Yves here. Mirabile dictu! A VoxEU article discusses, admittedly in suitably dense economese, how economists create and enforce biases against taxation by using terminology that presupposes that it’s bad. And as Lambert noted after he saw it went up here: “That post got Tyler Cowen really ticked off, so it must be good.”
By Charles F Manski, Professor in Economics, Northwestern University. Cross posted from VoxEU
Economists usually think of taxation as inefficient. This column argues that the anti-tax rhetoric evident in much lay discussion of public policy draws considerable support from the prevalent negative language of professional economic discourse. Optimal income taxation doesn’t have to employ the pejorative concepts of inefficiency, deadweight loss and distortion; and this column argues that it is high time for economists to discard them and make analysis of taxation and public spending distortion-free.
The anti-tax rhetoric evident in much lay discussion of public policy draws considerable support from the prevalent negative language of professional economic discourse. Economists regularly write about the ‘inefficiency’, ‘deadweight loss’, and ‘distortion’ of income taxation.
• An influential article of Feldstein (1999) begins “The traditional method of analysing the distorting effects of the income tax greatly underestimates its total deadweight loss as well as the incremental deadweight loss of an increase in income tax rates”.
• In a recent review article in the Journal of Economic Literature, Saez, Slemrod, and Giertz (2012) state: “under some assumptions all responses to taxation are symptomatic of deadweight loss. Taxes trigger a host of behavioural responses intended to minimise the burden on the individual. In the absence of externalities or other market failure, and putting aside income effects, all such responses are sources of inefficiency”.
Students of economics learn that the formal usage of the concepts ‘inefficiency’, ‘deadweight loss’, and ‘distortion’ in normative public finance refer to a theoretical setting where a private economy is in competitive equilibrium and a government can use lump-sum taxes to modify the endowments of individuals.
In this setting, classical theorems of welfare economics show that any Pareto efficient social outcome can be achieved by having the government use lump-sum taxes to redistribute endowments and otherwise not intervene in the economy. Income taxes and other commonly used taxes logically cannot yield better social outcomes than optimal lump sum taxes but they may do worse. Deadweight loss measures the degree to which they do worse.
Careful instructors caution students that the theoretical setting envisioned in classical welfare economics is far removed from reality for a host of reasons, from the impracticality of lump-sum taxes to the presence of many forms of market failure.
Nevertheless, prominent applied public economists continue to take the theory quite seriously. For example, Feldstein (1999) concludes his article on the deadweight loss of the income by writing that “The analysis implies that a marginal increase in tax revenue achieved by a proportional rise in all personal income-tax rates involves a deadweight loss of two dollars per incremental dollar of revenue. This has important implications for the cost of financing incremental government spending”.
The Feldstein article and similar research on deadweight loss appear predestined to make income taxation look bad. The research aims to measure the social cost of the income tax relative to the utterly implausible alternative of a lump-sum tax. It focuses attention entirely on the social cost of financing government spending, with no regard to the potential social benefits. If applied economists are to contribute fair and balanced analysis of public policy, I think it essential that we jointly evaluate taxation and public spending within a framework that restricts attention to feasible tax instruments and that makes a reasonable effort to approximate the structure of the actual economy.
A constructive approach is to specify a social-welfare function and determine the welfare achieved by alternative feasible taxation and spending policies. An appropriate social-welfare function recognises both the costs of taxation and the benefits of tax-financed spending, making it unnecessary to invoke one-sided concepts such as inefficiency, deadweight loss, and distortion.
Indeed, Mirrlees (1971) made no mention of any of these concepts in his seminal study of optimal income taxation. In Mirrlees’ work and in the body of research stemming from it, the specified social-welfare function is the only normative concept required for evaluation of public policy. The welfare function and the specified set of feasible taxation and spending policies express the assumptions made about the structure of the economy.
Income Taxation and Infrastructure Spending
The gross inadequacy of deadweight loss and related concepts for policy analysis is particularly striking when considering tax-financed public spending for infrastructure that aims to enhance private productivity. Even as strong a proponent of private enterprise as Milton Friedman recognised the need for government to provide infrastructure for voluntary exchange, writing “In… a free private enterprise exchange economy, government’s primary role is to preserve the rules of the game by enforcing contracts, preventing coercion, and keeping markets free” (1955).
Friedman’s statement focuses on the need for government to provide laws, regulations, and a justice system to enforce them. One might reasonably add many further governmental functions, including formation and execution of monetary policy, provision and oversight of transportation and communications, protection of the environment, and support of research. Each of these and other functions may be performed with varying intensity, at correspondingly varying cost. Taxation is the main mechanism that governments use to finance infrastructure.
In recent work, I have studied optimal income taxation to finance public spending on infrastructure (Manski 2013). My analysis follows Mirrlees (1971) in some respects and differs in others. Following Mirrlees, I suppose that each member of a population allocates time to paid work and to the various non-paid activities that economists have traditionally called ‘leisure’. Persons have heterogeneous wages. An income-tax schedule is applied to gross income, yielding net income. Persons allocate time to maximise utility, which increases with net income and leisure. Social welfare is utilitarian. The chosen policy must balance the public budget, equating tax revenues and government spending.
I depart from the Mirrlees setup in several ways.
• First, I consider the use of tax revenue to finance public spending on infrastructure.
• Second, I suppose that persons may have heterogeneous preferences for income, leisure, and public spending.
• Third, the social planner may have partial knowledge of population preferences and of the productivity of infrastructure spending.
In contrast, the body of research on optimal income taxation stemming from Mirrlees (1971) has commonly studied the use of taxation to redistribute income while holding government spending fixed and has assumed that all persons have the same, known, preferences.
For the present discussion, the essential feature of my research is the transparent way that it characterises how public spending on infrastructure may enhance private productivity. I suppose that wages are person-specific positive constants multiplied by an aggregate production function expressing the wage-enhancing effect of infrastructure spending. This contrasts sharply with the common research practice of considering wages to be fixed.
Analysis of optimal policy is particularly simple in an illustrative setting that yields easily interpretable closed-form findings. In this setting, the planner only considers tax schedules that make the tax proportional to gross individual income. Persons have Cobb-Douglas income-leisure preferences and no non-labour income. These assumptions imply that time-allocation choices are invariant to policy.
The assumptions imply that optimal infrastructure spending is determined by the shape of the aggregate production function expressing the private productivity of public spending. Increasing the tax rate is socially beneficial if and only if the additional infrastructure spending enabled by the tax rise yields a more than commensurate increase in wages. The optimal public-spending level maximises aggregate net (after tax) income.
Conclusions
Performing this research, I found no need to use the concepts of inefficiency, deadweight loss, and distortion. Over 40 years ago, Mirrlees had it right when he found it unnecessary to use these pejorative ideas in his study of optimal income taxation. I think it overdue for the profession to discard them and make analysis of taxation and public spending distortion-free.
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Golly gosh I’m glad I didn’t have to read all the econobabble behind this article! The few bits Yves let slip had me running for cover. To understand Relativity one must throw oneself off a cliff in order to see the trajectory of a cannonball as straight. I suggest we tell the economists about this and neglect to mention it’s a thought experiment!
Economists’ assumptions seem rarely expressed with clarity. The classic is the assumption that money-capital is neutral – never said and always assumed. Imagine setting a case study with accounts that show where the money came from:
1. money laundering for Carlos …
2. tax stolen from various countries …
3. front-running customer trades …
4. gold deposit from Mr Brown …
5. sales of sweatshop goods …
Figures are so much cleaner when expressed in balance sheet fictions.
It’s about time the myth about taxes was debunked. Implying that firms don’t need infrastructure, that each one is an immaculate conception, is another one of the Ptolemaic beliefs the cult of economists impose on us full persons. Like Ptolemy’s epicycles, however, the assumptions that prop up the belief system of economists are getting vanquished by the facts. Today, there is no person more dangerous than the Economics B.A. Without genuine, fact-based reform, these degrees and the courses that underlie them should be abolished. Limit capitalists to the Business Schools!
Here’s a nice article on total taxation as a percent of income,
http://ctj.org/ctjreports/2012/04/who_pays_taxes_in_america.php#.UhNbiG1qCYg
I have to thrust my finger down my throat to rid my gut of the article published above. – Somehow, the belief that taxing labor is the only econometric, or taxing businesses that employ productive labor (example of non-productive labor – banking), or taxing what labor produces. A classic neo-classicist in full Chicago garb defending an unjust tax system. Distortion free analysis of public spending when the economic rent extraction is actively distorting the economy is silly – A free market has meant and still means an economy free of economic rent.
Maybe I misread the article or jumped to a conclusion in error. I welcome some enlightenment in any form.
Tax destructive economic activity at a high rate: reduce taxes upon activity that is wealth creating.
In spite of the ingenious methods devised by statesmen and financiers to get more revenue from large fortunes, and regardless of whether the maximum sur tax remains at 25% or is raised or lowered, it is still true that it would be better to stop the speculative incomes at the source, rather than attempt to recover them after they have passed into the hands of profiteers.
If a man earns his income by producing wealth nothing should be done to hamper him. For has he not given employment to labor, and has he not produced goods for our consumption? To cripple or burden such a man means that he is necessarily forced to employ fewer men, and to make less goods, which tends to decrease wages, unemployment, and increased cost of living.
If, however, a man’s income is not made in producing wealth and employing labor, but is due to speculation, the case is altogether different. The speculator as a speculator, whether his holdings be mineral lands, forests, power sites, agricultural lands, or city lots, employs no labor and produces no wealth. He adds nothing to the riches of the country, but merely takes toll from those who do employ labor and produce wealth.
If part of the speculator’s income – no matter how large a part – be taken in taxation, it will not decrease employment or lessen the production of wealth. Whereas, if the producer’s income be taxed it will tend to limit employment and stop the production of wealth.
Our lawmakers will do well, therefore, to pay less attention to the rate on incomes, and more to the source from whence they are drawn.
Written around 1925
Pray tell, TomDor, who decides what is ‘wealth creation’ and what is economic rent?
Secondly, how does one engineer a capitalism without economic rents?
“Wealth creation” requires actually inventing or building something which improves people’s lives, generally speaking. Doesn’t seem to happen very often.
By whom?
Cost, the tax, needs to be analyzed based upon the beneficial outcome, after tax wage increase. Cost/benefit analysis. The right wing economics looks for the downside, and finds it as well as characterizing taxation in negative vernacular that can’t help but to demonize the government as an inefficient distortion factory of death panels, the dead weight of the dead. Deadly taxes, toxic to the core of a tax and spend leviathan. OHHH it makes me so mad to hear about it that way that I just want to join a tea party and vote for a Canadian to become president!
I had three responses to this article.(1) Why can’t economists learn to write in the English language? (2) Why postulate what people are like? There are polls and there is sociology. You can actually find out about people’s wants and needs. (3) Why not take a look at history? World War Two and the 1950s show how much damage was done to the economy by high taxes combined with high government expenditures.
I don’t think (as this guy does) that we want to maximize after tax income. I think we want to maximize a decent life in an environment that doesn’t collapse around us. I’d take a very low after tax income in return for national health, an improved national pension plan, free education, good social services, and national programs to build affordable, low energy housing and a sustainable world.
For what it is worth, when Republicans were the dominent party in Minnesota and refusing to raise taxes, the people of Minnesota passed two constitutional amendments by popular vote. Both raised sales taxes, one to fund transportation in the state, the other to fund clean water, the environment and the arts. People will take less after tax income in return for social goods.
Reminds me of the video on the town in Denmark that recently made the decision as a town to pay 80% taxes to cover all social expenditures including health insurance, etc (national program and very cost effective) and to keep only 20% of their income. Like a guaranteed 20% profit. The “health” insurance companies here, and big pharma, like that deal too – they want a guaranteed 20 – 30% profit for their cooperation in the US health industry. Just think, that windfall could come to us if we knew how to tax and govern.
I wanted to get a sense of Manski’s other work, so I did a BITFU search on Charles F. Manski and as expected, the results are dominated by this article on pejorative concepts like “deadweight”. , removing a reference to his latest article to get a sense of his past work.
So I stripped all reference to this latest work by searching the following: “Charles F. Manski”-deadweight. [A straight “-” before a word will strip all references in a Google search as well, so it can be a useful tip.]
“BITFU on Manski”
Manski’s work over the years genuinely reflects a concern about the “incredible certitude” of politicians and planners, when in actuality, they are ignorant (aka “ignorance postulate”). It’s a message that is sorely lacking; that is, to encourage planners to admit they “just know”.
I will also point out that a search of “Optimal Income Taxation” reveals much more commentary from the Left than the Right. This this is supposed to be a neutral concept in taxation theory, yet only one side seems to be discussing it.
Meanwhile, a search of “Excess Burden of Taxation” (the generally accepted term for Manski’s pejorative ‘deadweight’ reference) reveals much more commentary from the Right.
Go figure!
It’s fascinating to see supposedly neutral phrases reveal their true nature, which I guess is Manski’s point:
“Excess Burden and taxes”–BAD
“Optimal and Taxes”–Good?
The discussion was never framed in ways that every marketer knows is basic: your policy preferences are a product which needs to be sold, just like any other offering.
Do government services provide VALUE? Is government delivering on the products and services it offers?
The Pentagon knows this, and goes to considerable lengths to market itself. Not so, for any other agency of government I can think of.
Good post. Thanks.
60th-80th Percentile=$100,700
40th-60th Percentile=$12,200
Bottom 40%=$14,800
What scares me is control of voting via computer programs.
In last election I voted a straight D but, on review, all came up R
Robert Reich of University of California put it simple and truthful in a brief outline:
“Suppose a small group of extremely wealth people sought to systematically destroy the U.S. Government by finding and bankrolling new candidates pledged to shrinking and dismembering it—
intimidating or bribing many current senators and representatives—to block all proposed legislation, prevent the appointment of presidential nominees, eliminate funds to implement and enforce laws
and—threaten to default on the nation’s debt—taking over state governments in order to redistrict, gerrymander, require voter IDs, purge voter rolls and otherwise suppress the votes of the majority in federal elections—running a vast PR campaign designed to convince the American public of certain big lies, such as climate change is a hoax And—buying up the media so the public cannot know the truth—would you call this Treason or what?”
Who controls our voting machines and vote counters? Vote counter Diebold was sold to a Republican.
What a wonderful simple analysis on American politics today.
Selina Kyle: “There’s a storm coming, Mr. Wayne. You and your friends better batten down the hatches, because when it hits, you’re all gonna wonder how you ever thought you could live so large and leave so little for the rest of us.”
– The Dark Knight Rises
Unfortunately our world is inhabited by deaf, dumb, blind, brainwashed, ignorant fools who refuse to recognize that ALL governments have written their TAX CODES to exclusively benefit the CentaMillionaire$ and Billionaire$! Those Ultra High Net Worth Individuals have always used the POWER of that unconscionable wealth to enslave others and corrupt ALL economic activity!
All governments will continue to be run for the Benefit of those UHNWI’s unless We The People demand they be TAXED out of existence! The TAX CODE is the only way to control the corruption they rain upon the world!
AGREED!
When is Michael Moore going to do an expose on INHERITANCE?
Inheritance = Gordian knot of inequality
Exposé and eliminate pejoratives. Terrific idea!
Now, if the author could translate this turgid, heavily nominalized economese-speak into clear, forceful language, we might make far more headway.
Taxation needs its Churchill: bold, simple, courageous. And clear!
Yeah. Good.
Remembering that capital gains and dividends come out of speculation, profits, and rents (economically speaking);
and that classical economic theory says that profits are zero in the absence of monopolies;
and that economic theory disapproves of rents;
and that economic theory disapproves of speculation;
it seems that a 100% tax on capital gains and dividends is pure gain, socially, according to the principles of classical economics. The opposite of a deadweight loss. Most unearned income *is* deadweight loss and the rest is gambling profits which add nothing to the economy, so 100% taxation is correct according to classical economics.
But you never see classical economists saying that.
Now, classical economics is not correct, and as a result 100% taxes on capital gains and dividends are probably not correct either. But what gets me is the HYPOCRISY.