Submitted by Richard Epstein via CapX.com,
The recent world of political economy features the deep paradox. By common consent Thomas Piketty’s recent volume Capital in the Twenty-First Century has been hailed of the intellectual triumph of the year. Its bold recommendations make the theoretical case for a global income tax in the range of 54 to 80—a figure that has also been defended in the academic work of 2010 Nobel Prize winner Peter Diamond and Emmanuel Saez, a frequent coauthor of Piketty and the winner of the 2009 John Bates Clark award. The basic conceit of these distinguished authors is that preserving economic growth does not require governments to sacrifice the strong push to income equality, for which the strongly progressive taxes on both income and wealth are thought to be primary policy levers.
I have already expressed my theoretical disagreement with their position both here and here. But there is no reason to rest with these theoretical objections, in light of the unfortunate test case kindly presented by French President Francois Hollande, who made a two-year top tax bracket of 75 percent on salaries of over 1 million euros an essential part of his economic programme. His political boldness comes at a high price, as Hollande suffers from an enormous loss of popularity, racking up recent approval ratings in the order of 12 percent owing to the persistence of high unemployment rates in a zero growth economy.
The intellectual challenge is to explain the gap between Piketty’s confident theoretical assertions on the one side, and Hollande’s empirical abyss on the other. Clever social democratic economists can surely think of some confounding factor to explain the results in question. But to this lawyer, a set of simple economic propositions help to explain why the grand theories of Piketty and company cannot respond to the fatal flaws of their theoretical construction.
The basic question is why would anyone assume that major shifts in tax rates should have only relatively modest effects on the production of wealth. No one would say that about a cut in market wages of over 50 percent. So why assume otherwise in a tax context? To orient the discussion, any accurate prediction of the effects of high taxation critically depends on the distribution of benefits from those tax expenditures. In theory, some taxes should increase the willingness of individuals to work, but only if the public goods they generate for each taxpayer exceeds their tax contribution. But exactly the opposite conclusion applies to tax regimes that use, as do Piketty and Hollande, higher taxes as the first step in a large program of income and wealth redistribution to individuals further down on the income chain. At this point, the simple question is how earners and investors now respond to these new incentives.
To give the numerical examples suppose that we increase total taxation on the marginal euros from around 40 percent to around 75 percent. That move represents a reduction in disposable income from 60 percent to 25 percent, or a reduction in excess of 58 percent. People might not make any major adjustments to that tax burden if they knew that it were to last for only a year or two. But let the new tax rates be regarded as permanent, and it have enormous impact on the entire pattern of human activity from cradle to grave. People will be less reluctant to take short term sacrifices in (low-taxed) Euros today in order to earn (high-taxed) euros tomorrow, when the after-tax income from lower but flatter earnings profile exceeds that from a higher, but more peaked, earnings profile. The entire nation loses from the destruction of human capital.
In the short term, moreover, we should expect to see other effects, including considerable migration into more tax friendly jurisdictions. Just those types of dramatic movements are evident among states in the United States with its persistent relocation of people from high-tax to low-tax states. These movements take place notwithstanding the fact that the high levels of federal taxation apply across the nation. Those differentials are far smaller than the tax increases of the sort introduced in France. And as one wag has put it, there are many English people who live in France, and they are all retired, and many French who live in England, at the peak of their professional careers. No mystery here.
It will of course be answered that the reason for the migration is that the high tax rates are not imposed across the board. But if uniform high taxes solve one problem, they create another, which is that individuals will drop out of the formal labour market and engage in other tax avoidance strategies, including working in the barter or underground economy. Ordinary people may not have the sophistication of eminent French and American economists, but they nonetheless perceive the decline in their after-tax income and act accordingly. I confess that I am unable to find any empirical study which shows the various responses to the high marginal tax rates that have caused such widespread resentment in France. But that reason is simple. Most politicians have long some vestigial economic survival instincts that prevent them from going over the tax-cliff. Until now, people were reluctant to impose taxes at that self-destructive levels. The great danger of theoretical studies like Diamond’s and Saez’s is that it gives adventurous politicians the intellectual cover to try take that ill-advised plunge. Yet note how squishy their results really are given the 26 point range from 54 to 80 percent in the Diamond/Saez estimate. Prudentially, why would any champion of progressive taxation start at the top end of that dicey range remains a mystery to me.
The ultimate folly is that the highly-stylized models of Piketty and company misunderstand the productive interaction between capital and labour. A simpler economic model stresses that high taxation cuts off private investment by putting more capital in government hands. That capital which is consumed will not be invested. That which remains will be invested unwisely by government officials who are all too vulnerable to strong political crosswinds. The reduction of available capital for investment reduces in turn the demand for labour, as a complementary good. Wage stagnation is the result.
The American situation is by no means as grave as the European Union’s, but median U.S. family income has declined, as John Kyl and Stephen Moore recently wrote in the Wall Street Journal, in the six years since Barack Obama unleashed his own interventionist policies, whereby high taxes on the rich result in lower wages over much of the income distribution, at rates are far lower than those that Piketty has championed and Hollande has implemented.
Any economic sage should conclude that the cure for high taxation is, well, low taxation. Remember our job is not to maximize government revenues in the short run, but to improve living standards in the long run. As this is written, the Democrats in the U.S. Congress are engaged in a fierce debate about how to reverse the fortunes of the declining middle class that deserted them during the recent mid-term elections. But some people never learn. The major criticism of President Obama was that he put his health care program above the an economic program that featured tax cuts for the middle class and an increase in minimum wage rates and protections for labour unions. Even Mr. Hollande has to be aware that this program too is bound to fail, giving that restrictive labour market regulation will compound, not offset, the dangers of high taxation. France would do well to repudiate its native son Piketty, and move to align its policies with the Scotsman Adam Smith, who a long time ago advocated low-broad taxation and light-handed regulation of capital and labour markets.