Tuesday, September 27, 2011

Debating the Short Run and Long Run Consequences of Raising the Marginal Tax Rate

Economists should have something smart to say about the consequences of making our tax code more progressive. Yes, this will make Warren Buffet happy but will it make Jacob Mincer happy?  Will our future society have less human capital and skill because of such a policy change?

A useful debate is now playing out concerning the consequences of changing the tax code. This smart Harvard undergraduate argues in today's Crimson that increases in the marginal tax rate will not discourage work effort.  Did he receive an "A" in Dr. Mankiw's course?   He may be right about short run effects of his policy shift but he is ignoring the long run effects on human capital acquisition.

To quote the author;

"I’ll be taking on one such assumption right now: the claim that higher marginal income tax rates discourage work. Though an article of faith in economic policy, this misguided belief actually stems from inaccurate assumptions made to simplify economic arguments. When compared to the real world, it simply does not hold water."

He argues that; 1. people don't really understand the non-linear tax rates they face, 2. That high earning people do not control how many hours they work and thus can't optimize at the margin even if they wanted to.

He ignores the human capital accumulation issue.  Facing a higher marginal tax rate, will people continue to invest less in  specialized time intensive skills and learning?  Does high tax Europe have a high degree of specialization and investment in human capital?

The Nobel Laureate James Heckman and Pete Klenow have an under-appreciated paper available here.   Read page 44 of their paper, "The progressivity in the tax schedule will tend to discourage human capital investment."  This unintended consequence of raising marginal rates should be incorporated into cost/benefit analysis of tax changes.

At the bottom of page 48, they write; "For the most skilled, both schooling and post-schooling investment is likely to be reduced when taxes are progressive."

They argue that such taxes reduce inequality but also lower the possible growth of the entire economy by reducing the effort of the skilled to invest.

If human capital is the key to long run growth, then is this a wise choice?  We need more empirical work to know the size of this distorting effect on long run incentives.