Let Them Eat Cake, But Raise Their Taxes

Newly-elected Alexandra Ocasio-Cortez (aka AOC) is the youngest person in Congress. She is becoming very well-known. Last week, she was asked about funding the Green New Deal, the plan to eliminate U.S. carbon emissions and move away from fossil fuels within ten years. This is what she said:

Once you get to the tippie-tops, on your $10 millionth dollar, sometimes you see tax rates as high as 60% or 70%. That doesn’t mean all $10 million dollars are taxed at an extremely high rate. But it means that as you climb up this ladder, you should be contributing more.

Right-wingers immediately screamed that a tax rate that high would be the equivalent of slavery. They didn’t bother to point out that she was referring to the “marginal” tax rate, the percentage at which income over a certain threshold is taxed. That’s very different from taking 60% or 70% of someone’s entire income.

The economist Paul Krugman explains why the 60% or 70% marginal rate is an excellent idea:

The rightโ€™s denunciation of AOCโ€™s โ€œinsaneโ€ policy ideas serves as a very good reminder of who is actually insane.

The controversy of the moment involves AOCโ€™s advocacy of a tax rate of 70-80 percent on very high incomes, which is obviously crazy, right? I mean, who thinks that makes sense? Only ignorant people like โ€ฆ um, Peter Diamond, Nobel laureate in economics and arguably the worldโ€™s leading expert on public finance…. And itโ€™s a policy nobody has ever implemented, aside from โ€ฆ the United States, for 35 years after World War II โ€” including the most successful period of economic growth in our history.

To be more specific, Diamond, in work with Emmanuel Saez โ€” one of our leading experts on inequality โ€” estimated the optimal top tax rateto be 73 percent. Some put it higher: Christina Romer, top macroeconomist and former head of President Obamaโ€™s Council of Economic Advisers, estimates it at more than 80 percent.[

Where do these numbers come from? Underlying the Diamond-Saez analysis are two propositions: Diminishing marginal utility and competitive markets.

Diminishing marginal utility [i.e. the value of something at the margin] is the common-sense notion that an extra dollar is worth a lot less in satisfaction to people with very high incomes than to those with low incomes. Give a family with an annual income of $20,000 an extra $1,000 and it will make a big difference to their lives. Give a guy who makes $1 million an extra thousand and heโ€™ll barely notice it.

What this implies for economic policy is that we shouldnโ€™t care what a policy does to the incomes of the very rich. A policy that makes the rich a bit poorer will affect only a handful of people, and will barely affect their life satisfaction, since they will still be able to buy whatever they want.

So why not tax them at 100 percent? The answer is that this would eliminate any incentive to do whatever it is they do to earn that much money, which would hurt the economy. In other words, tax policy toward the rich should have nothing to do with the interests of the rich, per se, but should only be concerned with how incentive effects change the behavior of the rich, and how this affects the rest of the population.

But hereโ€™s where competitive markets come in. In a perfectly competitive economy, with no monopoly power or other distortions โ€” which is the kind of economy conservatives want us to believe we have โ€” everyone gets paid his or her marginal product. That is, if you get paid $1000 an hour, itโ€™s because each extra hour you work adds $1000 worth to the economyโ€™s output.

In that case, however, why do we care how hard the rich work? If a rich man works an extra hour, adding $1000 to the economy, but gets paid $1000 for his efforts, the combined income of everyone else doesnโ€™t change, does it? Ah, but it does โ€” because he pays taxes on that extra $1000. So the social benefit from getting high-income individuals to work a bit harder is the tax revenue generated by that extra effort โ€” and conversely the cost of their working less is the reduction in the taxes they pay.

Or to put it a bit more succinctly, when taxing the rich, all we should care about is how much revenue we raise. The optimal tax rate on people with very high incomes is the rate that raises the maximum possible revenue.

And thatโ€™s something we can estimate, given evidence on how responsive the pre-tax income of the wealthy actually is to tax rates. As I said, Diamond and Saez put the optimal rate at 73 percent, Romer at over 80 percent โ€” which is consistent with what AOC said.

An aside: What if we take into account the reality that markets arenโ€™t perfectly competitive, that thereโ€™s a lot of monopoly power out there? The answer is that this almost surely makes the case for even higher tax rates, since high-income people presumably get a lot of those monopoly rents.

So AOC, far from showing her craziness, is fully in line with serious economic research. (I hear that sheโ€™s been talking to some very good economists.) Her critics, on the other hand, do indeed have crazy policy ideas โ€” and tax policy is at the heart of the crazy.

You see, Republicans almost universally advocate low taxes on the wealthy, based on the claim that tax cuts at the top will have huge beneficial effects on the economy. This claim rests on research by โ€ฆ well, nobody. There isnโ€™t any body of serious work supporting G.O.P. tax ideas, because the evidence is overwhelmingly against those ideas.

Increasing marginal rates as income rises is called “progressive” taxation. It’s fair and practical. Republicans are against it, preferring a “flat” tax, where all income is taxed at the same rate. A flat tax let’s the rich keep more of their income. They say it’s fair and simple, but that’s not why they’re for it.