Mankiw's Mistakes

Greg Mankiw wrote an interesting piece for the New York Times this weekend about tax reform.  For those of you who don't know, Mankiw is a professor at Harvard and the first economist to become a millionaire from textbook sales.

Oh, yeah, he's also the Romney campaign's economic policy adviser.

Mankiw squawks about "tax[ing] consumption rather than income" and simplifying the tax code.  Unfortunately, he completely ignores the distributional effects of consumption-based taxes, and he tries to slip one by us when he suggests that "our progressive income tax could further evolve toward a progressive consumption tax".  For that to be true, we have to pretend assume that 1) effective tax rates in the US are actually progressive and 2) rich people consume proportionally more than poor people.

In fact, just the opposite is true.  As Mitt Romney's newly released tax returns show, the US tax system is not progressive at all, but rather, it's somewhat regressive.  American Progress provides a fancy little graph that demonstrates this:

Well, there goes one argument.  And here goes the second one:  Crunching a bit of data from the BLS (pdf) reveals Mankiw's "progressive consumption" fallacy:

That's not a mistake.  The poorest 20% of Americans, whose before tax incomes (I used pre-tax instead of post-tax incomes since we're talking about shifting from income to consumption taxes, not that it makes much difference in the relative ratios) range from just over $10,000 to around $18,000 per year have to spend almost twice what they earn on necessities like food, electricity and healthcare.  Compare that with the necessary consumption of the richest 20%.  There's obviously a downward trend there, and I would bet money that if the data were extended to include micro-level data (i.e. per person), that trend would continue, eventually reaching near-zero for the top few earners (cough, cough, "earners").

So, a consumption tax would actually be far more regressive than the current rates people end up paying. That means if I'm really poor, I'd actually be taxed on 200% of my income, while rich people would be taxed on less than 50% of theirs.

The piece also addresses negative externalities, invoking the oft-cited example of anthropogenic (man-made) climate change.  That's funny, considering some of his boss's past comments, but we'll overlook that and focus instead on his "gasoline tax" idea.

Mankiw is absolutely right that a tax on gasoline would help reflect the true social cost of driving, just like taxing coal-burning power plants would help reflect the social cost of SO2 and arsenic pollution, but so would ending fossil fuel subsidies.  Of course, Mankiw knows that it's not politically feasible to implement a tax on something that people rely on, and if he were a responsible, non-partisan economist, he would suggest (or at least mention!) the role subsidies play in distorting the markets and further embedding externalities in our economic model. 

There are some other mistakes in the post, e.g. the idea that people who are taxed more will work less.  That's not really true at all, intuitively or theoretically. Consider a rational actor who is utility-maximizing.  If his utility is a function of his consumption, and if his consumption is a function of his post-tax income, and if his post-tax income is a function of wage rate multiplied by the number of hours he works, then maximizing his utility will necessarily require maximizing the number of hours he works, to some threshold, of course.  Remember, it's all about wealth/utility/profit.  Now, I don't necessarily agree with that idea, but it's the theory that Mankiw espouses, so why not use his own rationale to discredit his fundamentally silly argument(s).

That's all.  The point about subsidies reminded me of an article I read the other day, so I'll blog about it when I get a chance.

dU/d(time spent doing Hamiltonians) < 0

If we extract perfectly substituitable resources r = i,...,j at rate R, from given stock* S, we should follow extraction path ρ (that's a rho, you fool, not a p) from time t = 1,...,T (social planner picks T), then society will be sOoO happy.  Utils maximized!**

*which we don't know

**assuming things that aren't real.

Farming for Brains

I attended a fascinating lecture last night by Philip Coggan on his new book Paper Promises. He talked about the evolution of paper (and digitized) money, and how the entire system relies on faith in government institutions. For the first time in history, there is no 'anchor' on the creation of money, and he thinks by 2050 or so, the financial system in which we rely on huge accumulations of debt to function will have collapse, with China replacing the United States as the world's regulator.  This implies that capital will flow less freely from country to country, and national budgets (while probably not balanced) will maintain much lower debt/GDP ratios.

Mr. Coggan also talked about the allure of working in the financial sector, which attracts the brightest minds in math, economics and even the natural sciences.  A friend of mine the other day was telling me about a recent Cambridge graduate who earned a PhD in biomedical engineering. She could have contributed tremendously to scientific fields like medicine and physiology, but instead, she went to work as an analyst for Goldman Sachs.  At LSE, I see equally brilliant people all the time who tell me, "Yeah, I'm really interested in poverty reduction in Africa, but I've only applied to Goldman Sachs and BCG."  It's a shame that such an unproductive sector, i.e. banking/finance, has such a monopoly on smart people.  Mr. Coggan is convinced that the gilding is about to wear off, though, and that all these would-be doctors and mathematicians and academics will be re-attracted to the pursuit of knowledge, rather than the creation of money.

Paul Krugman also brought up this issue of misappropriated human capital, citing a post by Greg Anrig (an excellent post, which I encourage you to read now) at the Century Foundation.  Really intelligent people are being forced to sit in front of a computer for their entire careers, helping rich people move their money around to find the lowest possible tax rate.  According to Krugman, the fact that the tax system is so complicated is "bad economics" because it diverts more human capital (i.e. smart people) into an industry (i.e. accounting/finance) than a less distorted market (i.e. with a simple tax code) would normally require.  Put simply, complicated tax codes mean really smart people have to be employed to figure it out, when they could (and, normatively, should) have have been employed elsewhere in more productive careers.  Anrig's fourth point sums this up nicely [italics added for emphasis]:

4. The tax-favored treatment of capital gains is a notorious source of complexity in the tax code, diverting the energies of highly paid accountants and lawyers into wasteful efforts to shelter the incomes of wealthy clients from taxes.  The elaborate tax forms known as Schedule D ("Capital Gains and Losses") and Form  8949 ("Sales and Other Dispositions of Capital Assets") provide a superficial glimpse at how the differential tax treatment of capital gains can suck up enormous quantities of time and money for the well-heeled and their tax pros. But much more costly and wasteful than the tedious forms are the strategic energies engaged in manipulating income flowing to the wealthy in ways that minimize tax liabilities....

[The shifting primary source of capital gains from stocks to "pass-through" entities] has required an enormous investment of brainpower, administrative work, and other energy that has profited individuals engaged in those activities without any discernable payoff to the rest of society. Little of that unproductive work would continue if capital gains were taxed at the same rates as earnings from work.

There's obviously a need for smart, well-trained financiers.  We need people to understand things like the derivatives class I sat in on this morning, which almost made me jump out of a window.  Finance is playing and will will continute to play a huge role in environmental and development initiatives (For a really excellent book on this, click here.), but we don't need millions of Excel experts whose job prospects rely on convoluted tax laws.  In a similar vein as Anrig's tenth point, society shouldn't glorify the financial analyst whose only job is to expand his client's wallet the global "capital pool".

I'm glad this debate has found its way into the mainstream.

London, Round 2

I arrived in London yesterday morning, and I'm excited to start the new term, especially since I only have class on Mondays and Tuesdays.

Some tasks for spring:

• Pick a dissertation topic
• Write that dissertation
• Find a job
• Get good grades
• Visit Istanbul
• Be a better blogger

I've haven't been great at keeping this blog (1) updated or (2) on track (i.e. environmental economics).  It's my blog, so I'm allowed to make fun of Republicans whenever I want to, but I'll start trying to focus more on the environmental side of money things.  Suggestions are always welcome, as are comments.