers (through reductions in their income tax rates) in the hope that their extra savings might somehow make their way into the hands of firm managers.
Very little, if any, of the billions of dollars that Republicans throw at rich people actually ends up helping needy entrepreneurs and firm managers. Contrary to the specious reasoning of Republican economists, additional injections of private savings into banks will not lower the interest rates that borrowers will be offered unless that is what the Fed wants. Not mentioned by Supply Siders is the fact that the Fed can lower those rates at will, even if private savings levels were to drop. (It can do so by injecting dollars into bank reserves that were not saved by any saver.)
If the wealthy use the tax cut windfalls they receive from Republicans to buy stocks or real estate, almost none of that money ends up in the hands of firm managers for economic investments. One rich person hands money over to another rich person for a piece of paper and little else of significance occurs. Normally, the only time a purchase of stock actually puts money for economic investments into the hands of firm managers is when an IPO occurs.
Why is it that Democrat economists do not challenge Republican economists on the outrageous inefficiency of the tax policy proposals they promote?

[Hunter Baker]

The problem with high marginal tax rates has been empirically proven and requires no study to do so. Anyone who lived during the period of punitively high marginal tax rates prior to Reagan's first big cuts knew people who didn't work part of the year because they weren't going to make over a certain amount only to have it taxed away at 70% or so. And we're not just talking about movie stars or CEO's. This phenomenon encompassed people like IBM salesmen.

[Peter H]

Hunter,

What is the empirical evidence showing that the Reagan tax cuts stimulated major increases in labor supply?