A new paper says that the income tax rate in socially useful jobs should be lower than in socially useless ones – here, regular guest-poster Charlotte Cavaille gives this argument a once-over, as part of a pair of posts on tax.
With the sharp growth of income inequalities well known to readers of this blog, researchers puzzle over the reasons behind “the absence of a breakthrough in American Politics that offers alternatives to growing inequality” (Stepan and Linz 2011). The most straightforward policies among the available “alternatives” is progressive taxation, an efficient way to decrease income and wealth inequalities (see Piketty’s work for an example).
Without simplifying much, one could argue that the study of progressive taxation is profoundly shaped by the researcher’s answers to the following two questions:
a) How much is mass support for progressive taxation shaped by the existing distribution of market income and wealth? – something I’ll return to in an upcoming post
b) What are the consequences of income taxation on people’s behavior?
The most ubiquitous answer to question b) is the claim that income taxation increases incentives to allocate more time to leisure activities at the expense of income-generating ones. The general consensus is that this effect is large enough to warrant lower tax rates than the ones observed, at least until the 1980’s, in most advanced capitalist countries.
Addressing income inequality through a better allocation of talent
In a recent paper, Lockwood, Nathanson and Weyl develop a theory of income taxation which challenges this claim. They argue that professions vary in the extent to which they generate positive or negative externalities (e.g. doctors and teachers might generate more positive externalities than lawyers). Readers who have taken a few econ courses might remember learning about the Pigouvian Tax, namely a tax that aims, in the case of a good whose production and/or use has negative externalities, to bring market costs closer to overall social costs. A typical example is the carbon tax which will inflate market price of fossil fuels, decrease demand for this good and hopefully move the market away from a welfare-decreasing over-consumption of the good.
Along the same lines, Lockwood et al provide a model of taxation where taxes would be higher for professions with zero or negative externalities (namely most of the value created in exercising this profession is privately appropriated through wages, or worst case scenario, no value is created, wages are just “stolen” value) and would be lower for professions with positive externalities. To simplify, a central planner might want to tax occupations in the financial industry higher to make sure a larger share of cohorts of recent graduates go into teaching rather than banking.
The behavioral consequences of taxation: work-intensity vs career-switching
The great insight in this paper is to think of individuals as arbitrating not only between work and leisure but also between different types of rewards, namely pecuniary/material consumption vs symbolic/sense of meaning. In Lockwood et al’s model, each profession is assessed by individuals along two dimensions, the money wage one expects if choosing this profession and the non-pecuniary (they call it “psychic”) income she would receive from performing and being associated with this profession. The relative utility provided by each component will be a function of how highly taxed wages associated with each profession is, thus increasing the relative weight of the non-pecuniary motive in shaping an individual’s decision. The authors cite evidence that support the claim that the behavioral reaction to a change in the tax rate is most likely to take the form of a career switch than of a decrease in working hours (or the decision to stop working).
I find this very convincing. Most of my friends are looking for meaning as well as material resources. When pay decreases, the extent to which they decrease their productivity is inversely proportional to the extent to which they like and find meaning in their work. In other words, productivity/intensity is tightly correlated with knowledge of the positive externalities one is generating through one’s activity on the job. Adam Grant at the Wharton School is building a high profile career (see recent NYT profile) on the finding that prosocial motivations and meaning heighten work productivity.
A less generous reading of this high-achieving group’s behavior is that they are not arbitrating between income and “meaning” but between income and prestige. I am myself heading for a prestigious but a relatively less well-paid occupation (academia). Talking to my friends in finance, my hint is that they might exchange the benefits of their house in the East Village for the prestige of being an “intellectual” if the probability of getting such house when becoming a banker was not much higher than the probability of becoming a respected public figure when entering academia.
What would this look like in practice?
In terms of policy making, if one believes that the supply of highly talented individuals is limited and that it should be distributed across professions according to the externalities generated by each, then this paper is a powerful counter-argument to the work vs leisure approach which focuses on productivity irrespective of the occupation in which work intensity is applied.
In practice, it might not be so easy to apply a taxation rate specifically to one profession. Lockwood et al compute average taxation rates for different income brackets, using data on the distribution of talented individuals by profession, conditional on income. For instance (I let my imagination run here), if in the $200-250k income bracket, 75 % are doctors with high positive externalities and the remainder are bankers, the average taxation rate for this income bracket might be lower than the $150-200 income bracket mainly populated by McKenzie consultants deemed as producing zero positive externalities.
This requires information on each profession’s externalities. Lockwood et al here chose the usual economists copout and leave citizens to agree on what this might be through a democratic debate. As they note, while both Occupy WS and Tea partiers agree on the negative externalities of bankers, they might disagree on the nature of the externalities generated by a liberal Ivy League political scientist. The authors are collecting data for future versions of the paper so go ahead and share your thoughts about profession-specific externalities here!
What does this imply for the issue of inequality and redistribution through taxation?
According to data collected by Goldin et al. (2013), “two to three times as many male Harvard alumni from the 1969-1972 cohorts pursued careers in each of academia and non-financial management than pursued careers in finance. Twenty years later, careers in finance were fifty percent more common than in academia and comparable with those in non-financial management.” The consequence of this shift is, using two of the authors’ beliefs about externality shares of different professions, an increase in the share of talented people entering professions where most of the value produced has been privately appropriated through wages (and bonuses) without producing any countervailing positive externalities.
According to the authors, this (mis)allocation of talent to non-(positive) externalities producing industries where wages capture most of the value created could explain why the share of the value privately appropriated by a (smaller) segment of the “talented” , namely income inequalities, has increased over time.
There are two important implications here: a) this shift can be potentially traced back to increasing wages in certain sectors such as the financial sector and to changes in taxation rates that increased the utility drawn from these professions, b) this shift is reversible by increasing the progressivity of income tax rates. Lockwood et al thus provide a way to think about income inequality and redistribution that by-passes the debate about the (unfair) expropriation of the talented by the non-talented and efficiency concerns. In a world where high wages are clustered in zero or negative externality producing professions, higher taxation rates will not only directly decrease inequality by taxing high income but also indirectly do so by pushing individuals in occupations with lower private wages. It will also increase total social welfare.