Lionizing Wealthy Americans, Rather Than Taxing Them

A new paper on optimal taxes in the latest edition of the Journal of Economic Perspectives, by the economists Peter Diamond and Emmanuel Saez, is a tough read (I’m still working on it myself), but there’s one discussion that I think helps make a useful point about current political debate.

In the first part of the paper, “The Case for a Progressive Tax: From Basic Research to Policy Recommendations,” Mr. Diamond and Mr. Saez analyze the optimal tax rate on top earners in the United States. And they argue that this should be the rate that maximizes the revenue collected from these top earners — full stop. Why? Because if you’re trying to maximize any sort of aggregate welfare measure, it’s clear that a marginal dollar of income makes very little difference to the welfare of the wealthy, as compared with the difference it makes to the welfare of the poor and middle class. So to a first approximation, policy should soak the rich for the maximum amount — not out of envy or a desire to punish, but simply to raise as much money as possible for other purposes.

Now, this doesn’t imply a 100 percent tax rate, because there are going to be behavioral responses — high earners will generate at least somewhat less taxable income in the face of a high tax rate, either by actually working less or by pushing their earnings underground. Using parameters based on the literature, Mr. Diamond and Mr. Saez suggest that the optimal tax rate on the highest earners is in the vicinity of 70 percent.

I hear loud screams from the right side of the room.

Parsing those screams, I hear the following arguments:

1. Theft! Tyranny! O.K., I hear you. This can’t be argued on rational grounds; I think there are a lot more important moral issues in the world than defending the right of the rich to keep their money, but whatever.

2. They’ll go John Galt! This amounts to saying that Mr. Diamond and Mr. Saez’s estimate of “behavioral elasticity” is too low. Maybe, but they’re pretty careful about that, and your gut isn’t better than their econometrics.

3. You’ll kill job creation! This is where it gets interesting.

Right now the official rhetoric of the right, and a fair number of people who consider themselves centrist, is that high-income individuals are “job creators” who must be cherished for the good they do.

Yet textbook economics says that in a competitive economy, the contribution any individual (or for that matter any factor of production) makes to the economy at the margin is what that individual earns — period. What a worker contributes to gross domestic product with an additional hour of work is that worker’s hourly wage, whether that hourly wage is $6 or $60,000 an hour. This in turn means that the effect on everyone else’s income if a worker chooses to work one hour less is precisely zero. If a hedge fund manager gets $60,000 an hour, and he works one hour less, he reduces G.D.P. by $60,000 — but he also reduces his pay by $60,000, so the net effect on other peoples’ incomes is zip.

Of course, he doesn’t actually lose all of that $60,000, since he ends up paying less in taxes. So there is a loss of revenue from that withdrawal of effort. But that’s precisely what the Diamond-Saez calculation takes into account, and the reason the optimal top tax rate isn’t 100 percent.

So, are conservatives comfortable with this analysis? I would guess not, since they have a deep-seated belief that the 1 percent, by working harder, are doing the 99 percent a big favor, creating jobs and raising incomes — and that this gain isn’t fully (or even largely) captured by the money they’re paid. My point, then, is that this claim — and the lionization of high earners as people who make a vast contribution to society — is not, in fact, something that comes out of the free-market economic principles these people claim to believe in. Even if you believe that the top 1 percent, or better yet the top 0.1 percent, are actually earning the money they make, what they contribute is what they get, and they deserve no special solicitude.

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Paul Krugman joined The New York Times in 1999 as a columnist on the Op-Ed page and continues as a professor of economics and international affairs at Princeton University. He was awarded the Nobel in economic science in 2008.

Mr Krugman is the author or editor of 20 books and more than 200 papers in professional journals and edited volumes, including “The Return of Depression Economics” (2008) and “The Conscience of a Liberal” (2007). Copyright 2011 The New York Times.