Why Able Abel has to be taxed?

Karl Smith points to this morality tale by Bryan Kaplan,

Suppose there are ten people on a desert island. One, named Able Abel, is extremely able.  With a hard day’s work, Able can produce enough to feed all ten people on the island.  Eight islanders are marginally able.  With a hard day’s work, each can produce enough to feed one person.  The last person, Hapless Harry, is extremely unable.  Harry can’t produce any food at all.
Questions:
1. Do the bottom nine have a right to tax Abel’s surplus to support Harry?
2. Suppose Abel only produces enough food to support himself, and relaxes the rest of the day.  Do the bottom nine have a right to force Abel to work more to support Harry?
3. Do the bottom nine have a right to tax Abel’s surplus to raise everyone‘s standard of living above subsistence?
4. Suppose Abel only produces enough food to support himself, and relaxes the rest of the day.  Do the bottom nine have a right to force Abel to work more to raise everyone‘s standard of living above subsistence?
How would most people answer these questions?  It’s hard to say.  It’s easy to feel sorry for the bottom nine.  But #1 and #3 arguably turn Abel into a slave.  And #2 and #4 clearly turn Abel into a slave.  I suspect that plenty of non-libertarians would share these libertarian moral intuitions.  At minimum, many would be conflicted.

The tale and the conclusions drawn lie at the heart of libertarian opposition to taxation and government intervention. But in the real world, the tale does not end as Kaplan envisions, but goes on. And here is a possible (among many) sequel.

Able Abel knows that he can produce more (of say, dates) and sell it to others and use the money realized to increase the quality of his leisure. He has heard of the neighbouring village island, Fishland, where he can pursue his dream hobby, fishing. So he strikes a deal with his other inhabitants. He offers to transfer a share of his extra production, if they help him with laying a road to transport his produce from the far-off fields to their village. 

Accordingly, the eight marginally able people sell one-fourth of their time to help Able Abel lay the road. However, taking pity on Harry, they also demand that he be provided subsistence feed by Able Abel, who readily agrees. Within three months the road is completed and simultaneously Able Abel has stored enough food for a week to cover his fishing expedition. 

He travels to Fishland and starts fishing. Now the people of Fishland find the dates which Abel eats irresistible and they offer him a deal. If Abel supplies them with ten bags of dates, they will in turn provide him accommodation for his fishing expeditions and also five buckets of fish, which he can take back and sell to his desert island villagers. Abel takes back fish samples to his village. As anticipated, his villagers like the fish and immediately agrees to buy it. 

But again the transportation problem crops up. Abel needs help to lay the road so as to transport dates and fish. Now it is a much longer road and needs help from the people of Fishland too. They all agree to contribute a share of their work in return for a share of Abel's earnings - dates for the people of Fishland and fishes for those from his village, including for Harry. And so the story goes on.

As can be seen, the fundamental issue here is not taxation or other transfers. Able Abel can pursue his economic activity only with help from his co-inhabitants. In the barter-world, this help comes in the form of work-sharing in return for a share of Abel's production. In the modern world, instead of the in-kind transfer, a share of his production or revenues is appropriated, in the form of taxation, to meet the cost of the infrastructure required to carry out that activity.

This help or support required to sustain an economic activity can be in many forms - maintenance of law and order to protect against thieves; mechanism to enforce contractual obligations; infrastructure to transport and store goods, and so on. It is unviable for individual economic agents to establish these support mechanisms. Someone has to co-ordinate the demands of all those needing these support systems and collect the cost required to establish and maintain them. The government steps in to provide them in return for a share in their incomes, in the form of taxation.

As I have blogged earlier, the abler, and consequently those more likely to be rich and well-off, generally benefit greater from these support systems. It is therefore only appropriate that they bear a greater share of the cost required to establish and maintain these systems.

Just as the eight villagers sympathized with Harry and demanded that Abel provide him with a share of Abel's produce in return for their labour to construct the road, there are certain underlying currents of morality in any society. Once social agreement on them break-down, Harry would not be able to rely on society to provide for him. Thankfully, societies today collectively agree on certain minimum moral principles, whose fulfillment they seek to achieve by setting apart a share of the proceeds from the taxation revenues. In simple terms, their willingness to contribute to the establishment of the support systems (which help people like Able Abel disproportionately) is conditional on the fulfillment of these moral obligations. 

To paraphrase Adam Smith, the villagers of the desert island and Harry get a share of Able Abel's produce not because of charity or some moral code or government expropriation, but because his own self-interest encourages Abel to strike the deal.   

Inequality and taxation in the US

America's deep fiscal hole and spectacular income growth at the top of the income ladder has ignited a debate on increasing the marginal tax rates, especially for the richest.

This striking graphic from Thomas Piketty and Emannuel Saez brilliantly captures the stunning magnitude of concentration of wealth at the top over the past quarter century. In order to mitigate the effects of this, they propose a "much higher top marginal tax rates on the rich, up to 50 percent, or 70 percent or even 90 percent, from the current top rate of 35 percent". Peter Diamond and Emmanuel Saez have estimated that the optimal tax rate on the highest earners is in the vicinity of 70%.


In fact since the mid-eighties, income gains at the topmost part of the income ladder dwarf those elsewhere. As the after-tax incomes of the top 1% households rose 277% in the1979-2007 period, those of the bottom quintile just nudged up 18%.

An important contributory factor to this rise in income inequality has been the declining marginal tax rates. As David Leonhardt points out, the effective tax rates - including income, payroll, and all other federal taxes - have declined dramatically in the last 50 years for the very rich. The US tax code while still progressive, is not nearly as progressive as it used to be.

See also this excellent series of graphics from Derek Thompson.

Update 1 (29/4/2012)

The Times has this graphic which shows how as corporate profits have exploded, effective tax rates have fallen. 

 

What is the maximum marginal tax rate?

Large sovereign debts and fiscal deficits are the biggest problems facing many developed world economies, including the United States. In this context, the need to raise government revenues has naturally led to a debate about raising taxes and, in particular, the impact of raising the marginal income tax rates on the incentive to work.

Christina and David Romer have a new working paper which examined the impact of the frequent, drastic, and heteregenous policy-induced changes in marginal tax rates on the incentive to work of those at the top 0.05% of the income distribution during the inter-war years. They write about four findings,

First, consistent with what one would expect given the tremendous identifying variation, they are very precise. Second, they show that taxes are indeed distortionary: the null hypothesis of no effect is overwhelmingly rejected. Third, they indicate that the distortions are small. Our baseline estimate of the elasticity of taxable income with respect to the after-tax share (that is, one minus the marginal tax rate) is approximately 0.2. This is considerably smaller than the findings of postwar studies (though generally within their confidence intervals). Finally, the estimates are extremely robust.

James Kwak interprets the Romer's finding that the elasticity of taxable income for these 0.05% (the super-rich) with respect to changes in the after-tax income share is 0.19.

"An elasticity of 0.19 implies that tax revenues would be maximized with a tax rate of 84 percent; that is, you could raise taxes up to 84 percent before people’s reduced incentives to make money would compensate for the higher tax rates."

He argues that instead of being dis-incentivized from working, these super-rich respond by trying to game the tax system,

Recent US history shows that when you raise taxes on the rich, they don’t stop trying to make money: they just pay their lawyers and accountants more to avoid paying taxes. The solution to that is a simpler tax code with fewer exclusions and deductions.

The interpretation of James Kwak is close to that estimated by a study on optimal taxes by Peter Diamond and Emmanuel Saez. Using parameters based on the literature, they suggest that the optimal tax rate on the highest earners is in the vicinity of 70%. See Paul Krugman's discussion here.

In this context Karl Smith points to the interaction between income and work to add another explanation for why the impact of higher marginal tax rates on the super-rich is likely to be minimal. As people grow rich, they slowly substitute their domestic and other non-core (other than their income earning activity) work and time/effort expenditures by hiring others to do that work (like household chores) or private charters (using their private jets instead of waiting at the airports) so that they can spend more time on their core-activity. This in turn increases incomes further. However, as they become super-rich, they would have more or less exhausted such substitution alternatives. They become indifferent to any marginal income changes.

India's fiscal crisis in graphics

It is clear that whatever the RBI does with monetary accommodation, the path towards creating conditions for sustainable economic growth lies in reining in the growing fiscal deficit.



A recent report by the Goldman Sachs estimated the combined fiscal deficit of states and center for 2011-12 to touch 9% of the GDP, easily the highest among all the major emerging economies. It attributes this high deficit to the twin problem of falling tax base and ballooning subsidy burden. The Rs 40000 Cr gap in the ambitious disinvestment target is another major contributor.



The biggest long-term concern is the low tax-to-GDP ratio. India's tax-to-GDP ratio is again among the lowest among the major emerging economies.



Worse still, after steadily rising since beginning of the last decade, it has been falling since the recession struck. And it shows no signs of having bottomed out and is expected to fall further this year.



Subsidies are the elephant in the room. The food, fertilizer and fuel subsidy bills have been rising alarmingly in recent years. Unfortunately, with the 2014 elections looming large, the prospects of structural reforms to roll-back subsidies appears bleak.

Are superstar cricketers like landlords?

Rajeev makes an interesting observation about India's high-paid superstar cricketers and the role of happenstance and good-luck in contributing to their fortunes,

Since the 1980s, the best cricket players in India have been growing ever richer. However, that they earn a hundred times what their predecessors used to earn doesn't mean that they are a hundred times as good at the game. They have grown richer mainly because Indians now watch television. In some other countries, the benefits have gone to Football players, while in other countries, Basketball players have gained. These beneficiaries may be great athletes, and they "deserve" their incomes in the sense that this is what others willingly pay them in the marketplace. They are like landlords who have seen the value of their properties explode because someone else built a highway or a railway station nearby.

I am in complete agreement on the role of luck in these cricketers fortunes, especially in relation to players from other sport like Hockey. But the analogy with landed rentier-class enjoying the windfall value appreciation from infrastructure and commercial development in the neighbourhood is debatable.

For one, unlike unproductive landlords, these cricketers are talented, hard-working, and productive and deserve to be rewarded. However, even if the market agrees, it is questionable as to whether they "deserve" their current extraodrinary incomes. Critics are right in asking whether their incomes are disproportionate to their abilities and productivity, especially when considered in relation to their peers in other more globally competitive sports.

But this analogy can be extended to many other areas and stands at the heart of the debate about executive compensation itself. Do traders, bankers, and corporate executives "deserve" the fantastic compensation packages they receive? While conceding their abilities and even a substantial premium in their salaries, it is very difficult to justify the size of their remuneration.

Consider this. Two friends, of more or less equal abilities, pass out of engineering college and pursue careers in core engineering and in finance. The former does an MS while his friend does an MBA, both from prestigious universities with equally stiff entry competition. Ten years down the line, the financial specialist earns five (or many) times more than the engineer.

It is too much a stretch to claim that the former has acquired superior skills or is more productive than the latter. The most charitable thing that can be said about his vast riches is that he was lucky to choose the right profession at the right time. And within the profession, he happened to specialize in the right sector and in the right firm. And, we could justly add, in case of financial market executives, that he happened to make the right bets, atleast till date.

Much the same underlying logic can be applied to analyzing the fairness and merits of remuneration in several fields, especially where it is disproportionately higher than the norm in similarly placed occupations. The wage-premium due to good luck is too high to be ignored. In this context, as I have blogged earlier, it may be fair to appropriate some of this disproportionate luck by imposing a higher marginal tax rate on those at the top of the income ladder.

Matt Yglesias too feels that large parts of the economy is becoming more Ricardian with higher resource rents.

Why redistribution matters?

John Sides in The Monkey Cage has an excellent post that points to the distinction between the progressivity of taxation and the level of inequality.

This paper by Moinca Prasad and Yingying Deng has an excellent graphic of the progressivity of direct taxes, as measured by the Kakwani index of taxation (a measure of the progressivity in the distribution of taxes among different categories that controls for the impact of income concentration on the concentration of the tax burden), in many advanced countries.



However, given its relatively higher Gini coefficient, America's progressivity of taxation does not translate into lower income inequality. So what gives? The aforementioned paper shows that the high progressivity in America's taxation system is matched by the low level of income redistribution through welfare policies. In simple terms, it is America's welfare policy that needs immediate attention than its taxation policy. The graphic below highlights the role played by income redistribution in lowering inequality.



The Scandinavian countries achieve twice as much inequality reduction (as measured by the lowering of their respective Gini coefficients) by redistributive policies than the Anglo-American nations. It is not a coincidence that these countries have much higher levels of taxation as measured by their higher tax-to-GDP ratios. It appears that higher redistribution goes hand-in-hand with higher levels of taxation.



Interestingly, the association between tax progressivity and overall re-distribution through taxation across countries is negative.



Though the study speculates on several political economy reasons, none of them are satisfactory enough to provide a good explanation for this surprising inverse correlation.

These graphics are an excellent empirical illustration of the importance of enlightened public policy in lowering inequality and poverty. It is also a strong reminder to free-market evangelists that unfettered markets fail to achieve the desired conditions necessary to promote growth and reduce poverty and inequality.

Tax and transfer to reduce inequality

I have blogged repeatedly about the critical role played by government transfers in reducing inequality and the unsustainability of economic growth in conditions of high inequality. However, transfers require tax revenues. This highlights the importance of taxation in addressing poverty and creating conditions for sustainable economic growth. The graphic below from The Economist draws attention to this.



In most European nations, the poverty rates are lower only because of the significant role played by government transfers. Transfers nearly halve poverty rates in these countries. Contrast this with the United States where the lower extent of transfers are responsible for keeping poverty rates high.

The role of taxes and transfers is even more pronounced with inequality measures. Similar trans-Atlantic trends persist with inequality reduction due to taxes and transfers. In case of many developing countries, as the cases of Mexico, Brazil, and Chile show, the low levels of transfers contribute towards their poverty and high inequality rates.

India tax fact of the day

The Comptroller and Auditor General (CAG) in its report tabled in parliament last year, found that as against the statutory 33.9%, 179 top companies with profit before tax (PBT) of Rs500 crore and above paid an effective tax rate of 22.1% in 2008-09. On the other hand, the effective rate for the companies up to PBT of only Rs1 crore was more at 25.5%, suggesting that tax concessions are being availed of mainly by large companies.

(HT : Livemint)

Why taxes are important to reduce poverty and inequality?

Free market conservatives oppose big government and favor reduction in taxes as the preferred route to the achievement of economic growth. They argue that governments are inherently ineffective in efficiently allocating resources and therefore should give way and facilitate private enterprise to achieve the same objective.

They claim that economic growth, thus achieved, will "trickle down" to benefit everyone by way of more jobs, higher wages, and better living standards. They therefore advocate that government's role should be confined to unshackling the restraints to private enterprise and providing everyone with the basic opportunities - health care, education, and skills - to compete in the market.

However, as Lane Kenworthy (see also this earlier) points out with empirical evidence, reality is not as simple. In fact, examining the trends in income levels among those at the lower end of the income ladder in the advanced economies since the 19760s, he finds that it was not trickle down but direct transfers that kept incomes growing. He writes,

"In almost all of these countries (Ireland and the Netherlands are exceptions) the earnings of low-end households increased little, if at all, over time. Instead, increases in net government transfers — transfers received minus taxes paid — tended to drive increases in incomes when they occurred."

The graphic below captures the average household income in the bottom decile of the posttransfer-posttax income distribution. Group 1 is Denmark, Finland, Ireland, Netherlands, Norway, Sweden, and United Kingdom, while Group 2 includes Australia, Canada, Germany, Switzerland, and United States.



Clearly, incomes have increased substantially after transfers for those in Group 1. In fact, Kenworthy goes further and argues that jobs and higher wages cannot produce the same trickle down effect on those at the bottom end. He writes,

"At higher points in the income distribution, they do play more of a role. But for the bottom 10 percent there are limits to what employment can accomplish. Some people have psychological, cognitive, or physical conditions that limit their earnings capability. Others are constrained by family circumstances. At any given point in time, some will be out of work due to structural or cyclical unemployment. And in all rich countries, a large and growing number of households are headed by retirees. We surely can do better at helping able adults get into (or back into) employment, but we shouldn’t pretend that paid work is a realistic route to guaranteeing rising incomes for everyone."

He also points to the importance of keeping income transfers dynamic enough to ensure that its share of incomes do not fall appreciably with time. He draws attention to the fact that in most affluent nations, including the Scandinavian ones, while transfers have increased, it has not done so at the rate required to keep its share of the GDP from falling. He writes,

"In most of these affluent nations... increases in the share of GDP allocated to public transfers largely stopped after the 1970s. In recent decades, the distinction has been between countries that kept transfers rising in line with GDP versus those that did not. Sometimes doing so requires no explicit policy change, as benefit levels tend to rise automatically as the economy grows. This happens when, for instance, pensions, unemployment compensation, and related benefits are indexed to average wages. Increases in other transfers, such as social assistance, typically require periodic policy updates. That’s true also of tax reductions for low-income households."

In particular about the US, his suggestion is,

"What the income data tell us is that the United States has done less well by its poor than many other affluent nations, because we’ve failed to keep government supports for the least well-off rising in sync with our GDP... Modest, regularized increases in the inflation-adjusted benefit levels of existing social programs — the Earned Income Tax Credit, unemployment compensation, social assistance (TANF and SNAP), housing assistance, and disability benefits — would yield significant improvements in the incomes of America’s least well-off."

Kenworthy's findings carry important lessons for policy makers in India. It clearly establishes that economic growth alone cannot address the problems of poverty and inequality, all the more so in regulated and under-developed markets like India. Government transfers are more important in achieving poverty reduction objective, especially for those at the bottom of the income ladder. However, there are two points of qualification.

One, transfers can be meaningful only when the the fiscal balance is in order and governments have the resources to carry out such transfers. Robust economic growth is the only route to keeping public finances in good strength. Two, it is important to ensure that these resources are utilized to deliver bang for the buck. The most effective strategy to optimize public spending is to channel it towards those activities which address market failures and enables equality of opportunity to all citizens in accessing the market. This requires a very scarce commodity - far-sightedness in public policy making.

Framing the inequality debate

Widening inequality is arguably one of the most important socio-economic challenges facing societies, rich and poor, across the world. Unfortunately, despite the steep widening of inequality in recent years, it has not generated the anticipated level of social outrage.

In a recent article in the NYT, Ian Ayres and Aaron Edlinn, had called for a Brandeis tax, as a tax directly on inequality. The Brandeis Ratio is the average income of the richest one percent of household to the average median household income. This ratio has risen alarmingly from 12.5 in 1980 to 36 by 2006. The Brandeis tax be an automatic extra tax on the income of the top 1 percent of earners — a tax that would limit the after-tax incomes of this club to 36 times the median household income. It would therefore be an inequality capping tax.

In a series of posts in Freakonomics, they take their argument one step ahead and advocate that the debate on income inequality be framed in terms of "medians". They write,

"Framing income inequality in terms of "medians" is also part of a larger goal of making the median household incomes more salient... Part of our goal is to change the way politicians speak about income equality. Framing the income of the wealthy in relation to the median income will help us all keep in mind the relative success of the middle class.

It might even be useful to describe other things in terms of medians. A new Cadillac Escalade will run you 1.4 medians. A year’s tuition at Yale Law School is about .88 medians. We might even restructure government salaries so that they automatically adjust with the median... To raise the prominence of the median measure, government could standardize a "mi" symbol."

Behavioural psychologists have long pointed to the power of framing in re-orienting the human mind. In the instant case, absolute income numbers are not very effective in signalling about the degree of inequality. However, when the same is framed in terms of "mi", the extent of inequality becomes cognitively striking.

Similar framing can be an effective strategy in the various conservation (water, electricity etc) and environmental awareness campaigns. Water closets could be rated based on the number of buckets of water used. Air conditioners can be rated by describing their energy consumption as a multiple of that of a fan. In all these cases, the message is framed in a language that is readily graspable and therefore cognitively salient.

In this context, economist Robert Frank has constructed a Toil Index to more evocatively highlight the middle-class squeeze. It represents the number of monthly hours of work required to rent a house in an area served by a school of average quality. And it has just shot up vertically since the last decade.

India's software sector and exchange rate fluctuations

In the second half of 2010, spurred by capital inflows, the rupee appreciated substantially against the dollar. Infosys CFO V Balakrishnan then called for urgent intervention by the RBI to stabilize the currency,

"The RBI should intervene right now to halt heavy speculative inflows through the FII (foreign institutional investments) route to reduce the currency volatility, which is currently ranging from 10-15 percent... With a trade deficit of $13 billion, such a wide currency fluctuation is unsustainable for the country as well as the software services sector, which depends largely on export revenues. We hope the central bank (RBI) will step in to ensure the quality of inflows."

Now, with the opposite trend playing out and rupee falling sharply, thereby boosting the rupee value of software exports, Narayana Murthy finds nothing amiss and finds it a general phenomenon,

"Value of rupee keeps fluctuating. This is normal. At some point of time value of Rupee was at 39 against a dollar."

The two contrasting, or opportunistic, remarks provide an insightful peek into India's software industry. The software sector, while undoubtedly globally competititive, benefits from substantial government support. It continues to enjoy most of the benefits extended to it as a sunrise industry in the nineties. The industry has lobbied intensely to retain the tax breaks given to exporters located inside the Software Technology Parks. The sector has the lowest effective tax rate of 15-18%, compared to the statutory corporate tax rate of 34%, and lobbies hard against removing tax exemptions.

Used to double digit growth rates for decades now, it is important that India's software sector adjust to the vagaries of global market place. Instead of relying on free lunches resulting from cheap labour, low tax rate or weak currency, the industry should seek to raise its competitiveness by increasing productivity and moving up the value chain.

Capital gains and income inequality

Capital gains, mainly from financial assets, is the biggest source of income growth for those at the top of the income ladder. Consider this from an Economix post by Laura Tyson,

According to the Congressional Budget Office, from 2002 to 2007 more than four-fifths of the increase in income inequality was the result of an increase in the share of household income from capital gains, with the remainder the result of an increase in other forms of capital income. Capital and business income are much more unevenly distributed than labor income and have become more so over time. Capital gains income is the most unevenly distributed — and volatile — source of household income. The top 0.1 percent earns about half of all capital gains, and such gains account for about 60 percent of the income of the top 400 taxpayers.

Ironically, it is also that income stream which is taxed at the lowest rate. Capital gains tax was lowered from 28% to 20% by Clinton in 1997 and then to 15% by Bush in 2003. As "carried interest", President Bush extended this rate to fees earned by hedge fund and private equity managers. In other words, while wages are subject to both federal income tax and the payroll tax, capital gains and dividends are taxed at 15% and are not subject to the payroll tax.

These trends are not unique to the US and has become the norm across the world. In fact, in India, long-term capital gains, defined by investment of more than one year, in many assets are tax exempt. Apart from the dramatic concentration of wealth and the widening inequality, the incentives created by the lower capital gains taxes is responsible for the skewed growth of the financial sector itself. Raising this tax to the level of that for other labor income streams, would curtail outsize compensation in the financial sector. Besides, in these times of fiscal crisis, it would provide a much needed boost to government finances.

The largest income transfer in history?

I have blogged here, here, and here with graphics about the alarming concentration of wealth in the US. But this superb graphic series in Mother Jones is simply outstanding and cognitively striking.

This graphic compares how much various income groups make today versus how much they would be making if everyone's incomes had grown at similar rates since 1979. By 2005, the bottom 80% were collectively earning about $743 billion less per year while the top 1% were earning about $673 billion more.



Over the past three decades, the US economy has become the classic winner takes all economy. Even as incomes of all others have remained more or less stationary, those of the top 1% have ballooned.



Productivity has increased, but income and wages have stagnated for all Americans, except those at the top one percentile.



Despite all these, why do Tea Party activism generate front page news? It can atleast partially be attributed to ignorance, as this cognitively striking graphical representations of actual distribution of income and wealth conveys.



I would not be surprised if this would constitute the largest income transfer ever in history anywhere in the world from one income category to another. The public policy dynamics of these three decades in the US has facilitated this widening of inequality. On similar issues, see the comparison of the US with Canada, Germany and Sweden.

Would be great to have such graphical representations of income distribution and other inequality determining aspects in India. The importance of such information in awareness creation and contributing to the depth of public debates on issues of popular concern is underestimated. If the rich data collected by state and central government departments, including the census office, on various sectors is made freely available in readily usable formats, it would be picked up by various advocacy groups and researchers, to generate such striking graphics. Public debate would be the richer for that.

Taxes and growth/incentives

The central tenet of supply-side economics has been the argument that higher taxes disincentivizes human effort and therefore a reduction in taxes will increase effort and total tax revenues. Paul Samuelson called this "snake oil economics" and it has been repeatedly exposed as being based on questionable assumptions.

Here are two latest examples that contradict this claim. One, Antonio Fatas (in response to Robert Lucas's claim that higher marginal tax rates in Europe discourage married women from working) posts a chart of marginal tax rates and female employment to population ratio for the 25-54 age range for 2010. It shows that countries with high taxes show higher level of efforts as measured by employment to population ratios, whereas the US, with its low taxes, also has low levels of effort.



Second, the CBPP blog points to the respective impacts on output and employment of the Clinton tax increases in the nineties and the Bush tax cuts in the last decade. Both job creation and economic growth were significantly stronger in the recovery following the Clinton tax increase than they were following the 2001 Bush tax cut.



Update 1 (7/10/2011)

Matt Yglesias points to the fact that the late Steve Jobs, despite being a more successful businessman than Bill Gates or Larry Page, has a modest share of Apple's massive market capitalization. He writes,

"It’s worth thinking about this kind of thing when trying to consider the impact of financial incentives at the margin for high-achievers. Greg Mankiw and others, I think, want us to believe that the ups-and-downs of the estate tax were an important driver of the quantity and quality of entrepreneurial effort undertaken by these guys. That doesn’t seem even remotely right to me."

The "Tax Us More" movement

In a case of supreme irony, as the sovereign debt crisis lurches on, atleast some of the super-rich Europeans and Americans have appropriated the leadership mantle vacated by their political leaders and are advocating higher taxes on themselves.



Consider this. On the one hand, the political leaders and economists have been arguing that higher taxes will distort incentives, discourage people from working, and therefore lower total tax revenues. On the other hand, now the same rich target group, who the former have been trying to protect from higher taxes, comes forward and says, "why are you molly-coddling us, we want you to impose higher taxes"!



Warren Buffet took the leadership role in the US with his remarkable NYT op-ed a few days back. In Europe, the voices for higher self-taxation has been growing. A group of 16 of the richest people in France - Liliane Bettencourt, the billionaire heiress of L’Oreal; Christophe de Margerie, the head of oil giant Total; Frederic Oudea of bank Société Générale; and Jean-Cyril Spinetta, president of Air France KLM SA - signed a petition asking the French government to increase their taxes.



Their offer of a "special contribution" to tide over the difficult times is a refreshingly candid acknowledgement of their desire to perpetuate the existing system,

"We are conscious of having benefited from a French system and a European environment that we are attached to and which we hope to help maintain... When the public finances’ deficit and the prospects of a worsening state debt threaten the future of France and Europe and when the government is asking everybody for solidarity, it seems necessary for us to contribute."

Taking cue from them, a group of 50 rich Germans, who claim that they have "more money than they need", have joined the "tax me harder" movement and called on Chancellor Angela Merkel to "stop the gap between rich and poor getting even bigger". The German group, Vermögende für eine Vermögensabgabe (The Wealthy for a Capital Levy), consisting of not the super-rich, but inheritors of fortunes, claims Germany could raise €100bn (£88.5bn) if the richest (individuals with more than €500,000 in capital wealth) paid a 5% wealth tax for two years. One of them said,

"I would say to Merkel that the answer to sorting out Germany's financial problems, our public debt, is not to bring in cuts, which will disproportionately hit poorer people, but to tax the wealthy more. We are always hearing about savings packages, but never tax rises. Yet tax increases are a way out of this mess. That's where the money is: rich people... Something needs to be done to stop the gap between rich and poor getting even bigger."

An Italian, Luca di Montezemolo, President of the iconic Ferrari Group, too has joined in offereing to pay higher taxes. It is the strongest indictment of the absence of leadership among governments facing an extraordinary sovereign debt crisis. Given the fact that very few will volunteer to have higher taxes on them, these voices are surely a reflection of a much broader willingness of these people to take higher taxes. It would be a great opportunity missed to turn back the tide on lower taxes if the politicians do not act on this.



The offer from Europeans is all the more surprising given the already high taxes in these countries. The French pay a top rate of 40%, plus annual wealth and other taxes on their total assets. The richest Germans are taxed a maximum of 42%. This is yet another empirical nail in the coffin of those who argue that higher taxes crowd-out incentives among those taxed to generate more wealth.



This movement has greater significance for countries like India, where clearly by any yardstick, the rich benefit disproportionately more directly from government expenditures of all collected tax revenues and enjoy the indirect benefits of crony capitalism (how many of the big business success stories in the country does not have a few skeletons?).



So, when is this global movement by the rich themselves coming forward to pay higher taxes going to reach India? When are our rich willing to show some leadership and have their carpe diem? A good place to start would be the progressive "young turks" of the second and older generation of businessmen, who have inherited rather than created their wealth.

Incentivizing efficient road usage - per kilometer driving tax?

Arguably the biggest challenge with traffic management in coming years would be the issue of managing demand response among private vehicle users. Congestion tax, road toll, vehicle miles travelled tax, and so on are being experimented in different cities across the world.



In this context, Times points to an experimental six-month road pricing trial conducted in Eindhoven, where a few cars were outfitted with a meter, hooked to wireless internet and a GPS, that would inform drivers in real-time of a road fee which is calculated based on the vehicles fuel efficiency, miles driven, time of road use, and the route being used. The fee is a measure of the cost to the society in the form of pollution, traffic congestion, greenhouse gas emissions and wear and tear on roads. At the end of each month, the vehicle’s owner would receive a bill detailing times and costs of usage, not unlike a cellphone bill.



The trial, which logged more than 200,000 test kilometers, showed that with the help of technology, drivers can be motivated to change their driving behavior, reducing traffic congestion and contributing to a greener environment. Its findings include,

"70% of drivers improved their driving behavior by avoiding rush-hour traffic and using highways instead of local roads. On average, these drivers in the trial saw an improvement of more than 16% in average cost per kilometer... Instant feedback provided via an On-Board Unit display on the price of the road chosen and total charges for the trip is essential to maximizing the change in behavior."

The Netherlands is debating the introduction of a new road-use charge, per-kilometer driving tax, starting in 2012 for trucks and lorries, and 2013 for passenger cars, and become nation-wide by 2016. Its objective is to reduce traffic delays and CO2 emissions and lower private vehicles road use and increase public transit use. The government was to reduce or even eliminate conventional taxes on vehicle purchases and registration and replace them with a single per-kilometer driving tax. However, political considerations have forced these plans to be atleast delayed.

Warren Buffet advocates higher taxes

In a forthright NYT op-ed, displaying leadership that have been missing in action elsewhere, Warren Buffet takes the issue head on and advocates higher taxes on the well-off.



Lamenting that while most Americans struggle to make ends meet, the mega-rich continue to get their extraordinary tax breaks (more specifically the 15% capital gains tax on carried interest earned by investors), he questions the oft-repeated claim that higher taxes disincentivizes effort,

"I have worked with investors for 60 years and I have yet to see anyone — not even when capital gains rates were 39.9 percent in 1976-77 — shy away from a sensible investment because of the tax rate on the potential gain. People invest to make money, and potential taxes have never scared them off. And to those who argue that higher rates hurt job creation, I would note that a net of nearly 40 million jobs were added between 1980 and 2000. You know what’s happened since then: lower tax rates and far lower job creation."

For the record, he himself was taxed at only 17.4% of taxable income, a lower percentage than was paid by any of the other 20 people in his office, whose tax burdens ranged from 33-41% and averaged 36%. And his advice for the 12 member Congressional Committee entrusted with the responsibility of reducing 10 year US budget deficit by atleast $1.5 trillion, is emphatically unambiguous,

"I would leave rates for 99.7 percent of taxpayers unchanged and continue the current 2-percentage-point reduction in the employee contribution to the payroll tax. This cut helps the poor and the middle class, who need every break they can get. But for those making more than $1 million — there were 236,883 such households in 2009 — I would raise rates immediately on taxable income in excess of $1 million, including, of course, dividends and capital gains. And for those who make $10 million or more — there were 8,274 in 2009 — I would suggest an additional increase in rate. My friends and I have been coddled long enough by a billionaire-friendly Congress. It’s time for our government to get serious about shared sacrifice."

It will not be a surprise if the Tea Party conservatism in the US is outflanked by the alleged "victims" themselves of higher taxation. If this gathers momentum and others join in support of higher taxes on themselves, then we could have the extraordinary event of tax payers mobilizing and demanding higher taxes on themselves, thereby forcing a "reluctant/hesitant" government to actually raise taxes on the super-rich. Is it a sign of the bankruptcy and partisanship of the current political leadership and the statesmanship of a handful of America's super-rich?



Update 1 (23/8/2011)



Warren Buffet's proposals to increase the current 35% top rate for those making morethan $1 million, a further increase for those more than $10 m, and taxing dividends and capital gains (currently, they are taxed at a maximum rate of 15 percent) as ordinary income, elicits a strong approval from Bruce Bartlett.

Tax and subsidy way to healthy eating?

Mark Bittman bites the bullet and advocates taxing unhealthy food like soda, French fries, doughnuts and hyperprocessed snacks, and subsidizing fruits and vegetables.

He suggests that sweetened drinks could be taxed at 2 cents per ounce, so a six-pack of Pepsi would cost $1.44 more than it does now. An equivalent tax on fries might be 50 cents per serving; a quarter extra for a doughnut. He argues that "taxes would reduce consumption of unhealthful foods and generate billions of dollars annually. That money could be used to subsidize the purchase of staple foods like seasonal greens, vegetables, whole grains, dried legumes and fruit."



Such taxes are justifiable despite arguments that it will unfairly target poor people who pay a higher percentage of their income for food. Such critics overlook the long-term health effects of these foods and the much higher medical and other costs imposed on low-income people. Such criticism can be mitigated by subsidies on high-quality, fresh and healthy foods.

Though no American city today has taxes that are explicitly aimed at reducing consumption, many have proposals to tax soda or all sugar-sweetened beverages. Research by the Rudd Center for Food Policy and Obesity at Yale have found that such soda taxes become significant at the equivalent of about a penny an ounce. Further, it is also suggested that these taxes should be in the form of excise taxes on inputs, so that the taxes will be incorporated into the shelf price of the drink, thereby nudging consumers on their purchasing decisions.

There is also an excellent graphic that points to how economic incentives, signalled through prices of cigarettes, have contributed to a dramatic drop in smoking among Americans since the eighties.



Remarkably, more than half of all Americans who once smoked have quit and smoking rates are about half of what they were in the 1960s.

Exploring India's "dynamism-dysfunction" paradox

The NYT has a thought-provoking article that uses the example of Gurgaon to highlight the increasingly obvious paradox with India - "dynamism wrestles with dysfunction"! Its conclusion - dynamism comes from private sector and the dysfunction can be traced to the government.

As the Times article writes with the example of Gurgaon, "economic growth is often the product of a private sector improvising to overcome the inadequacies of the government". In Gurgaon and elsewhere in India, the answer to the country's economic growth paradox that has gained currency is that "growth usually occurs despite the government rather than because of it". It is argued that if governments - central, state, and local - could get their act together, then everything could be so different. Is it as simple as that or does it merit a more nuanced perspective?

It is undoubtedly true that governance remains generally weak and ineffectual across the country. Bureaucracy is stifling, professionalism scarce, political populism rampant, and corruption all pervasive. It is also true that India's private sector, especially in the services, have been remarkable global success stories and have played a major role in placing the country into a robust growth path. Private entrepreneurship has blossomed spectacularly over the past decade despite numerous governance related obstacles.

Therefore, is the problem merely one of a dynamic private sector and a dysfunctional government? Will the problems and deficiencies in public infrastructure service delivery disappear and entrepreneurship bloom if governments become efficient? As always with public policy debates, there are several critical dimensions to the issue that have been brushed under the carpet in our eagerness to find answers and fix blame.

However, even if governments become more efficient and outcome focused, there are certain other critical pre-requisites for any government action to deliver results. Efficiency improvements and planning can only create the platform for effective public service delivery. It cannot be a substitute for the massive capital investments required to actually deliver public services. Further, a substantial share of such resources, for setting up the infrastructure and more importantly for its operation and maintenance, have to come from its users. Governments will have to bear the subsidy burden for the poor.

Let me illustrate both these issues with reference to the Times article.

1. Development requires massive financial investments. Development spending in India resembles a trickle-down drip, whereas the need of the hour is a large-sized pipe. The Times article writes about Gurgaon's deficiencies,

"Gurgaon... does not have: a functioning citywide sewer or drainage system; reliable electricity or water; and public sidewalks, adequate parking, decent roads or any citywide system of public transportation. Garbage is still regularly tossed in empty lots by the side of the road.

With its shiny buildings and galloping economy, Gurgaon is often portrayed as a symbol of a rising 'new' India, yet it also represents a riddle at the heart of India’s rapid growth: how can a new city become an international economic engine without basic public services? How can a huge country flirt with double-digit growth despite widespread corruption, inefficiency and governmental dysfunction?"

Addressing all these deficiencies require huge investments, running into thousands of crores. Each major city would require a few thousands of crores. After they are put in place, issues of governance assume importance. Governance improvements with deficient infrastructure is equivalent to running a complex software on a low-end and out-dated computer. However, unfortunately the trends in this direction have been far from encouraging.

In recent years, an impression has gained ground that government investments in infrastructure services could be substituted with private investments in the name of public private partnerships (PPP). All it requires is for governments to either contribute land as its equity or agree to pay an annuity to the developer to deliver the service, and private investors will que up. Governments at all levels across the country have been chasing PPP investors in the past few years to partner with governments in delivering civic and public infrastructure services. As can be seen, except in a few inherently private investment friendly sectors, the results have been dismal everywhere.

This outcome is to be expected. In its broad historical sweep, no major country in the world, including both developed and now emerging economies, have developed their public infrastructure except through massive direct public investments. Nowhere in the world have private investors replaced governments as the major or even a significant provider of services in sectors like urban civic infrastructure, mass transit, roads and bridges etc. These investments have been and continues to be the preserve of governments.

There is no secret for this. Investments in these sectors are capital intensive and require high user charges or tariffs to be sustainable (some like public transit run into problems even with high tariffs). The user charges and tariffs in India are too small that it is inconceivable that any government could permit raising them by the many times required to recover these user charges. The other alternative of governments subsidizing private service delivery would require massive annuity type payments, which are again beyond the resources of most local and state governments.

This gridlock is unfortunate because atleast some Indian cities have fairly robust and professional governance systems in place. There are a few cities which even have excellent City Development Plans, professionally prepared, which could not be operationalized for lack of resources. In fact, urban governance has improved considerably in many cities across the country in the past few years. But the hardware is missing.

2. Where do these massive investments have to come from? If these services are to be sustainable, there is no denying that users have to bear a considerable share of the cost, much more than what they are paying today, of accessing these services. Sample this from the Times,

"To compensate for electricity blackouts, Gurgaon’s companies and real estate developers operate massive diesel generators capable of powering small towns. No water? Drill private borewells. No public transportation? Companies employ hundreds of private buses and taxis. Worried about crime? Gurgaon has almost four times as many private security guards as police officers."

Herein lies another paradox - people are individually paying exorbitant rates to access services from private providers but collectively unwilling to agree to pay for the same from government agencies. The politics of taxes and tariffs is a major stumbling block to any increases in them. There is also the fact that only a small proportion of the population are actually paying for these high-priced private provision of civic services. (The anecdotal examples of poor people accessing drinking water from informal bore and tanker operators etc is a misleading generalization)

The misconception that privatization is the alternative for government service delivery and government service delivery is inherently inefficient has merely amplified this collective reluctance to pay for services. Why pay the government for a service, when its delivery is unreliable and quality questionable?

It is ingrained into the public discourse that government providers are inefficient and expensive, whereas private service providers can deliver the same service with much greater quality and cheaper. This misconception persists despite the fact that private service delivery costs much higher. Critics counter this argument by claiming the people are willing to pay higher user fees or prices if they are assured of reliability and quality. While theoretically unexceptionable, as I have argued here, this stumbles when faced with real world implementation.

The rich live in near complete isolation. They have their reliable and world-class utility services - water, sewerage, electricity, telephone etc - delivered by private service providers. They hire private security guards to maintain law and order in their gated communities. These self-contained communities have their own parks, gyms and other recreational facilities. They have all the exclusive global brand retail outlets and shopping malls to satisfy their desire for conspicuous consumption. Though they still have to endure the traffic congestions and bad roads, they can afford to do it from the luxury of their chauffeur driven limousines. (It is surprisingly less discussed in all debates about public transit systems about how the rich have no incentive in establishing it) And when they want to get away from even these, they have access to world-class airports and luxurious resorts.

In other words, the rich and upper middle-class are increasingly finding diminishing incentive in improving public infrastructure. And unfortunately, they are among the only category of users who can afford to pay the high prices required to establish and deliver world class civic services. If they abdicate, the ability of local governments to finance and sustain such services become even more tenuous.

None of this is to absolve governments and its machinery off blame for the dysfunctionality of our governance systems. It is just that the society and its government need to face up to the reality that world class public service delivery requires massive investments in infrastructure and a willingness by citizens (and wherever they cannot, by governments) to pay much higher than what they are paying now in the form of tariffs and taxes. Simplified explanations that attribute the dysfunction-dynamism paradox to the standard private-public sector stereotypes are merely brushing issues under the carpet.

Gurgaon's fundamental problem is that it requires massive investments in civic infrastructure. Possibly tens of billions of dollars. The city has grown far too fast for its cash-strapped local government (India is possibly the only major country where local governments do not get any share of the larger central and state taxes) to sustain any meaningful investments. It is of course important that the urban governance systems have to be competent and efficient enough to professionally plan and execute these investments and then effectively maintain them. But the finances for the hardware has to come first.

No major Indian city is presently capable of executing projects on a scale that cities like Gurgaon need nor have the financial resources to do so. I am also not sure whether the supply side has the expertise and capability to deliver on them even if the financial bottlenecks are overcome. After all, for all talk of government lethargy, the actual execution is done by private contractors.

Government spending Vs public debt

Conventional wisdom attributes the massive public debts that many developed countries face today to a legacy of large government spending. In this context, Lane Kenworthy points to an insightful graphic that matches net government debt in 2010 to government expenditures (as a % of GDP) over the 1990-2010 period, and finds no co-relation whatsoever.



His conclusion is spot on,

"A high level of government spending doesn’t necessarily produce heavy government debt. Nor does low spending guarantee low debt. Debt levels are a function of government expenditures and revenues and economic growth."

As Mark Thoma has written, the conservatives have tried to sell their "shrink the government" agenda by arguing that expenditure cuts are the only way out of the huge public debt. Raising taxes, the other side of the fiscal balance equation, is opposed on ideologically spurious supply-side (being on the other-side of the Laffer curve) arguments.

This conservative ideology has exercised a firm grip on politics in even many developing economies. The high rates of economic growth have been responsible for keeping the fiscal status of these governments on the balance.