Marginal Income Tax Rates Matter

I can’t ignore this anymore, Barry Ritholtz at Big Picture has been trading fire with Greg Mankiw over his New York Times article I referenced here.  In his latest offensive, Ritholtz has clearly overstated his position with this statement:

The point, which Mankiw so deftly ignored, was that in the real world, people do not respond aggressively to minor incentives (such as marginal changes in income tax).

Really?  Where’s the evidence for such a bold assertion.

First, if behavior does not respond to marginal changes, then economics as we know it does not exist.  Everything is determined at the margin.  Remember the Diamond-Water Paradox that folks struggled with for eons . . . it was solved by the invention of marginal analysis.  Surely, Ritholtz doesn’t mean to overthrow all of economics.

So, secondly, maybe by saying “aggressively” he means folks may change some, but not enough to make a difference.  Well, I’ve been studying migration patterns for some time now.  In two separate states, Connecticut (pdf) and Minnesota (pdf), I have found that out-migration is positively correlated with high state and local tax burdens, especially income taxes (another study in progress finds the same thing)–meaning folks move to where state and local taxes are, on average, lower.  I would consider up-and-moving a pretty “aggressive” tax minimization strategy.  As the saying in Maine goes, “The tax savings from Maine is paying for my house in Florida.”

Finally, don’t just take my word for it.  Harvard economist Martin Feldstein pioneered the empirical estimations of deadweight loss created by “marginal changes in income tax.” In Feldstein’s own words (pdf):

The appropriate size and role of government depend on the deadweight burden caused by incremental transfers of funds from the private sector. The magnitude of that burden depends on the increases in tax rates required to raise incremental revenue and on the deadweight loss that results from higher tax rates … recent econometric work implies that the deadweight burden caused by incremental taxation (the marginal excess burden) may exceed one dollar per one dollar of revenue raised, making the cost of incremental government spending more than two dollars for each dollar of government spending.

I could go on and cite numerous other academic studies that Feldstein and others have done showing significant changes in taxpayer behavior due to changes in the marginal income tax rate.  So, I wonder, who is ignoring reality in this debate?

As for the whole Harvard, Yale, Dartmouth angle . . . Barry Ritholtz fails to distinguish between what Mankiw’s after-tax income would be at each different institution.  It is possible that Mankiw’s professorial talents are high enough that an employer would gladly pay his taxes for him by offering him a higher level of compensation.  If so, then Mankiw would be indifferent to the state that he works in.  My point is . . . just because it could be rational for one person to live in a high tax state, does not mean it is rational for everyone living in the state.

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  • http://www.ritholtz.com/blog/ Barry Ritholtz

    I found Professor Mankiw’s original column filled with misleading assertions and half truths. My questions were to poke holes in his academic rhetoric.

    New Hampshire’s state tax rate as zero vs Massachusetts as 5.3% was to show how academic his argument was. Mankiw claims he will work less if there is a 3% change in his income tax at the Federal level, yet he willingly pays an extra 5.3% because he lives a state over.

    The point I was making is how academic that claim is. Its not how people — even Harvard economists — behave in the real world.

    Not only will people will not stop working due to a 3% swing in marginal taxes, there are studies that suggest many people will work harder, in order to make up for the income loss.

    PS: Based on the performance of most economists over the past decade, overthrow most of economics might not be the terrible idea you presume it to be.

  • Scott

    Barry, thanks for the comment. I agree that over the past decade, we would be better off if certain types of economists were overthrown. I doubt you and I would agree, however, on which ones. Many Austrians were warning of the housing bubble for many years. My points was that marginal analysis is the basis of all economics and all evidence since then shows people respond to changes at the margin–even “small” ones. Sometimes, however, economists simply are not clever enough, or the tools strong enough, to detect them.

    Take taxes for example. Newer studies employing more sophisticated types of analysis, including a study by Christina Romer (Pres. Obama’s former CEA chair), have found that higher taxes are more destructive than studies found decades earlier. So, Barry, you may want to go back and check the date of those so-called article that find “people will work harder” to pay their higher tax bill.

    Oh, and not all economists are are irrational as you claim Mankiw is being . . . I did move to New Hampshire, in part, because of lower taxes :-)

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