How Income Taxes Distort the Economy

>> Joshua Rauh: All right, last kind of set of things is something that I have to sort of go through these because I feel like I have to disabuse you of certain things that you've been taught. So one thing is you've probably heard about the Keynesian Multiplier, so here's John Maynard Keynes, he was sort of a rock star economist of the early 20th century.

And one of the basic hypotheses that he came up with was the idea that an increase in net government spending is gonna increase GDP by more than the amount of the spending. So the idea is, if the government spends a dollar today, you're gonna create $2 worth of prosperity and economic activity, that was his idea.

And furthermore, if the government can actually invest in capital like infrastructure, that you can create even more growth and economic activity. There are a lot of studies out there that try to measure what the Keynesian Multiplier is, the problem is it's really hard to do it. And the reason is that these Keynesian interventions, big government increases in monetary policy or in fiscal policy, tend to happen during a time when the economy is in a cyclical downturn.

And then when the cycle reverses, you get increased growth, but you don't know whether you can't attribute it to the government spending, you don't know whether it's due to the government spending or whether it would have happened anyway. And so there's a lot of problems with the Keynesian Multiplier, both empirically and also in theory, I mean, here's one example, right.

So if people are forward looking, then financing government spending with current taxes or current deficits is gonna have the same effect on the economy, it doesn't matter whether you tax people or whether you run deficits. And the reason is that you think about what people might do, the question for Keynes is, who's gonna buy the government bonds that finance spending, and would that money have been spent elsewhere?

So if I think about the government raising debt, and then the individual says, well, this debt's gonna have to be repaid sometime, what am I gonna do with the money, am I gonna go shopping and spend it, or am I gonna save it? I'm gonna save it, and this is pretty much what happened during COVID and it said, I'm gonna sit home, I'm gonna watch Netflix, that's what I'm gonna do, I'm gonna save the money in fact, only 15% of people, after COVID said that they would spend their stimulus checks.

So essentially, there are real problems with just assuming that every dollar injected into the economy is gonna be forward looking. Scott's standing up and is telling me I need to have time for questions, or are you just taking off, are you? Ok fine, I do wanna say one other thing though, which is I just wanna talk about what happens with income taxes and distortions of the economy, so anybody heard of the Laffer curve?

Okay, so Laffer curve is this idea that if you tax people have higher income taxes some people, then eventually they're gonna work less, and you're gonna reach a point where increasing taxes is counterproductive even from the perspective of just raising revenue. So that's the Laffer curve, the Laffer curve shows the theoretical relationship between tax revenue and the tax rate, so there's some rate here t* which maximizes government revenue.

And so Laffer, Arthur Laffer is an economist who came up with this idea, emphasized this idea that, hey, it might be that by cutting taxes, we might be able to bring in more government revenue. He was given the Presidential Medal of Honor by Donald Trump, and then immediately, as though on cue, the New York Times wrote something called the dangerous folly of laugherism.

Okay, so very interesting, I don't know whether they assess Laffer on his own basis or not, but I actually also have some trouble with Lafferism. I have to tell you, the Laffer curve is only optimal in a very narrow sense, government revenue, it tells you what would maximize government revenue with a single tax rate.

And the real problem is, what about overall production and prosperity? To get to the top of the Laffer curve involves so much discouraged economic activity, so much lost prosperity. And there's research that goes back a long time that shows that for every dollar of increased government revenue, that there's a deadweight loss of $2 in the economy.

So, I actually think there's also a problem with Lafferism, which is that it sets a very, very narrow goal, its goal is, let's maximize government revenue, that's not the goal. The goal should be, let's optimize and maximize economic prosperity for everybody. And so no question that the rate that would maximize government revenue is higher than the rate that would be optimal for economic prosperity.

So, okay, that's it, what's the appropriate size of government? That's for you to determine, you're the voters but at least we've gained some facts about what exactly the current size of government is and what some of the issues are. Overreach in any of the areas that I talked about, the rule of law, the social safety net, the provision of public services when there aren't really danger of public failures.

Any overreach there is gonna lead to dangers for society, and this is a great graph from Kevin Williamson or a great picture from Kevin Williamson, the National Review, or maybe the National Review journalists put it on there, he wrote, the Coronavirus will be the Leviathan's Enabler. Coronavirus has certainly led to a huge increase in the size of government, and in some ways, you'll hear from Scott live is about intrusion to people's individual lives and into their health.

I tend to focus on the intrusion into the economy, which has been vast, and there's been very substantial overreach there, so I will leave a few minutes for questions.

>> Joshua Rauh: Okay, I'll take some questions.

>> Audience 1: Thank you for this very interesting lecture, especially when we talked about unemployment benefits and how that creates an implicit tax rate, that creates a disincentivizing mechanism.

I was wondering whether college financial aid creates that same mechanism whereby middle class families, it's very hard for them to get a huge amount of financial aid, that if they decrease the total household income in aggregate, once they get the aid, it would actually be more. So, I was just wondering whether that concept applies there as well.

>> Joshua Rauh: Yes, I have known people and heard of people who have literally done things like taken unpaid sabbaticals and things like that in order to increase the amount of financial aid that they can get based on financial aid income statements. And that is a clear example of the type of distortion that you have in mind, that's pretty extreme, but that is another example.

The cost of college in the United States is very, very high, and qualification for the programs is based on income and goes down when people earn more. And there are definitely at least journalistic accounts of people who have exploited that to a great extent, I haven't seen an actual large scale study that asks how much has that cost the US economy?

That's a great question, yep, over here I'm trying to get broad hear from people I haven't heard from yet.

>> Audience 2: I just wanted to get your thoughts on the political business cycle and how you think electoral incentives might impact either increases or decreases in spending or those redistributive tax policies.

>> Joshua Rauh: Well, on, I'll say, on deficits both parties have been really bad and there's not gonna be any much excuse there. And the beginning of first half of the COVID response was under republican administration, and the second half was under a democratic administration. So the political cycle, it's kind of hard to say, and the reason it's hard to say is it certainly is true that the Democrats wanna do more social spending, there's no question about that.

But these crises are so important because during the crises, that's when government spending really ratchets up, and there, it doesn't seem to matter whether a republican or Democrat administration is in office. Government spending ratchets up hugely, so I think that's kind of the way to think about it, maybe the Democrats tend to increase government spending on a gradualistic basis, but during crises, it just goes up.

Sorry, okay, you can take this question here, I didn't need to.

>> Audience 3: I was wondering if you could expand on your points earlier, that the top 1% earn 20% of the revenue, but pay 40% of the total taxes. I guess I'm just wondering, how does that work? How is that possible?

>> Joshua Rauh: Okay, well, it's possible by the fact that the upper income people face a higher tax rate than lower income people. So if you earn over a certain amount of money per year, then you actually pay a higher tax rate, so, like in California, for example, a top tax rate in California is 13.3%.

People earning over a million dollars pay that rate, if you earn between 500,000 and a million, you pay either 11.3% or 12.3%, depending your marital status. So that's an example of progressive income taxation, and that's how it happens, yep.

>> Audience 4: Hi, thank you for this lecture, I just wanted to address your comments about inequality in the United States.

Obviously, there's one discussion to be had about the flows of income and so revenue, and as it's, people making money. But there is a separate discussion to be had about money making money, because the wealth gap between the top 5% and the bottom 5% has more than doubled between 1989 and 2016.

So if we're gonna have a discussion about inequality in the United States, I just wanted to ask you to address that side of it, rather than just the flow side, more of the stock side as well, cause that's an important part of it.

>> Joshua Rauh: Right, so, wealth inequality, actually, I don't agree with your statistics necessarily, it depends on what measures of wealth inequality you use.

And there are various measures of wealth inequality that attempt to back out how much people. The problem is there's no disclosure to the government of how much wealth a person has in the United States. And so economists do a lot of trying to back that information out by looking at things like they try to get access to tax returns and they try to estimate based on the tax return what the person's wealth is.

That is a really tricky exercise, and depending on what assumptions you make in there, you can get a lot of different answers about how wealth inequality has evolved over time. So I am sort of skeptical about the idea that wealth inequality has exploded. Another issue is that when you think about wealth that people have, the fact that every individual has got the right to Social Security for life after they retire.

The present value of that is wealth, and that's something that is often not incorporated in the wealth statistics, and rich people don't get much more than poor people on that. So it's a much trickier measurement question than you're making it out to be, yeah, I'll go back here.

>> Audience 5: Thank you, I just had a question regarding the role of school choice in public education and funding. I guess my question is, what's the role or the potential of having school choice in a public education system?

>> Joshua Rauh: I'm a bad person to be the expert on that question, and the reason is that we have two experts on it, Caroline Hoxby and Terry Moe, coming in a couple days.

And so I'm gonna defer it to them because they are the experts, good to not talk about things when you don't know what you're talking about, one more over here, yes. Yep.

>> Audience 6: Hey, thanks for the conversation, in one of your writings, you talked about the value of tax evasion, and it's a topic I hadn't ever covered before incredibly small.

But on the topic of charitable contributions, trust for descendants, what's the topic of conversation happening there and is it at all a large part?

>> Joshua Rauh: Okay, so are you thinking more about inheritance taxes, are you thinking about abuse of non-profit organizations.

>> Audience 6: Could go either direction.

>> Joshua Rauh: Okay, or both, or how they work together as John Cochrane said, the US tax code is incredibly complex.

And I think that the bottom line is everybody would be much better off if we had a tax code that was just much simpler, if necessary, with lower tax rates for everybody than something that has a lot of opportunity for very, very complex tax evasions. People who really actually gain from complex tax avoidance tend to be tax lawyers and tax accountants and things like that.

Obviously, there's a lot of talk now about how much additional money the government can potentially get by investing in the IR's and having the IR's crack down on people. Well, I think it remains to be seen, what would be better and more efficient for society would be if we didn't have rules that were that complicated.

So it wasn't that hard to actually figure out how much somebody owes in taxes so you don't have to pay $87 billion to figure it out. Let's just have a simpler system where you don't have to invest so much money to figure out how much somebody actually owes in taxes.

And that kind of feeds into the whole question about trusts and estates and things like that.