Monday, October 11, 2010

The indispensable Professor Thoma

Having spent a lot of time recently on the issue of compensation, this post by Mark Thoma caught my eye:

Greg Mankiw complains that if taxes go up for people with incomes as high as his, he won't work as hard and that means he won't be able to leave as much for his kids. Incentives matter he says. If that's the case, I wonder why someone who is trying to take away the incentive for his kids to work hard and be successful on their own doesn't leave academia and become a high paid consultant.

I'm sure Greg Mankiw could clean up as a consultant. The same effort he puts into academics would be much more highly compensated somewhere else. The fact that he decided to become an academic in the first place indicates that it's not all about the money.

As Greg Mankiw makes clear every chance he gets, he's at Harvard. That tells me that the return to his ego is every bit as important as the financial return. I'd further guess that even if the New York Times stopped paying him for his column, he'd write it anyway. It's a boost to his ego and reputation that he'd want even without whatever small payment he gets for each column (he could make more by using the time to prepare a talk "to a business group, consulting on a legal case, [or] giving a guest lecture," so the opportunity cost of the column is quite high).

I have only anecdotal evidence for the following statement (but it is pretty damned extensive anecdotal evidence so here goes):

When it comes to assumptions, statisticians and economists (particularly freshwater economists) tend to take opposite approaches. Statisticians generally insist on running through more assumptions than the listener has any interest in hearing about, often including those of no relevance to the situation you're in. (A former manager of mine once joked that it was easy being a statistician -- whatever the question, you just answered "it depends.") Economists tend to leave assumptions unsaid, even the really important ones that probably aren't being met.

I can give you plenty of examples of these buried assumptions (if you can make it through a chapter of Freakonomics without finding a few you're not paying attention), but there are also economists who do their best to unearth these assumptions, to bring them back into the debate where they belong. One of the best and most diligent of those diggers is Mark Thoma.

Which brings us back to Greg Mankiw's recent column. On one level, Mankiw's argument is sound. Every product that reaches the marketplace did start with the producer asking "Is this worth my while?" Tax rates do factor into that calculation, so, yes, there can a situation where dropping the Bush tax cuts would cause someone to decide not to make a product.

But there are a couple of big assumptions here. First, since we're talking about a return to Clinton (not Eisenhower) era tax rates here, a product would have to be just barely worth doing now -- the drop in returns under the proposed change is very small. Since this is known economic territory, we know that Clinton's tax increase caused at most a trivial number of products and services to be dropped for the reason Mankaw suggests and the Clinton rates were as high or higher than anything proposed by Obama. (Mankiw gets around this by starting out talking about the income tax increases for people making over 250K then slipping in the estate tax about half a page down, leaving most readers with the impression that making the income tax slightly more progressive will cut his take home pay in half but that's more a case of lying through misdirection than of burying the assumption).

The second, and more important assumption is where Thoma really shines. The idea that a producer will stop making a product if the tax rate passes a certain point assumes that primary return on that product is taxable, an assumption that is in no way justified here. As Thoma points out, the compensation Mankiw receives in the form of ego-stroking and reputation-building far exceed the $650 he gets for each column. I would add to that the satisfaction of influencing the debate. Conservative groups spend millions of dollars getting anti-tax arguments in the papers. When Mankiw does it, the papers send him the check.

When the compensation for a product or service is overwhelmingly non-taxable, an increase in tax rates will almost never cause a provider to drop that product or service. Mankiw is smart enough to be aware of this (he is at Harvard, after all); he just doesn't want the rest of us to realize it.


  1. "Every product that reaches the marketplace did start with the producer asking "Is this worth my while?" Tax rates do factor into that calculation, so, yes, there can a situation where dropping the Bush tax cuts would cause someone to decide not to make a product."

    Please look up the long established in economics income and substitution effects and the backward bending labor supply curve.

    If low after tax income per hour gives you less of an incentive to work, then why did people 100 years ago work more than today at a tiny fraction of the wage per hour?

    If your income went from $30/hour to $1 million per hour would you work more hours, or would you go from 60 hours per week to 60 hours per year? and spend the rest of the time living it up on your $60 million per year?

    There's no theoretical basis for people working more hours per week. This is due to the income effect. Empirically this has been well studied and this is the conclusion of a top expert in this literature, MIT economist Jonathan Gruber, “Changes in tax rates appear to have relatively modest effects on total gross income; the total amount of income actually generated through work or savings does not respond in a sizable way to taxation”, (“Public Finance and Public Policy”, 2nd edition, 2007, page 734)

  2. And yes Mankiw knows this well; he's intentionally misleading as usual for libertarian ends.

  3. Richard,

    I'm not sure we're really disagreeing here. You say the effect is not sizeable; I said it was "very small." It's there but it's consistently swamped by other factors.


  4. But also, the effect can go in the other direction. An increase in taxes can make people work harder, more hours, and empirically this appears to happen with those upper middle class and higher.

    Plus, of course, if the tax money is used to provide high return government investments of the kind the pure free market will grossly underprovide, or inefficiently provide, due to long established in economics free market problems (externalities, etc.), then people can be made much more productive. Such investments include education, infrastructure, basic scientific and medical research, and much more.