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Matthew O’Brien wrote an odd article for The Atlantic last Friday, using the Tax Policy Center’s analysis that I’ve written about here and here to criticize Governor Romney’s tax proposal. He argues that if the Romney proposal were to meet its goals, it could only be because the rich get much richer and “income inequality explodes.”
First of all, Mr. O’Brien ignores many previous critiques of TPC’s study and relies overmuch on its somewhat tenuous estimation of a revenue gap.
But more importantly, O’Brien makes a fundamental mistake in his analysis. He assumes, without saying why, that only the rich would benefit in terms of increased income from economic growth under a Romney-style reform. The root of the misconception seems to be that he thinks the growth effects of the reform would stem from increased work incentives for the rich. However, the bulk of the growth effects would come from capital accumulation and more efficient allocation of capital. As my colleagues Alex Brill and Alan Viard wrote in a recent blog post:
Governor Romney’s tax plan for individuals would lower statutory tax rates on ordinary income while leaving tax breaks for saving largely untouched. His corporate tax reform plan would further improve the allocation of capital and foster economic efficiency. Overall, the governor’s plan translates into a reduced tax burden on savings and investment, which are key drivers of long-run growth.
I wish O’Brien had read that before badly misapplying another paper of theirs.
Especially when unemployment is high, it’s not just work incentives that get the poor and middle class to work more and earn more income. An unemployed or underemployed person is someone who, by definition, is not working as much as he wants. So increased income will flow from the availability of more jobs and work, and that is exactly what capital accumulation from Romney’s proposal would provide. Aparna Mathur and I have explained the link between capital and labor more technically in another context:
In the long run, as the stock of capital declines [increases], workers have relatively lower [higher] stocks of capital to work with and the marginal product of labor declines [increases]. Because wages are assumed to be equal to the marginal product of labor, wages also fall [rise].
For the sake of argument, though, let’s say that the scenario plays out as O’Brien fears: All of the growth comes from higher (taxable) income for the wealthy, and the rich get richer while the poor and middle class stay the same. When a policy can make some people better off and no one worse off, it’s called Pareto improving, and to anyone who has tried to design policy, finding room for Pareto improvement is akin to stumbling on the Holy Grail. One of the real oddities of O’Brien’s article is that what he couches as a criticism is quite far from it. And actually, it’s not just the rich who would be better off under this hypothetical, but anyone who has a chance of one day becoming rich. Given that there is economic mobility in this country, that set of people includes about every American. Whatever the intrinsic costs of inequality might be, I have a hard time imagining there are many people who would be willing to limit the expected value of their future earnings in order to make the rich a little less rich.
It’s not that I don’t harbor a criticism or two of the Romney tax proposal myself. While it follows smart base-broadening reform principals and I applaud it for avoiding the tax hikes on savings and investment that President Obama supports, I believe it could go further towards spurring growth by eliminating taxes on savings and investment altogether in a move to consumption taxation.
That type of criticism seems perfectly reasonable; economists disagree about what is most effective, and political constraints get in the way of the fantasies of think tankers like myself. I can also understand why some people might criticize the goals of revenue neutrality and distributional neutrality. If you want to argue that tax revenues should be hiked or cut, or that more or less wealth should be redistributed by the tax code, crack open your philosophy books and go ahead. But even if we accept your flawed analysis, writing a scare piece about a proposal that you think might be ‘merely’ Pareto improving strikes me as quite odd.
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