Keep the Bush tax cuts

Our tax system should be lower, broader, and simpler

Deadweight loss triangles are a tough concept to explain to laymen. They require discussions of marginal cost and benefit, of incidences and elasticities, and of Pareto optimalities. Perhaps that’s why, in the 10 years since passage, the mainstream media has altogether forgotten the reasonable motivations behind the Bush tax cuts and substituted a narrative of its own. Today the airwaves are filled with serious men touting the ridiculous notion that the Republicans passed the tax cuts in order to give money to their favorite class, the ultra-wealthy.

As difficult as it may be for non-economists to grasp, the rationale behind the Bush tax cuts cannot be lost to history. Now, more than ever, the general public needs to understand the basic considerations that underlie sound tax policy, and Democrats need to understand that their opponents are sensible, data-driven people, not the oafish, ideological strawmen they have been made out to be.

So here it is, in 500 words, the economics of taxation:

People respond to incentives, and they are most responsive to incentives that act at the margin of an individual’s decision making — that is, incentives are most likely to change an individual’s decisions when they change the payoffs between an individual’s first-best and second-best choices. If you raise or lower the rewards for doing something, individuals will do more or less of it respectively, and in particular, if you increase the tax on an individual’s marginal dollar of labor income, he will respond by working less, taking jobs that compensate with non-taxable rewards, and hiring others to find loopholes and reduce the amount he has to pay the government.

By distorting people away from their first-best choices, taxes create what we call a deadweight loss. The size of the deadweight loss represents the degree to which the choices an individual makes in the face of taxation are less optimal than their original ones. Deadweight loss is both a reduction in the resources available to society and a misallocation of existing resources.

The extent to which an individual responds to taxation is called his or her elasticity of taxable income. An elasticity of taxable income with respect to the marginal tax rate (henceforth called the elasticity of taxable income, or ETI) of 0.5 would mean that for each 1 percent increase in an individual’s marginal tax rate, he or she would respond by decreasing taxable income by 0.5 percent. Ceteris paribus, raising the marginal tax rate of an individual with a high ETI will create more loss to society per dollar of revenue collected than taxing someone with a low ETI.

Moreover, not all increases in tax rates are increases in an individual’s marginal tax rate. Increasing the tax on a citizen’s 10,000th dollar of income will distort the decisions of those making $10,000 per year, but the tax will be paid by everyone making more than $10,000 per year without significantly distorting their behavior.

And finally, not all deadweight loss is incident on the individual being taxed. Imagine a hospital, which produces healthcare through the combination of nurses (“low-quality” labor), doctors (“high-quality” labor), and medical equipment (capital). The productivity of each input is dependent on the availability of the other inputs — a hospital without medical equipment means that the doctors and nurses will have very low productivity, a hospital without nurses would mean very inefficient use of doctors and equipment, etc. If income taxes are raised on high-quality laborers, it is not just the high-quality laborers that will suffer — anyone whose labor resources are complementary to those of professionals will also be harmed.

An ideal tax policy is thus the product of a complex but solvable equation, which uses the relative weight that society assigns to the well-being of each income class, in combination with a set of relevant economic parameters, to produce an optimal set of tax rates.

So what does this mean for the Bush tax cuts?

In part, Republicans pushed for tax cuts on the upper class because unlike Democrats, who place value on equalizing income, Republicans place value on letting individuals keep what they have rightfully earned. Their taste and distaste for the tax policy was and is, to some degree, a product of intractable philosophical differences. But the Republican call for tax cuts was also the result of considerable empirical evidence which suggested that the upper class had much higher ETIs than the middle class, and that the government was causing undue societal harm through its tax policy.

A good example of this empirical evidence is a 2000 paper by Jon Gruber and Emmanuel Saez, The Elasticity of Taxable Income: Evidence and Implications. Gruber and Saez estimated that the ETI for those making $10,000 to $50,000 per year was 0.18, the ETI of those making $50,000 to $100,000 was 0.11, and the ETI for those making above $100,000 was a whopping 0.57. The rich, to use someone else’s turn of phrase, were “going Galt,” and contrary to Democrats like Barack Obama, who consider harming the rich to be a good in-and-of-itself, Republicans see them as Americans too, worthy of being considered in a utilitarian summation of the nation’s collective welfare.

That the upper class is more responsive to taxes than their middle-class peers is unsurprising — deadweight loss increases non-linearly with the marginal tax rate, with higher tax rates causing more-than-proportional losses. The rich face the highest marginal tax rates in the nation, and those individuals making more than $100,000 per year, even after their tax cut, are responsible for five-sixths of the total income tax collected by the federal government.

Republicans continue to advocate for a lower, broader, and simpler tax code, not just because they place less value on income redistribution, but because they are doing the math and noticing that such a tax system could raise just as much revenue at a far smaller cost to society. The Democrats, by contrast, have offered nothing more than a blind application of moral preference. They dislike the rich, and their conversation ends there.

Our tax policy must be formed from sterner stuff than populist demagoguery. If Democrats cannot pull out their calculators and tackle reform with the same technocratic vigor that Republicans have, the voters should turn them out of office.

Anonymous almost 12 years ago

Keith, It's hard to take anything you write as objective. Though you make an effort to provide numbers and economic theory (which I admit to not knowing much about), phrases like this hurt your credibility:

"...unlike Democrats, [...] Republicans place value on letting individuals keep what they have rightfully earned."

You criticize the Democrats of demagoguery, but this common rhetoric of what is "rightfully earned", and the horror that the government could be so insane as to feel entitled to MY MONEY..., is nothing close to objective.

boblothrope almost 12 years ago

I pound my keyboard 10 harder when my tax rate is reduced by 10.

boblothrope almost 12 years ago

And percent signs shouldn't be silently deleted by this comment interface.

Steve almost 12 years ago

"Contrary to Democrats like Barack Obama, who consider harming the rich to be a good in-and-of-itself, Republicans see them as Americans too, worthy of being considered in a utilitarian summation of the nations collective welfare."

Wow, I thought this was fairly even-handed until then, but you really blew it. Your premise is that Democrats in general don't consider wealthy people to be Americans. Do you honestly believe that?

Ignoring the blatant bias, your argument seems to be that the wealthy will not earn as much taxable income if tax rates go up. Maybe true, but given the economic boom during Clinton and Reagan, with slightly higher tax rates, it is difficult to prove.

And while your recommendations may provide the optimum tax rate, they ignore the fact that since 1985, 80 percent of the income growth has gone to the top 1 percent earners. The well-being of the country depends on some extent to lowering income disparity. A "broader" tax will just put less burden on the wealthy, increasing the disparity.

And please explain how CEOs who ruined their companies "earned" tens of millions of dollars. Or just explain how the typical CEO "earns" 100 times more than their average employee, without whom they would make nothing.

If you see people as machines for producing tax revenue, your analysis makes sense. If you see them as people who value fairness, contributing resources to a vibrant, egalitarian society, then your analysis falls flat.

Don Woods almost 12 years ago

Excellent article, but gibberish to 90 of the voting public. 1000 economists protested the Smoot-Hawley tariff but it was passed. I wish more economists would tell the public that raising the top marginal rates will not raise more revenue, but will slow economic growth.