Sunday, April 26, 2009

Luck, income distribution and progressive taxation

Before Tea, Thank Your Lucky Stars, by Robert Frank, Commentary, NY Times: The link between success and luck is stronger than many people think. Analysis of this connection provides a useful framework for weighing ... recent “tea parties,” where orators ... bemoaned their “crippling” tax burdens. ...

Contrary to what many parents tell their children, talent and hard work are neither necessary nor sufficient for economic success..., some people enjoy spectacular success despite having neither attribute. (Lip-synching members of boy bands?...)

Far more numerous are talented people who work very hard, only to achieve modest earnings. There are hundreds of them for every skilled, perseverant person who strikes it rich — disparities that often stem from random events. ...

Malcolm Gladwell reports that a disproportionate number of pro hockey players owe their success to the accident of having been born in January, which made them the oldest, most experienced players in every youth league growing up. For that reason alone, they were more likely to make all-star teams, receive special coaching and eventually become professionals.

Although people are often quick to ascribe their own success to skill and hard work, even those qualities entail heavy elements of luck. ... People born with good genes and raised in nurturing families can claim little moral credit for their talent and industriousness. They were just lucky. ...

Even in markets where luck plays no role, minuscule differences in performance often translate into enormous differences in salaries. ... In law, consulting, investment banking, corporate management and a host of other occupations, the ablest performers are often paid hundreds or even thousands of times as much as others who perform nearly as well.

Another important message of recent research is that a person’s salary depends far more on where she is born than on her talent and effort.

For example, as a Peace Corps volunteer in Nepal long ago, I hired a cook who had no formal education but was spectacularly intelligent and resourceful. ... Yet his total lifetime earnings were less than even a very lazy, untalented American might earn in a single year. Well-paid Americans owe an enormous, if rarely acknowledged, debt to the social investments that supported their success.

The president’s proposal is modest: raising the top marginal tax rate from 35 percent to 39.5 percent, its level when Bill Clinton left office and well below the corresponding level in most other industrial countries. There has never been a shortage of talented people willing to work hard for success... And the president’s proposal would not cause such a shortage...

It would, however, promote more efficient provision of public services... For example,... when government levies higher tax rates on the wealthy, we can provide public services that the wealthy and others greatly value but that would otherwise be beyond reach. Under such a tax system, the heavier tax bill becomes payable only if we’re lucky enough to end up among life’s biggest winners.

Financially successful tax protesters seem blissfully unaware of how incredibly fortunate they are. To borrow from the late Ann Richards and her description of the first President Bush, they were born on third base and thought they’d hit a triple.

Luck, Skill, and Progressive Taxes:In the debate over tax policy, the power of luck shouldn't be overlooked, by Hal Varian, NY Times, 2001: President Bush's proposed tax cut has rekindled an age-old debate: how progressive or regressive should the income tax be? ...

Those who argue for a more progressive income tax emphasize equity: a tax dollar paid by a rich person causes less pain than a tax dollar paid by a poor person. Those who argue for a less progressive system emphasize efficiency: the most productive people should face lower tax rates to give them strong incentives to work harder and produce more.

These trade-offs have been examined in the economic literature... This formulation of the optimal income tax problem was first examined by the economist James Mirrlees... In the simplest version of the Mirrlees model, taxpayers differ only in their ability: how much they can produce with a given amount of effort. One striking result of this model is that those at the very top of the income scale should face low marginal rates.

This result emerges from a detailed mathematical analysis, but the intuition is not hard to explain. Let us assume, for the sake of argument, that Bill Gates made $1 billion in 2000, an amount larger than any other American taxpayer. Suppose further that despite the best efforts of his accountants, he ended up paying 40 cents of the last dollar he earned to the Internal Revenue Service.

Consider the following thought experiment: drop the marginal tax rate from 40 percent to zero for all incomes above a billion dollars. The I.R.S. won't lose any revenue from this reduction, since no one has an income larger than $1 billion. And who knows -- the lower marginal rate might encourage Mr. Gates to work a little harder in 2001, producing new products that would make him, and the rest of us, better off.

Of course, the fact that it pays to reduce the marginal tax rate for billionaires doesn't say much about what tax rates should be like for mere millionaires, a point that has been emphasized by Professor Mirrlees himself and confirmed by subsequent researchers, like Peter Diamond ... and Emmanuel Saez... But the intuitive argument presented above is pretty compelling: if income depends only on ability, those at the very top of the income-ability distribution should face low marginal tax rates.

But perhaps this model is too simple. One might well argue that Mr. Gates, as productive as he is, doesn't owe his success entirely to ability: there was a lot of luck involved, too. And, if truth be told, that's probably true even for mere millionaires.

So let's consider a different model: one in which differences in income are a result only of luck and have nothing to do with ability. In this case, the optimal income tax may well involve taxing billionaires at very high marginal rates. True, aspiring billionaires won't work quite as hard, since the after-tax reward from hitting $1 billion has been reduced. But the chances of becoming a billionaire are pretty low anyway, so taxing billionaires at a high rate won't really discourage much effort by those hoping to become one.

Thus a model where luck is the driving force tends to yield a more progressive optimal tax than a model where ability is the driving force. This is about as far as theory can take us, but it highlights the critical question: How much income results from ability and how much from luck?

It is safe to say that this question has not yet been completely resolved by the economics profession. Still, everyone seems to have an opinion about it: if you want to determine whether someone is a Republican or a Democrat, just ask that person whether differences in income come mostly from luck or from ability.

The preliminary evidence available from in-depth surveys like the Panel Study for Income Dynamics at the University of Michigan shows that income varies a lot from year to year for many households. Economists have found that random events like episodes of bad health, accidents, marital dissolutions and family emergencies play a large role in short-run year-to-year fluctuations in income.

A Harvard social policy professor, Christopher Jencks, and his collaborators pointed out many years ago that income inequality among brothers, who share similar genetic and environmental characteristics, is almost as great as for the population as a whole. This suggests that luck is an important factor in the long run as well.

If luck plays a substantial role in the determination of income, it makes sense to have a progressive income tax, creating a form of social insurance in which the lucky subsidize the unlucky. Perhaps the folk singer Phil Ochs had the best answer for why the upper half of the income distribution should pay so much more in taxes than the lower half: ''And there but for fortune, may go you or I.''

Link from Economist's View

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