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Sunday, April 15, 2007

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.

    Posted by on Sunday, April 15, 2007 at 04:23 PM in Economics, Policy, Taxes | Permalink  TrackBack (0)  Comments (22)


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