Find the error

by Russ Roberts on April 17, 2007

in Inequality

Robert Frank wants higher taxes on the rich to finance universal health care coverage. His argument:

Providing universal coverage will be expensive. With the median wage,
adjusted for inflation, lower now than in 1980, most middle-class
families cannot afford additional taxes. In contrast, the top tenth of
1 percent of earners today make about four times as much as in 1980,
while those higher up have enjoyed even larger gains. Chief executives
of large American companies, for example, earn more than 10 times what
they did in 1980. In short, top earners are where the money is.
Universal health coverage cannot happen unless they pay higher taxes.

Can you find the logical error in the second sentence of that paragraph? It’s subtle, but readers of Cafe Hayek should be able to find it. The error can be summarized in five words.

Frank goes on to argue that higher tax rates will not have significant incentive effects:

The surface plausibility of trickle-down theory owes much to the
fact that it appears to follow from the time-honored belief that people
respond to incentives. Because higher taxes on top earners reduce the
reward for effort, it seems reasonable that they would induce people to
work less, as trickle-down theorists claim. As every economics textbook
makes clear, however, a decline in after-tax wages also exerts a
second, opposing effect. By making people feel poorer, it provides them
with an incentive to recoup their income loss by working harder than
before. Economic theory says nothing about which of these offsetting
effects may dominate.

If economic theory is unkind to
trickle-down proponents, the lessons of experience are downright
brutal. If lower real wages induce people to work shorter hours, then
the opposite should be true when real wages increase. According to
trickle-down theory, then, the cumulative effect of the last century’s
sharp rise in real wages should have been a significant increase in
hours worked. In fact, however, the workweek is much shorter now than
in 1900.

Trickle-down theory also predicts shorter workweeks in countries with
lower real after-tax pay rates. Yet here, too, the numbers tell a
different story. For example, even though chief executives in Japan
earn less than one-fifth what their American counterparts do and face
substantially higher marginal tax rates, Japanese executives do not log
shorter hours.

He’s right that income and substitution effects work in different directions. He’s also right that the work week has been getting dramatically shorter over the last century as people have decided to enjoy more leisure. But it’s not clear that higher tax rates today will have no effect. His Japanese example is rather thin. Edward Prescott takes a more thorough look and comes to a different conclusion.

There is also a big difference between taxing a lawyer or doctor and taxing the owner of a small business. The biggest effect of dramatically higher tax rates would be to discourage risk-taking and the creation of new ventures.

UPDATE: Mankiw on Frank

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{ 26 comments }

Yanick April 17, 2007 at 11:24 am

Error: They aren't the same families.

Chris Meisenzahl April 17, 2007 at 11:30 am

Aside from the economic problems with his argument, there are glaring Constitutional and moral problems with it.

Russ Roberts April 17, 2007 at 11:45 am

Yanick,

Well done. The first part of the sentence you can give him the benefit of the doubt. By the end, when he invokes "gains," he's presuming they're the same people. In fact, they are not.

Forbes April 17, 2007 at 1:02 pm

Prof. Roberts: I read a little too fast, so this was the sentence I focused on, "In contrast, the top tenth of 1 percent of earners today make about four times as much as in 1980, while those higher up have enjoyed even larger gains."

It seems to me, when talking about the "top tenth of 1 percent of earners," there isn't anyone "higher up" to enjoy "larger gains."

In both instances, today and 1980, Mr. Frank is comparing the same top slice of taxpayers–the top tenth of 1 percent. Inasmuch as today's taxpayer in the 99.99 percentile makes more than that of the 99.9 percentile, short of introducing data demonstrating otherwise, there no reason to believe the "four times as much as 1980" relationship is inadequate to describe the change over time.

T Sowell fan April 17, 2007 at 1:32 pm

Isn't one logical error that "median" income changes don't tell us anything about changes in the tax burden (absolute or relative) of any particular middle class family of today?

i.e. Don't we need to know about changes in the statistics of the ratio of individual taxes to income rather than just income?

To put it another way, couldn't the tax paying population have increased faster since 1980 than the inflation-adjusted tax burden?

John S April 17, 2007 at 2:00 pm

I have often heard the claim that the supply of labor from the wealthy is inelastic in support of taxing the wealth more than we do now, and from what I gather, this is certainly true of the short run. However, I would expect the supply of labor from the wealthy to be much more elastic in the long run because the ratio of lifestyle adjustment costs to income is much lower in the long run.

Methinks April 17, 2007 at 3:02 pm

Isn't another problem with that sentence that "income" doesn't include any redistribution or the growth in non-money income such as health benefits? So, while real money wages may have declined a bit, if all benefits were included, real wages are actually higher. I believe Thomas Sowell made that point not that long ago.

Methinks April 17, 2007 at 3:30 pm

Well, the supply of labour may be largely inelastic. However, the willingness of that labour to supply capital for risky ventures is highly elastic.

But Frank is an idiot in other ways. Socialized medicine is more expensive and of lower quality. I was a "victim" of socialized medicine in Europe for four years. Demand regularly outstrips supply and the supply is of much lower quality than in the United States. Death from cancer is higher and rarely are extra measures taken to save a life. Waiting months or years for non-elective surgery is common and the facilities are only marginally better than Soviet Russia. The only way to get anything resembling standard care in the United States is to be very very wealthy or very well politically connected. Socialized medicine truly only favours the very rich.

Anonymous Austrian April 17, 2007 at 4:12 pm

In addition to the fact that the median income doesn't represent the same families today as the median income from 1980, the top 1% by income are different people. Chances are that a 55 year old CEO today in the top 1% was not a 28 year old CEO in the top 1% in 1980.

cpurick April 17, 2007 at 4:32 pm

"Chances are that a 55 year old CEO today in the top 1% was not a 28 year old CEO in the top 1% in 1980."

No, in fact, he was probably in the middle class then. Thus, Frank has unwittingly explained what really happened to the poor downtrodden middle class of the 1980s.

Patrick April 17, 2007 at 5:52 pm

Errors aside, the argument is again based on a the redistribution of wealth paradigm-Marx put in a more polite way than Stalin did or Hugo Chavez does now. The same ridiculous phallacy and the old "after all, they can afford it.." mentality. It stems from the old socialist theme that if one person gets money it takes away from another or, "the rich get richer…" nonsense. Since capital is not finite but can be created and expanded and passed on and through society in free trade transactions. Just utter crap-and don't even get me started about universal health care-if it happens it will totally shatter our economy.

Jim VAT April 17, 2007 at 6:54 pm

How about, "You have it, I want it, hand it over."?

Methinks April 17, 2007 at 8:24 pm

"It stems from the old socialist theme that if one person gets money it takes away from another or, "the rich get richer…" nonsense."

aahhh. The lump of wealth fallacy. My favourite. I'm endlessly amused by the number of (sort of) Economists – like Krugman – who commit it vigorously and constantly.

SaulOhio April 18, 2007 at 6:32 am

Wasn't it someone on this blog that claimed there is no such thing as a "trickle-down theorist"? Trickle down theory is a strawman.

Steven E. Landsburg April 18, 2007 at 9:21 am

Let's take Frank's implicit assumptions at face value:

1) Given the current median income, the median family doesn't want to spend more for better health care.

2) We ought to tax the rich to help those in the middle.

How the HELL does it follow that you should tax the rich to give people in the middle something that they would *prefer not to have*, given the cost?

Methinks April 18, 2007 at 9:23 am

"Trickle down theory is a strawman."

The New York Times is a straw man factory.

Methinks April 18, 2007 at 9:27 am

"How the HELL does it follow that you should tax the rich to give people in the middle something that they would *prefer not to have*, given the cost?"

It follows for people who believe in slavery and don't understand incentives – socialists.

Objectivist April 18, 2007 at 11:59 am

Frank's support for socialized "medicine" is repulsive. Everyone knows that we need to eliminate Medicare and Medicaid. Besides that, I am also in favor of allowing imports of drugs from other countries, since that supports free market competition. If other countries socialist systems cut down fair prices for drugs, I see no reason why Americans should not take advantage of the subsidies provided by foreign governments which "negotiate" lower drug prices.

steep April 18, 2007 at 1:32 pm

The marginal tax rate discussion is still missing one important point. The $1000 Child Tax Credit is applied against FICA taxes as well.

Dale gribble April 19, 2007 at 1:10 pm

Good point that the top 1% or higher taxpayers are not all the same. Lawyers doctors professionals etc will draw a stead check year in year out. risk takers will not, maybe a few big scores and then likely a drop off. Easy for the Lieyars to demand higher taxes since they feed off the high tax system.

Methinks April 19, 2007 at 2:09 pm

"Lawyers doctors professionals etc will draw a stead check year in year out. risk takers will not, maybe a few big scores and then likely a drop off."

Good point. What's the latest failure rate for star-ups? The last number I saw was 80%.

Mesa EconoGuy April 20, 2007 at 9:16 pm

Up until about 1995, it was extremely unusual to find vocal economic zero-summers in the financial markets/commentary. See any of Russ Roberts’ previous posts (and the complete economic history of this country, and the world, et al.) as to why this view of the economy and markets is factually incorrect.

Now, it is relatively commonplace (see Paul Krugman). I would probably categorize George Soros as one of them, though not exclusively due to his far left politics.

It is this incorrect bias that leads to the incorrect conclusion that 1) taxing the rich will lead to more overall prosperity, and 2) there is too much (perceived) income inequality.

In fact, the real problem is there are too many economically ignorant journalists telling us there is too much income inequality. To wit:

http://www.traderdaily.com/magazine/article/5343.html

“Back then, I was a Marxist economist and have not completely rid myself of the man’s influence — thus explaining why I chose a career on the risk side. Many people think of Marx exclusively as the father of communism, forgetting his key contribution to the field of economics: pointing out the dangers of a capitalist economy with too much wealth concentrated in too few hands.

From a recent United Nations study (which showed that the richest 2 percent of the world’s adults own half its wealth) to this year’s Forbes 400 (no one with a net worth under $1 billion qualified) to the Trader Monthly 100 issue you’re holding (featuring a record five traders who earned at least $1 billion last year alone), accelerated wealth concentration is becoming ever more quantifiable.

This issue might not inspire Al Gore to make a documentary, but it should be no less serious a concern than outsized carbon emissions.
[Note the Marxist connection to Carbon emissions.]
When, as Marx believed, wealth accrues in too few hands, demand dries up and the whole system collapses under its own weight. I’ve been thinking about this as I watch what I believe to be the investment playing field’s increasing tilt in favor of the fat cats.
My assertion is this: The big players now possess an unprecedented — and growing — advantage. Only the biggest pools of capital (and at no time in history have those capital pools been this big) get access to the sweetest investment opportunities. Thus, the highest rollers, going forward, will outperform everybody else by an increasingly wide margin. “

Pardon my French, but Bullshit! No, no, no, no, no, no…how do you then explain the greatest ever menu of financial products and services publicly available, the proliferation of inventive and accessible investment vehicles like ETFs and Mutual Fund marketplaces, the largest ever proportion of the public participating in the investment arena, and the eventual elimination of commissions altogether? Not to mention the continued and massive expansion of the independent Registered Investment Advisor market?

This is highly luddite – and this guy was a professor, albeit Marxist, i.e. not credible. Of course there are more billionaires, there are also more millionaires, too! Economic performance has been phenomenal over the past 5 years. And there are (depending on what statistics you choose) fewer middle-class: because many are now upper class, as confirmed by IRS tax receipts:

http://opinionjournal.com/weekend/hottopic/?id=110008889

According to this guy’s highly flawed reasoning, we should all be working for one J. Pierpont Morgan right about now. Granted, this is the FHM of the financial press, but the point stands.

So this “tax-the-rich”/”too-much-income-inequality”/”I’m-jealous-of-your-car-but-I’m-too-lazy-and-irresponsible-to-take-charge-of-my-own-choices” Paul Krugman litany is basically false, and the people making it are boring and stupid, especially the ones with PhDs. Unfortunately, they’re the ones getting lots of press and misleading our kids.

Mesa EconoGuy April 20, 2007 at 9:23 pm

And universal healthcare will fail.

David P. Graf April 20, 2007 at 9:29 pm

As a Navy brat, I grew up going through the military healthcare system. It seemed good to me on the whole. Of course, you did have to question why they put the ward for pregnant women almost eye level on the flight path for the naval air station in San Diego. My youngest sister, not surprisingly, was born a bit premature. Why would a system like this be objectionable?

Mesa EconoGuy April 20, 2007 at 9:44 pm

David, that system isn’t objectionable at all; it could never be run efficiently on a national scale by any government.

See Walter Reed.

Then ask Canada.

rob April 28, 2007 at 7:37 am

Error: Do you mean because these wages don't include employer provided fringe benefits like healthcare. Or could it be that he's not accounting for technology gains?

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