Home > finance, musing > When are taxes low enough?

When are taxes low enough?

November 7, 2012

What with the unrelenting election coverage (go Elizabeth Warren!) it’s hard not to think about the game theory that happens in the intersection of politics and economics.

[Disclaimer: I am aware that no idea in here is originally mine, but when has that ever stopped me? Plus, I think when economists talk about this stuff they generally use jargon to make it hard to follow, which I promise not to do, and perhaps also insert salient facts which I don’t know, which I apologize for. In any case please do comment if I get something wrong.]

Lately I’ve been thinking about the push and pull of the individual versus the society when it comes to tax rates. Individuals all want lower tax rates, in the sense that nobody likes to pay taxes. On the other hand, some people benefit more from what the taxes pay for than others, and some people benefit less. It’s fair to say that very rich people see this interaction as one-sided against them: they pay a lot, they get back less.

Well, that’s certainly how it’s portrayed. I’m not willing to say that’s true, though, because I’d argue business owners and generally rich people get a lot back actually, including things like rule of law and nobody stealing their stuff and killing them because they’re rich, which if you think about it does happen in other places. In fact they’d be huge targets in some places, so you could argue that rich people get the most protection from this system.

But putting that aside by assuming the rule of law for a moment, I have a lower-level question. Namely, might we expect equilibrium at some point, where the super rich realize they need the country’s infrastructure and educational system, to hire people and get them to work at their companies and the companies they’ve invested in, and of course so they will have customers for their products and the products of the companies they’ve invested in.

So in other words you might expect that, at a certain point, these super rich people would actually say taxes are low enough. Of course, on top of having a vested interest in a well-run and educated society, they might also have sense of fairness and might not liking seeing people die of hunger, they might want to be able to defend the country in war, and of course the underlying rule of law thingy.

But the above argument has kind of broken down lately, because:

  • So many companies are off-shoring their work to places where we don’t pay for infrastructure,
  • and where we don’t educate the population,
  • and our customers are increasingly international as well, although this is the weakest effect since Europeans can’t be counted on that so much what with their recession.

In other words, the incentive for an individual rich person to argue for lower taxes is getting more and more to be about the rule of law and not the well-run society argument. And let’s face it, it’s a lot cheaper to teach people how to use guns than it is to give them a liberal arts education. So the optimal tax rate for them would be… possibly very low. Maybe even zero, if they can just hire their own militias.

This is an example of a system of equilibrium failing because of changing constraints. There’s another similar example in the land of finance which involves credit default swaps (CDS), described very well in this NYTimes Dealbook entry by Stephen Lubben.

Namely, it used to be true that bond holders would try to come to the table and renegotiate debt when a company or government was in trouble. After all, it’s better to get 40% of their money back than none.

But now it’s possible to “insure” their bonds with CDS contracts, and in fact you can even bet on the failure of a company that way, so you actually can set it up where you’d make money when a company fails, whether you’re a bond holder or not. This means less incentive to renegotiate debt and more of an incentive to see companies go through bankruptcy.

For the record, the suggestion Lubben has, which is a good one, is to have a disclosure requirement on how much CDS you have:

In a paper to appear in the Journal of Applied Corporate Finance, co-written with Rajesh P. Narayanan of Louisiana State University, I argue that one good starting point might be the Williams Act.

In particular, the Williams Act requires shareholders to disclose large (5 percent or more) equity positions in companies.

Perhaps holders of default swap positions should face a similar requirement. Namely, when a triggering event occurs, a holder of swap contracts with a notional value beyond 5 percent of the reference entity’s outstanding public debt would have to disclose their entire credit-default swap position.

I like this idea: it’s simple and is analogous to what’s already established for equities (of course I’d like to see CDS regulated like insurance, which goes further).

[Note, however, that the equities problem isn’t totally solved through this method: you can always short your exposure to an equity using options, although it’s less attractive in equities than in bonds because the underlying in equities is usually more liquid than the derivatives and the opposite is true for bonds. In other words, you can just sell your equity stake rather than hedge it, whereas your bond you might not be able to get rid of as easily, so it’s convenient to hedge with a liquid CDS.]

Lubben’s not a perfect solution to the problem of creating incentives to make companies work rather than fail, since it adds overhead and complexity, and the last thing our financial system needs is more complexity. But it moves the incentives in the right direction.

It makes me wonder, is there an analogous rule, however imperfect, for tax rates? How do we get super rich people to care about infrastructure and education, when they take private planes and send their kids to private schools? It’s not fair to put a tax law into place, because the whole point is that rich people have more power in controlling tax laws in the first place.

Categories: finance, musing
  1. November 7, 2012 at 11:03 am

    The way you look at rich people seems like a caricature. Your view seems to be that they are self interested to the point of being pathological. Maybe it’s just that the rich people in finance are very different than the rich people in Silicon Valley?

    This seems a lot more typical of the kind of behavior that is unsurprising to me.

    http://www.businessinsider.com/sergey-brin-is-secretly-buying-up-property-and-charging-below-market-rent-2012-8

    • November 7, 2012 at 11:07 am

      I’m just reading the newspaper. I wish I could count on human decency, but then I read this.

      But another, better way to answer your reasonable remark is that I’d like to think like an economist for a moment and wonder at what point people’s incentives actually are aligned to pay taxes rather than avoid taxes. In other words, assuming people act in their own best interest in terms of effecting tax policy, to what level would the natural rate of taxes fall?

  2. November 7, 2012 at 11:17 am

    Cathy, your last paragraph seems to have ended in mid-thought. The whole topic of fairness in taxes is of great interest to me, as you know. Could you finish your thoughts?

  3. November 7, 2012 at 11:18 am

    Odd…after I posted my comment, the sentence appeared in complete form. Sorry to complain.

  4. UncleMookie
    November 7, 2012 at 11:31 am

    Heck, I’m not super-rich…in fact, I’m part-time employed and functionally flat broke and I’m not a happy customer of the infrastructure in the most affluent county in California.

    My ADHD kid is being pushed through grades under the guise of “No Child Left Behind” while my self-employed partner is hit up for money every time she walks onto the elementary school campus even with her exorbitant property taxes. I’D send my kid to private school if I could, too!

    Our local roads are a mess, our local politicians are double-dipping jobs on top of lucrative pensions…what’s to be so optimistic about?

    Super-rich taxing is gonna solve it? I live (struggle) amongst what would be considered the super-rich and it ain’t Utopia by any means. If this meets the criteria for a proof-of-concept, what’s the next great idea?

  5. November 7, 2012 at 11:34 am

    I guess posting my comment accomplished the same thing as refreshing the page. It does become a rather sticky problem, and I think you hit the nail on the head in the earlier part of the post – when the old incentives that might make even the rich and powerful desire a fairer society have disappeared, what leverage is left?

    Are you familiar with the arguments Robert Frank makes in The Darwin Economy?

    He thinks that in the future, Darwin will be considered the father of modern economics rather than Adam Smith (pardon the paternalism). Since I try to take an evolutionary perspective on this stuff, it made a lot of sense to me.

    He claims he was writing the book to try to convince “rational libertarians” that it made sense for them to pay higher taxes to achieve a more equal society. He advocates major changes in the tax structure itself, moving it toward taxing harmful behaviors, externalities and consumption rather than income.

    I know there is still the problem of how do you actually accomplish change, but if you make the uncertain assumption that change is possible, I think he makes a good case that this is a tax structure that the rich might swallow more easily.

  6. November 7, 2012 at 12:44 pm

    One reason for wealthy people to care about taxes and other redistributive processes is that the redistribution functions as a hedge or insurance against mistakes in asset allocation decisions made by the wealthy. There’s some optimal level of decision-making distribution that maximizes economic growth (and thus quality of life for wealthy people). Most wealthy people believe that central planning is not so great. As the wealth distribution gets more extreme, we get closer to a situation of centralized planning, though it’s central planning by individuals, not government. If Warren Buffet makes a big mistake (or Dick Fuld?), the consequences could be significant for everyone’s quality of life. To an extent, taxes are comparable to investment diversification.

  7. Steve Stein
    November 7, 2012 at 1:37 pm

    Resolved: The Rich Are Taxed Enough.
    Speaking in favor: Glenn Hubbard, Arthur Laffer
    Speaking against: Robert Reich, Mark Zandi

    http://intelligencesquaredus.org/debates/past-debates/item/775-the-rich-are-taxed-enough

  8. November 7, 2012 at 3:05 pm

    Cathy, you may already be familiar with Robert Frank, but in researching something else I came across a couple of articles that are both relevant to your post, I think. First, as to your analysis of the problem:

    http://blogs.wsj.com/wealth/2010/08/02/do-the-rich-even-need-the-rest-of-america-anymore/

    And then, a short form version of his approach to the solution:

    http://www.nytimes.com/2012/09/23/business/nations-choices-neednt-be-painful-economic-view.html

  9. Michael A. Lewis
    November 8, 2012 at 9:52 am

    I think this part of your post: “How do we get super rich people to care about infrastructure and education, when they take private planes and send their kids to private schools?” sums up the issue well. Here is a possible answer. Since we’re talking about the super rich in the U.S. (I assume) we could appeal to what might be called their ideological or philosophical self interest. I don’t think this is an idea you find much in economics but I think it might be consistent with how they tend to view human behavior. One of the values those of us in this country pride ourselves on is the idea that the U.S. is the land of equal opportunity. So perhaps the conversation should be a fairly detailed discussion of what’s required for there to be real equality of opportunity. For example, everyone is entitled to free public education up to a point. One question is, given the nature of the economy and how it seems to be changing, is free public education up to just high school really providing for equality of opportunity when some can afford to send their kids to college and beyond while others cannot. Is it really a country where there is equality of opportunity if some kids start out with large sums of inherited income and wealth while others do not? I’m not suggesting that the answers to these questions are obvious or easy. The point is that part of self interest, on the part of the rich and all the rest of us, might be a desire to behave in a way that’s consistent with what we value or believe. Perhaps we could frame the tax discussion as part of a broader discussion about how we organize our society in such a way that we can better realize the value of equality of opportunity that we all seem to hold dear. This way the rich wouldn’t need to send their kids to public schools, fly with the rest of us, or hire a labor force in this country in order to be convinced that they should pay taxes, perhaps even more than the rest of us have to pay. What they would need to do is believe that the U.S. is about promoting equality of opportunity and become convinced that taxing them is a key part of creating the conditions for doing so.

  10. November 16, 2012 at 11:16 am

    the game theory that happens in the intersection of politics and economics.

    Great book:

    http://books.google.com/books?id=q3h_M3QI7OYC&lpg=PA38&dq=person%20tabellini&pg=PA38#v=onepage&q&f=false

  11. November 16, 2012 at 12:17 pm

    In other words, the incentive for an individual rich person to argue for lower taxes is getting more and more to be about the rule of law and not the well-run society argument.

    More and more? This hasn’t always been the case?

    Namely, might we expect equilibrium at some point, where the super rich realize they need the country’s infrastructure and educational system, to hire people and get them to work at their companies and the companies they’ve invested in, and of course so they will have customers for their products and the products of the companies they’ve invested in.

    Strictly speaking, nobody has an individual interest in paying taxes to keep the society well-run. It’s like public radio donations. Even if the biggest donor (biggest taxpayer) were taken out of the funds received, that wouldn’t kill the radio station (government). If there’s some “reasonable level” that even those who wish for the smallest size-of-government would wish for, it probably comes about for another reason than an equilibrium. I’ve seen arguments by libertarians that “Government should operate with the same profit margin as business” (argument by analogy) or, more coherently, estimates by flat-tax advocates of what tax rate would pay for X,Y,Z (whatever they decide are the things government really should provide).

    But the above argument has kind of broken down lately, because:

    So many companies are off-shoring their work to places where we don’t pay for infrastructure,

    Is it actually true that off-shoring is “high” these days?

    It’s worth noting, as well, that multinational corps centreing their business elsewhere than the United States affects corporate tax receipts, which comprise only 8% of US tax revenue. http://en.wikipedia.org/wiki/United_States_federal_budget#Major_receipt_categories

    The usual disproof of [Laffer-curve abusers saying that higher tax rates will cause rich people to move away], at least in the US, is that California and New York state charge higher tax rates than, for example, South Dakota, and yet rich people flock to those areas.

    http://video.ft.com/v/1664617396001/PPR-CEO-uber-optimistic-on-economy (minute 5 or 6 Pinault says he won’t leave France even with the higher taxes under Hollande, the socialist)

    It makes me wonder, is there an analogous rule, however imperfect, for tax rates?

    There are already complex disclosure rules, in the US and elsewhere, that deal with relocation and “shell games” or “paper shuffling” as well as incenting companies to relocate their jobs in “our country”.

    But as I said above, it seems like you’re alliding corporations and rich people when the conflict in the US election (the “class warfare”) was over personal income tax rates, not corporate taxes. I’m pretty sure President Obama also wanted low corporate taxes.

    How do we get super rich people to care about infrastructure and education, when they take private planes and send their kids to private schools?

    You sound like http://gawker.com/5943005/theres-a-simple-solution-to-the-public-schools-crisis . Calling for lower tax rates is, I believe, actually more common among the “bottom of the 1%” than among private-jet owners. Americans making $10mm/year https://twitter.com/RKHilbertSpace/status/267788375203930114 (roughly top .01% or 15,000 households) realise, I think, the privilege afforded by their government (so you see Warren Buffett writing http://www.nytimes.com/2011/08/15/opinion/stop-coddling-the-super-rich.html) and are OK with paying tax (not to say they won’t pay as little as legally required–that’s tax avoidance, not tax evasion). In the upper quantiles-but-not-the-highest, I gather http://t.co/Pw1XOOQb the rich-but-not-ultra-rich are close enough to the stratospheric incomes at the top of the power law to feel *really* poor and disadvantaged — or something like that. Anyway, I think it’s not the top .01% (private jets) that constitute the GOP’s broad support base for lower tax rates–that would only be 15,000-30,000 people, nothing like the numbers who support “fairer” low marginal rates on the rich.

    Anyway, I think the direct answer to your question is: Reason with them. If “What’s the Matter With” Kansas can be convinced to vote against its economic interest in favour of values and morals, then so can America’s rich.

    When are taxes low enough?

    When are taxes high enough? How many government transfers, how good of an education, how much police and fire protection, how much of the news media, and so on, should be run by government? It’s unclear that even in principle there could be an optimal answer. (since it’s my interest in small government versus your interest in large, a direct conflict which we have no good way of resolving through pure reason)

    BTW, the people who deeply study this stuff do have well-thought-out ideas about it http://elsa.berkeley.edu/~saez/ http://www.voxeu.org/article/eliminating-known-unknown-firm-evidence-tax-multipliers so we don’t need to reinvent the wheel as far as thinking these issues through.

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