Ezra Klein responds to my post on tax incentives. He comments

Smith thinks the income effect is stronger. But he’s not thinking about it like a Republican.

Which is interesting in itself, given that I spent much of my adult life as a strident Republican.

Ezra goes on

I recently spent some time listening closely to Republican rhetoric on taxes, and it’s important to realize that when they talk about the way in which even minor tax hikes will destroy the economy, they’re not talking about you and me. They’re talking about the rich. “You can’t tax the people we expect to invest in the economy and create jobs,” explains John Boehner. “Class warfare may be clever politics, but it is terrible economics,” Paul Ryan warns. “To stimulate GDP growth, a tax cut has to cut the marginal tax rates upon which the decision-makers in the economy base their decisions to work and, above all, to invest,” arguesthe Club for Growth’s Louis Woodhill.

The thing is I agree with Paul Ryan’s comment. I think Boehner’s statement is a little shakier and Woodhill’s is essentially wrong.

Ezra has talked to them so maybe he can clue me in, but what I’d have to guess what’s going on here is that Ryan and the other Republicans are believe that you are either for the wealth creators in which case you want to make life easy for them, or you are against the wealth creators, in which case you want to make life harder.

Yet, there is a difference between the idea that the wealth creators do all of these wonderful things for us and the empirical conjecture that marginal tax rates will drive down growth.

These ideas are conflated because paying taxes hurts and it seems like common sense that you wouldn’t want to hurt the people who are providing you with these wonderful things. Perhaps, ironically economics is supposed to help us get past this confusion between good intentions and good consequences.

This issue is a lot more complex than the issue of work incentives, but I think there is reason to doubt that marginal tax increases – in the range that are being discussed – will have major effects on growth rates.

Let me walk through one of them here.

There relationship between taxes and profit-seeking is complex. Evasion, emigration and risk-aversion are important issues to consider. However, I want to start with a simple story on marginal rates, so you can see they may not be as important as you might think.

Lets imagine that wealth creators have two choices: create wealth and pay the taxes or don’t create wealth and forgo the taxes.

If you go with the first option then that’s obviously worse than creating wealth and not paying taxes. However, its likely to be better than the second option, not creating wealth at all.

A concrete example: creating Facebook and making a Billion is cool. Creating Facebook and only taking home 500 million after taxes is significantly less cool. However, its still way cooler than not creating Facebook and not taking home 500 Million.

This example generalizes to a range of options. Think of all the options you have to get rich. Now, think of the one with the highest possible payoff. That’s the one you want to pick and that’s the one that in a perfectly functioning market would be best for society.

Now, take all of your options and cut the return in half, because that’s what you’ll owe in taxes. It turns out that the option with the biggest return before is still the option with the biggest return now. Its still the best thing for you to do and it’s the best thing for society.

If we want to get all fancy town we would say that any monotonic transformation of the payoff set preserves ordinality.

That monotonic transformation bit is a big deal and that’s why we can have much longer and more detailed discussion over wringing inefficiencies out the tax code. However, the marginal rate itself is not what is at issue.

Again, marginal taxes can be very uncool. A Billion is a lot better than 500 Million. However, it doesn’t mean that creating Facebook or Wal-Mart is no longer your best shot at getting rich.

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