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Sunday, November 04, 2007

knzn: Incentive Effects of Progressive Taxation at the High End

knzn says that making taxes more progressive acts as insurance against bad economic outcomes thereby encouraging additional entrepreneurial activity:

Incentive Effects of Progressive Taxation at the High End, by knzn: Does progressive (labor) taxation at the high end reduce the incentive to engage in high-value activities? It seems to me that (to the extent that highly lucrative activities really are high value) it actually increases the incentive. Most of the people with the highest compensation -- movie stars, star athletes, CEOs of large corporations, successful hedge fund managers, successful entrepreneurs, etc. -- have that high compensation not just because of decisions to engage in (ostensibly) high-value activities but because of a combination of an intentional occupational choice decision and unpredictable outcome of success in that occupation. The ones who made the same occupational choices but weren't so successful -- ordinary actors, minor league athletes, middle managers of large corporations, hedge fund managers without a lot of assets under management, entrepreneurs with limited or no success, etc. -- don't get that ultra-high compensation.

How could the tax code encourage people to undertake these activities? If people were risk-neutral, the progressivity wouldn't make much difference, since any increase in taxation of the high rewards for being successful would be offset by a decrease in taxation of the lower rewards of being not-so-successful. But economists usually assume that people are risk-averse. If so, progressive taxation encourages people to enter high-risk, high-value occupations, because it provides a form of insurance for people who choose to do so. If you're successful, you make gobs of money, and you have to pay a lot in taxes, but you still end up with gobs of money; if you're not so successful, you don't make so much money, but you get an insurance payment in the form of a reduced tax bill. If the government were explicitly providing an at-cost insurance policy for actors, athletes, business people, hedge fund managers, and so on, I don't think there would be much question that the policy would encourage, rather than discourage, entry into these occupations.

Some people may be entrepreneurs and some people workers precisely because of differences in preferences for risk, i.e. entrepreneurs may be entrepreneurs because they are have more tolerance for risk. This would mean that increased progressivity of the tax code would not have a large impact on the behavior of those agents who are near risk neutrality, i.e. on existing entrepreneurs, but would impact those with larger aversions to risk, i.e. workers near the risk tolerance margin. Thus, an explicit insurance policy may encourage workers at the margin to become entrepreneurs. [One question for knzn. What if entrepreneurs, or at least a fraction of them worth worrying about, are risk lovers?]

This plays into a more general point about social safety nets that is often overlooked. Suppose you are thinking of quitting your long-held steady job and using your accumulated savings to invest in a business (or you are thinking of moving to a potentially better job, but there are risks). When would you be more likely to do so, when there is a social safety net to catch you if things don't work out, a net that allows a smooth return to wage employment and covers things like health insurance, or when there is little, if any help waiting for those who fail to make the business or the move to a new job work? We hear that social insurance stifles effort and risk-taking, but there are forces working in both directions.

    Posted by on Sunday, November 4, 2007 at 11:43 AM in Economics, Taxes | Permalink  TrackBack (0)  Comments (27)

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