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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