When are taxes low enough?
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 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.