Saturday, September 24, 2011

The Buffet Tax Deception

"It is no crime to be ignorant of economics, which is, after all, a specialized discipline and one that most people consider to be a 'dismal science.' But it is totally irresponsible to have a loud and vociferous opinion on economic subjects while remaining in this state of ignorance." - Murray Rothbard Making Economic Sense (1995)

Should we really be talking about national tax policies based on the random, anecdotal observations of a celebrity businessman? Recently there has been a lot of talk from the media, politicians, and other commentators about a ‘Buffet Tax’ to ensure that billionaires pay their fair share of taxes. The battle cry comes from comments by very successful businessman and investor Warren Buffet, who claims that his secretary pays more in taxes (as a percent of income) than he does.  There are also claims that income for middle Americans has stagnated, while the wealthiest Americans have enjoyed most of the gains in income growth over the last decade. This is a long post, but the short of it is that these claims may sound good politically, and make great headlines for the media, but they don’t stand squarely with the facts.

Let’s look at the first claim. Do billionaires really pay less in taxes as a percent of income than their secretaries? 

Source:  Historical Effective Federal Tax Rates: 1979 to 2005 Congressional Budget Office

Since these rates have not changed in the last 5 years, these numbers are still relevant, and show that historically the rich (like Warren Buffet) have always paid more. In fact, when it comes to ‘fairness’, the U.S. has one of the most progressive (meaning the rich pay more) tax systems in the world (see the data here at the Tax Foundation).  Sure it is possible that with the correct shelters/loopholes/wealth management, a wealthy person like Buffet could actually end up paying lower overall rates than their secretary. However, what the data shows is that overall, on average, the rich do pay more, with only a few rare and random cases like Buffet paying rates similar to or less than working class Americans. This brings up many questions. Why make major changes in the tax code that will affect millions to address the very few Warren Buffets of the world? Some would say to be ‘fair’ but as noted above, we already lead the world in terms of tax fairness based on income and the rich are already paying more. In terms of all income taxes collected by government, the wealthiest Americans pay most of the taxes.

The top 10% of earners make up about 10% of all households earn about 40% of all income, but pay 55% of all taxes (way more than their proportional share of income). The top 1% of earners make up only about 1% of households, earn about 18% of all income, but pay almost 30% of all taxes, again more than their share of national income.

Source:  Historical Effective Federal Tax Rates: 1979 to 2005 Congressional Budget Office

No matter how you slice the data, there is no way you can claim that the rich are not paying ‘their fair share’ of taxes. (Note this is even after the tax cuts in the early this decade)

Another myth related to this, is that income for middle Americans has stagnated, while the wealthiest Americans have enjoyed most of the gains in income growth over the last decade. Again, this is not supported by the data. The first problem is that commentators and politicians with axes to grind typically refer to the ‘median household income’ to represent ‘middle class.’   While using the median is statistically more robust (less biased) than just the average when it comes to skewed income data, using median household income is still inappropriate. As economists Thomas Sowell and Russ Roberts explain clearly here (video) and here, households have changed tremendously over time, and really aren’t comparable over time. But there are even more reasons why median household income can be misleading.  Researcher Steve Conover points out in a recent article at the American Enterprise Institute’s American magazine, just looking at the median to define middle class is a very restrictive definition. After assembling data on income over the last decade based on data from the US Census Bureau and the Bureau of Labor Statistics, Conover developed several definitions of ‘middle class.’  No matter how many different ways we could define ‘middle class’ when we actually look at data on income gains over the last few years, we find in fact that the middle class income gained much more than the top 20% of earners, while the top 5% actually lost.

  Source: The Myth of Middle-Class Stagnation, Steve Conover

Of course, if we are concerned about the distribution of income in society, the important thing isn’t so much who’s gaining in which category, but instead its how often people move up and improve their standard of living.  After all, the American dream is not based on how much the rich pay in taxes vs the poor, or who gets the biggest piece of the pie. The American dream is about going out and getting your own piece of pie, or in other words, income mobility.  As economist Steve Horowitz explains in this video, even if you insist on looking at ‘median’ income earned by ‘households’ vs. individuals, when we look at the data, and follow these people over time, we see lots of income mobility as they move from one part of the income distribution to another.  The data shows that income mobility in the U.S. has been very robust.    As reported in the U.S. Treasury report Income Mobility in the U.S. from 1996 to 2005:

"Economic growth resulted in rising incomes for most taxpayers over the period from 1996 to 2005. Median incomes of all taxpayers increased by 24 percent after adjusting for inflation. The real incomes of two-thirds of all taxpayers increased over this period. In addition, the median incomes of those initially in the lower income groups increased more than the median incomes of those initially in the higher income groups. The degree of mobility in the overall population and movement out of the bottom quintile in this study are similar to the findings of prior research on income mobility."

So, we’ve debunked the myth that the wealthiest Americans aren’t paying there fair share, we’ve shown that middle class Americans have received significant gains in income over the last decade, and that income mobility in the U.S. is a reality. What other excuses can we/they come up with to raise taxes? One might claim that this is necessary to increase revenues, or reduce the budget deficit. In a previous post I’ve already shown how revenues actually increased while the budget deficit drastically dropped after the Bush tax cuts.  Quite a bit of additional research actually shows that higher income individuals are extremely sensitive to tax increases, and that tax increases can contribute to decreased job creation and investment. 

Were it not for the recession, the data shows that the middle class and the American dream was thriving. Instead of focusing on class warfare inspired non-issues (at least when it comes to real data), the media, commentators and our law makers should focus on the real issues at hand, chiefly the regulatory climate and the uncertainty  (as mentioned last month) that it is creating. Besides being based on bad evidence and false perceptions, a ‘Buffet’ tax could also be detrimental to the economy and such talk only adds to the cloud of uncertainty preventing us from getting out of the current economic rut.

Monday, September 05, 2011

Homeland Security, The Knowledge Problem & Constitution Week

Below are excerpts from two economists (David Henderson and Sam Clovis) on faculty at the Naval Post Graduate School. Note, Henderson will be speakingat WKU this year during Constitution Week. (special thanks to the BB&T Center For the Study of Capitalism at WKU).

"Central economic planning can't work, explained Hayek, because no small number of people at the top, however brilliant or informed, can aggregate all the trillions of pieces of data needed to plan an economy well. The main information that matters in real time is what Hayek called "knowledge of particular circumstances of time and place" and this information is necessarily decentralized: it exists only fleetingly in the minds of millions of people.....Hayek's argument applies whether the good being produced is food, steel, or internal security. In fact, in her testimony before the 9/11Commission, Dr. Rice explained the problems with centralization eloquently;


                  You have thousands of pieces of information . . . and you have to depend to a certain degree on the intelligence agencies to tell you what is actually relevant,

                 what is actually based on sound sources, what is speculative. 

The lesson of September 11 is not that government should plan better and not that a Republican president plans better or worse than a Democrat president. The lesson of 9/11 is that central planning doesn't work and that government should not get in the way of our planning. "  LINK


In addition to the  'knowledge problem' discussed above, Sobel and Leeson have identified several other issues with the top down approaches in homeland security regarding incentives, the tragedy of the anticommons, and type II error policy bias. Absent market prices, how do we deal with these issues? Attempts to address these problems, to some extent, can be found in scholarship related to homeland security and federalism:


"an agency that forms partnerships with state and local governments instead of coercive top-down regulation-heavy regimes is an appropriate response on the part of the national government to deal with the particular needs of all the other governments in this country. Further, this agency should work at giving state and local governments as much flexibility as possible in dealing with own-source challenges. By facilitating cooperative networks of communities/jurisdictions a far more realistic and pragmatic approach to all hazards preparedness is a logical outcome. The national government should provide the organization around which such networking might take place." –Homeland Security Affairs VI, no. 2 (May 2010) – Sam Clovis

Efficient Markets and Prices

‎"I prefer true but imperfect knowledge, even if it leaves much indetermined and unpredictable, to a pretence of exact knowledge" - F.A. Hayek
"The financial crisis invalidated a naïve notion of "efficient markets," but the most sophisticated version is still viable. Whereas the invalidated version holds that markets never err and always adjust instantaneously, the sophisticated version, associated with the ideas of Adam Smith and F. A. Hayek, holds that markets mobilize individuals to realize gains from trade and to innovate and thereby produce generalized prosperity."
"In the 1940s, Hayek warned his fellow economists of the misleading standards of perfect competition and static efficiency in assessing the market economy. As he wrote in Individualism and Economic Order, "[T]hese adjustments are probably never 'perfect' in the sense which the economist conceives them in his equilibrium analysis. But I fear that our theoretical habits of approaching the problem with the assumption of more or less perfect knowledge on the part of almost everyone has made us somewhat blind to the true function of the price mechanism and led us to apply rather misleading standards in judging its efficiency" (1948, 87)"

"The great free market economic thinkers from Adam Smith to F. A. Hayek never argued that individuals were hyper-rational actors possessed with full and complete information, operating in perfectly competitive markets.... Efficient markets are an outcome of a process of discovery, learning, and adjustment, not an assumption going into the analysis."

Friday, September 02, 2011

Taxes, Elasticity, Revenue, and Economic Activity

Romer, Christina and David Romer, (2010). "The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks," American Economic Review, vol. 100(3), pages 763-801.

tax increases to be highly contractionary with a negative effect on investment

Alesina, Alberto and Silvia Ardagna (2010) "Large Changes in Fiscal Policy: Taxes versus Spending" In Jeffrey Brown, 2010. "Tax Policy and the Economy, Volume 24," NBER Books, National Bureau of Economic Research.

Fiscal stimulis based on tax cuts increases the probability of future economic growth greater than spending

Carroll, Robert, Douglas Holtz-Eakin, Mark Rider, and Harvey Rosen (2000) "Income Taxes and Entrepreneurs Use of Labor," Journal of Labor Economics, 18 (2), April pp. 324-55

Increases in marginal tax rates reduce the probability of future increased hiring and are associaed with reduced growth in wages.

Gruber, Jon and Saez, Emmanuel, 2002. "The elasticity of taxable income: evidence and implications," Journal of Public Economics, vol. 84(1), pages 1-32.

Finds a very elastic response for incomes over $100k, (.57) with an elasticity of about .17 for incomes < $100k.

Gentry, William and Glenn Hubbard (2000) "Tax Policy and Entrepreneurial Entry" American Economic Review, vol. 90, pp. 283-287.

Finds a significant increase in entrepreneurial activity when tax rates are less progressive.

Djankov, Simeon, Tim Ganser, Caralee McLiesh, Rita Ramalho, and Andrei Shleifer, (2010). "The Effect of Corporate Taxes on Investment and Entrepreneurship," American Economic Journal: Macroeconomics, vol. 2(3), pages 31-64, July.American Economic Association.

"our estimates of the effective corporate tax rate have a large adverse impact on aggregate investment, FDI, and entrepreneurial activity"

The Effect of Marginal Tax Rates on Taxable Income: A Panel Study of the 1986 Tax Reform Act Martin Feldstein Journal of Political Economy
Vol. 103, No. 3 (Jun., 1995), pp. 551-572

Estimates the elasticity of taxable income to range from about 1.0 -3.

Lindsey, Lawrence B. 1987. "Individual Taxpayer Response to Taxcuts, 1982-1984." J. of Public Economics 33 (July) 173-206

Found elasticity of taxable income by income category to be .728 for income > $50k, 1.023 for >$100k, 1.413 for >$250k, and 2.0 for > $1 million. Also derived the tax revenue responses to reductions in marginal taxes for those earning more than $200k / yr. Revenues increased by 19% in 1982, 35% in 1983, 56% in 1984.

Economic Inquiry, 2008, vol. 46, issue 2, pages 197-207


Why Do Americans Work So Much More Than Europeans?
Federal Reserve Bank of Minneapolis Quarterly Review
Vol. 28, No. 1, July 2004, pp. 2–13

Finds that taxes, and particularly higher marginal tax rates have a negative effect on labor hours.