Mankiw: I Can Afford Higher Taxes. But They’ll Make Me Work Less.

Filed Under (U.S. Fiscal Policy) by Nolan Miller on Oct 21, 2010

I try to be an intellectually honest economist.  As such, answers to complex policy questions such as whether we should raise taxes on the highest-income Americans should, I believe, depend on a number of empirical factors about the costs of taxation, losses due to decreased work incentives, and the benefits of redistributing wealth from rich to poor.  To my point of view, sometimes the costs and benefits line up in favor of lowering taxes, sometimes they line up in favor of raising taxes.  But, from a policy perspective, this is fundamentally an empirical question.

This is the reason why I find it so frustrating to listen to ideologues on the left and right who seem to know the answer to the question before looking at the facts.  And, this is why I found Greg Mankiw’s recent column in the New York Times to be so refreshing.  In the piece, Mankiw, who is a Harvard economist and chaired the Council of Economic Advisors under George W. Bush, made the following point about President Obama’s proposal to increase marginal tax rates for Americans with the highest income: the rich can afford to pay higher taxes, but raising tax rates will probably make them work less.  Upon reading this I thought to myself “finally, somebody who presents both sides of an argument.”

Rather than rehash Mankiw’s argument, in which he discusses the impact of taxes on his own incentives to engage in discretionary labor such as giving an additional invited lecture, I’ll let Mankiw’s piece speak for itself.  Although some are disputing his exact numbers (see Mankiw’s response here), the basic point is clear.  Rich people probably can afford to pay more in taxes.  But, we should not assume that just because rich people can afford to pay more taxes, that increasing taxes on the rich would be without costs.  In response, we should expect that these people will work less.  We’re probably not talking about Atlas Shrugged here, with the economy grinding to a halt, but we should expect that people will work less.  As with every policy, there are costs and benefits.

So, what is the right way to think about whether we should raise taxes on the rich as a way to close the budget gap?  Well, there are alternatives to raising taxes on the rich: we could reduce spending, raise taxes on everyone, or just continue to fund the government by issuing debt.  Each of these has its costs and benefits.  An intellectually honest approach to the problem involves carefully laying out the costs and benefits of each and deciding, based on overall social goals, which one does the best job.  To argue either that, just because the rich can afford to pay more they should pay more, or that just because higher taxes will reduce work incentives for the rich they should not be raised, is ideology, not economics.

Should a Proposal “Pay for Itself” (and How do We Know if it Does)?

Filed Under (U.S. Fiscal Policy) by Don Fullerton on Sep 18, 2009

A member of Congress who wants to spend additional money often has to say what tax will be raised to pay for it.  Somebody else who wants a particular tax cut for their favorite lobbyist may have to say what other tax will be raised.  As a general principle, this kind of “budget neutrality” is often a good idea.  In all likelihood, the Tax Reform Act of 1986 only succeeded because it was revenue neutral.  It broadened the tax base and lowered tax rates, to fix the tax system without changing the amount collected.

But how is revenue neutrality calculated?  Politicians on both sides of the aisle call upon the non-partisan Congressional Budget Office (CBO) as the arbiter of budget balance.  If important policy choices must pass the CBO’s litmus test, then we need to understand what test is being administered.  According to its website, the “CBO’s [cost estimate] statement must also include an assessment of what funding is authorized in the bill to cover the costs of the mandates and, for intergovernmental mandates, an estimate of the appropriations needed to fund such authorizations for up to 10 years after the mandate is effective” (http://www.cbo.gov/CEBackground.shtml).  This CBO test has a few major problems that could limit the benefits from a policy, or even prevent enactment of a good policy.

First of all, not every act of Congress must be revenue neutral.  But policymakers may want the restriction of revenue neutrality, in order to “prove” they are fiscally responsible.  Recently, President Obama in his health care policy speech to a joint session of Congress promised that he “will not sign a plan that adds one dime to our deficits — either now or in the future.”  Thus, one general problem is: who decides which projects must be revenue neutral?

Second, of course, a project may generate revenue or cost savings after ten years.  President Obama’s health care reform has initial start up costs, but it may “bend” the long-run cost curve for federal expenditures on Medicare and Medicaid, so that cost savings accrue and accumulate over more than ten years.  In general, the CBO’s ten-year balance sheet could say that a policy adds to the debt over ten years, even though it may save taxpayer dollars in the long-run.  On Wednesday, September 16, 2009, the CBO released its official cost estimate for the Senate Finance Committee’s draft health care bill, stating that it would have a “net reduction in federal budget deficits of $49 billion over the 2010–2019 period” (http://cboblog.cbo.gov/?p=354).  However, an additional, unofficial estimate by the CBO concluded that the “the added revenues and cost savings are projected to grow more rapidly than the cost of the coverage expansion”, meaning that over a longer time horizon that the bill further reduces the deficits.

To be clear, the federal debt is a real concern.  Running massive deficits that pile up year after year is unsustainable and irresponsible.  But a strict CBO ten-year cost estimate test may not be the best way to evaluate a potential policy change.

A third problem is that any such test must be somewhat arbitrary, regarding what is counted as “revenue”.  Does it just count actual dollars flowing into government coffers?  What about features of a policy that reduce future outflows?  Some pieces of additional spending in proposed health care reforms are intended to improve future heath and thus to avoid the need for some future medical expenses.  The CBO would count current “preventive care” spending as a cost, but it may not count the fact that this current spending could reduce the need for Medicare and Medicaid to pay for some future medical procedures.

Fourth, and most importantly, even if NOT revenue-neutral, SOME policies are still valuable, important, and worthwhile.  A project may have generalized benefit to everybody in society that exceeds the actual social cost, meaning that it passes a benefit-cost test, even though it requires government spending and is not “revenue neutral”.

Any revenue-neutrality test is a way for policymakers to “tie themselves to the mast” and prevent them from pork spending of the most egregious sort.  Maybe that’s good and worthwhile.  But it may also mean we can’t have some other worthwhile policies either.