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Monday, May 08, 2006

Progressivity EconoMatch Recap

In case you somehow missed it, here's a recap of DeLong versus Mankiw on whether taxes have become more progressive since the Bush administration took over, a topic also addressed here and at Angry Bear. All of this is in response to a commentary in the WSJ by Lazear and Baicker. There is also a reminder at the end not to forget about the counterargument to another claim made in the commentary about the role of education in explaining the growing income gap:

Round 1:
Mankiw Post: DeLong Response:

Framing and Progressivity

In today's CEA op-ed, the sentence that will likely generate a blogosphere debate with the most heat and least light is this one: "The president's tax cuts have made the tax code more progressive."

The basic problem is that there is no single way to gauge changes in progressivity. As a result, people can take the same set of numbers, look at them from different angles, and reach very different conclusions.

Consider a simple example (which I used in a fall ec 10 lecture). There are two people. A rich guy earns $200,000. A poor guy earns $20,000. At first, the rich guy pays $50,000 in taxes, and the poor guy pays $1,000. Then a new President takes office and cuts the rich guy's taxes to $48,000 and the poor guy's taxes to $800.

Who is getting the better deal?

  • You could say the rich guy gets the better deal: The rich guy gets an extra $2000 in take-home pay, while the poor guy gets only $200. After the tax cut, the difference in take-home pay between the two guys is larger.
  • You could say the deal is evenly balanced: Everyone gets to keep an extra 1 percent of his income.
  • You could say the poor guy gets the better deal: The poor guy gets a 20 percent tax cut, while the rich guy gets only a 4 percent tax cut. After the tax cut, the rich guy pays a larger share of the total tax burden.

It is impossible to say on purely economic grounds which of these perspectives is better. All of these statements are mathematically correct, even if they leave the reader with very different impressions. If you are a politician or a journalist trying to argue that this tax cut is good for the rich, good for the poor, or somewhere in between, you can do it!

The lesson: Be careful when you read debate about the progressivity of the recent tax changes. The conclusions that a commentator reaches depends on how the issue is framed.

Recent Tax and Income Trends among High-Income Taxpayers

Edward Lazear and Katherine Baicker say:

WSJ.com - America at Work: The president's tax cuts have made the tax code more progressive, which also narrows the difference in take-home earnings.

Last month, Joel Friedman, Isaac Shapiro, and Robert Greenstein said:

Recent Tax and Income Trends among High-Income Taxpayers, 4/10/06:

  • High-income households will experience a larger increase in after-tax income as a result of the tax cuts than any other income group. The average after-tax income of the top one percent of households will grow by 5 percent in 2006 as a result of the tax cuts, twice the percentage increase in after-tax income that will be experienced by the 20 percent of households in the middle of the income spectrum. Tax filers with incomes of more than $1 million will see their after-tax income grow even more, by 5.7 percent, as a result of the tax cuts. The tax cuts thus have made the distribution of after-tax income more unequal.
  • Not surprisingly, high-income households are receiving the largest dollar tax cuts, by far, of any group. Those in the top one percent of the income spectrum will receive an average tax cut of $39,000 in 2006, or 52 times as much as households in the middle of the income spectrum. Those with incomes of over $1 million will receive an average tax cut of more than $111,000, or nearly 150 times the average tax cut that middle-income households will receive.

Friedman, Shapiro, and Greenstein are right. Lazear and Baicker are wrong. You can redefine "progressive" in such a way that there are tax cuts which increase after-tax income differentials that are "progressive"--the same way that when Alfred Kahn was working for Carter he redefined "banana" to mean "recession." But you cannot argue that the president's tax cuts have narrowed after-tax earnings differentials. No way. No how.

Round 2:
DeLong Post: Mankiw Response:

Jane Galt Says George W. Bush Is a Leveling, Redistributionist Mole!

Jane Galt says that the Bush tax cut will, in the end, be progressive:

Asymmetrical Information: You say "Progressive", I say "Regressive": There are four ways that I can think of for the US to deal with its debt burden.... 1) Raise taxes to pay it off. This will be a burden on America's relatively poorer members only to the extent that the tax burden falls on them. But while overall withholdings are only very mildly progressive in America (thanks to Social Security payments), income tax is extremely progressive.... Is the tax system likely to change? Colour me sceptical. "Raise taxes on the poor" just doesn't have much of a ring to it.... I find it much more likely that we will see another Clinton style increase on the top earners, while keeping Bush innovations like the 10% tax bracket, meaning that the rich will be doing the bulk of any debt repayment...

The argument that a tax cut for the rich is ultimately progressive because it runs up the deficit and creates a political backlash that ultimately leads to bigger tax increases for the rich than the tax cut--that is not one I've heard before. Yet it does have a certain plausibility, now that I think about it.

George W. Bush, redistributionist mole!

The Progressivity of Budget Deficits

Bloggers Jane Galt and Brad DeLong have been debating my previous post on evaluating tax progressivity, focusing on the fact that deficit-financed tax cuts require lower spending or higher taxes in the future. Let me add to the discussion:

Economists are not good at judging redistributions of income. Indeed, they often claim that this issue is outside of the sphere of economics altogether. It is, therefore, somewhat surprising that economists decry budget deficits with such consensus and assurance.

One widely accepted standard for judging redistributions is the ability-to-pay principle: redistributions of income are desirable if they go from better-off to worse-off people. By this criterion, the redistributions arising from changes in factor prices are undesirable. Many people hold little wealth and consume the income from their wages, while a small part of society holds most of the economy’s wealth. When crowding out raises the returns on capital and reduces wages, the wealthy gain at the expense of the less wealthy.

Yet, from the standpoint of the ability-to-pay principle, the direct effect of budget deficits—the change in the timing of taxes—is harder to reconcile with the conventional view that deficits are undesirable. Because of technological progress, the income and consumption of a typical individual in the economy rises over time. Because budget deficits shift taxes forward in time, they benefit relatively poor current taxpayers at the expense of relatively rich future taxpayers. If reducing inequality is a goal of policy, shouldn’t budget deficits be applauded?

One way to answer this question is to go beyond neoclassical economic theory. Although standard models assume that people desire to smooth consumption evenly over time, popular discussions of economic policy presume that consumption should rise over time. Politicians often assume a moral imperative that the current generation sacrifice to ensure that future generations enjoy a substantially higher standard of living. This view suggests that it is undesirable to shift a tax burden onto our children, even though our children will be better able to shoulder that burden than we are.

Another possible answer is that levels of taxation should be based on the benefits principle, which holds that people should pay for the government benefits that they receive. For example, the use of a gasoline tax to pay for road repair is not based on the abilities to pay of drivers and non-drivers; instead, it is justified on the ground that drivers should pay for roads because they benefit from them. Similarly, one might argue that each generation should pay for the government it provides itself, regardless of its level of income.

These issues are not easily resolved. Yet one point is clear: saying whether and why deficits are undesirable requires judgments that are more philosophical than economic.

Brad may be tempted to read this post as further evidence of how low I have sunk as an economist. But he would be wrong: I have always been this bad! The above six paragraphs are an excerpt from a 1995 paper I wrote with Larry Ball.

With all the focus on progressivity, it might be useful to point out once again that there is a second part of the editorial to ask questions about, the claim that the education gap caused the income and wealth gap, and hence that education is the solution to the growing income gap problem. There is evidence to suggest otherwise. On this point, see Paul Krugman: "Graduates and Oligarchs."

    Posted by on Monday, May 8, 2006 at 11:32 PM in Economics, Income Distribution, Policy, Politics, Taxes | Permalink  TrackBack (0)  Comments (1)

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