Frank Talk

by Russ Roberts on October 15, 2007

in Podcast, Standard of Living, Taxes

In the latest EconTalk, I talk with Robert Frank about the virtues of learning economics via puzzles and stories rather than graphs and equations. I am a big fan of graphs but I’m a bigger fan of puzzles and storytelling and I believe that Frank is absolutely right that puzzling over puzzles and telling and listening to stories is a crucial way that many people learn and remember. We discuss a number of interesting puzzles from his new book, The Economic Naturalist including why people in New York might appear ruder than people in Topeka and why brides buy their dress and grooms often rent their tux even though brides usually never wear their dress again and grooms wear tuxes later on.

We spend a little time on the issue of whether people get pleasure from owning a big house or whether they only get pleasure when their house is bigger than their neighbors’ houses. Frank sees the growing size of houses as an example of an arms race where the competition to have a bigger house is wasteful—yes, at first when you build a bigger house, you’re better off. But when your neighbor builds a bigger house that matches yours, you’re back to where you started. I see larger houses as an example of people living better with more living space. When I pressed him during the podcast on this issue, he answered by saying that both factors are relevant—it’s an empirical question as to the magnitudes of the two effects.

In this editorial in the New York Times which I saw just after the interview was taped (HT: Rick Koch), Frank makes his case more forcefully and argues that the arms race for bigger houses justifies a steeply progressive consumption tax:

Consider a family that spends $10 million a year and is deciding
whether to add a $2 million wing to its mansion. If the top marginal
tax rate on consumption were 100 percent, the project would cost $4
million. The additional tax payment would reduce the federal deficit by
$2 million. Alternatively, the family could scale back, building only a
$1 million addition. Then it would pay $1 million in additional tax and
could deposit $2 million in savings. The federal deficit would fall by
$1 million, and the additional savings would stimulate investment,
promoting growth. Either way, the nation would come out ahead with no
real sacrifice required of the wealthy family, because when all build
larger houses, the result is merely to redefine what constitutes
acceptable housing. With a consumption tax in place, most neighbors
would also scale back the new wings on their mansions.

I disagree with the premise that there is "no real sacrifice involved." I think people enjoy the larger house. By discouraging them from building the larger house, the tax reduces the happiness of  homeowners. But my real disagreement is with the claim that the additional savings would stimulate investment. Frank is assuming that everyone will work equally hard in a world where consumption is taxed at very high rates. I doubt it.

Frank goes on to argue for another benefit of high tax rates on consumption:

A progressive consumption tax would also reduce the growing
financial pressures confronting middle-class families. Top earners,
having received not only the greatest income gains over the last three
decades but also substantial tax cuts, have been building larger houses
simply because they have more money. Those houses have shifted the
frame of reference for people with slightly lower incomes, leading them
to build larger as well. The resulting expenditure cascade has affected
families at all income levels.

The median new house in the
United States, for example, now has over 2,300 square feet, over 40
percent more than in 1979, even though real median family earnings have
risen little since then. The problem is not that middle-income families
are trying to “keep up with the Gateses.” Rather, these families feel
pressure to spend beyond what they can comfortably afford because more
expensive neighborhoods tend to have better schools. A family that
spends less than its peers on housing must thus send its children to
lower-quality schools.

Now it turns out that 1979 was a very good year for family income, but even so, median family income rose 15% between 1979 and 2005 and rose almost 20% between 1980 and 2005. And the way the government measures income doesn’t include fringe benefits which are an increasingly important part of compensation. And I don’t think the price index that converts nominal into real dollars overstates inflation and understates the growth in real income. So I disagree with Frank that income is up only slightly. So when I see houses getting bigger, I see people spending a larger share of their income on something they care a lot about rather than people keeping up with the Gateses.

I think Frank is right about two things in his article on taxation. One, I think people do spend money on houses trying to get into better school districts and that bids up the price of houses artificially because houses are tied to schools. The way to fix that is to get rid of the connection between houses and schools. The second thing I agree with is that it’s better to tax consumption rather than income. But I don’t think steeply progressive rates are a good idea. I think they would have strong disincentive effects on productivity, creativity and innovation. I think part of the reason people work long hours and start new businesses and take second jobs is to have more stuff. Taxing the accumulation of stuff at very high rates reduces the incentive to work hard.

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{ 10 comments }

Shakespeare's Fool October 15, 2007 at 1:06 pm

If wealthy people spend less on houses
and that leads everyone else to also spend
less, the real pain will be felt by carpenters,
plumbers, electricians, masons,
truck drivers, and others who work
in the construction industry.

John

anonymous October 15, 2007 at 1:50 pm

I slightly disagree with Frank's explanation why women buy wedding dresses. I think part of it has to do with the fact that women want to have their wedding dress as a memento of their wedding day. They can break it out years later and show it to their children and grandchildren and remember the day.

By the way, this is an awesome podcast! The reason I chose to major in Econ years ago was because it gives you a good way at looking at interesting questions you've never thought about.

Sam Grove October 15, 2007 at 1:59 pm

Remeber when congress increased the tax on luxury yachts?
Yacht builders had to cut way back on production, firing workers, etc.

David October 15, 2007 at 1:59 pm

Gee, if the Feds are gonna start taxing consumption, I better start saving a lot more receipts. 'Cuz no doubt my purchases of socially desirable products like solar panels, biodiesel and organic food (unless I buy it from Wal-mart) are gonna be tax-deductible!

wintercow20 October 15, 2007 at 2:06 pm

I have yet to see Frank explain why he ignores the other side of the market when there are "positional arms races."

When my neighbor buys a bigger yacht, who produces it? When he builds an addition, who puts it on for him? When people buy the $1,000 ultra-supreme BBQ grill, does it come from the North Pole?

This ignorance seems awfully incongruous with the screams of many learned people who worry that "lower consumer spending" as a result of the mortgage crisis is going to hurt the economy.

So, per usual, we hear things that you simply can't have both ways. Too much consumer spending is bad, and too little consumer spending is bad too!

Methinks October 15, 2007 at 2:14 pm

I remember that tax, Sam.

It was proposed in part by a senator from Maine whose name escapes me now in 1991. It wasn't just on yachts. It was a general luxury tax on everything that only The Rich consume – like furs, yachts and assorted other luxury goods.

Proponents of the bill were salivating. This is AWESOME! We can raise taxes on The Evil Rich and it'll only be paid by them. It won't be paid by The Middle Class or The Poor. How clever, how clever!

A year later that same senator, now looking haggard and worn out, pleaded on the senate floor to repeal the tax. Seems that shipbuilding is (or was then) a very large part of the Main economy and the demand for yachts is pretty elastic. The tax destroyed the ship building industry in Maine. And whaddaya know, it's not The Evil Rich who rely on building yachts to eat, it's The Poor and The Middle Class. The Evil Rich simply made do with their old yachts and the former yacht builders made do with food stamps.

The tax was repealed.

Last I heard, the Maine shipbuilding industry never recovered.

No market failure could possibly hold a candle to government failure.

johngaltline October 15, 2007 at 10:05 pm

"My guess is that there are a few really high earners who spend so little and save so much that, for them, Frank's plan would actually be a tax cut. If you're currently in the top 1%, being able to deduct all of your savings might very well be worth paying 50% on your spending money. Right now, you're already taxed at a marginal rate around 40%, and you don't get any deduction for saving."
more…

t freak October 15, 2007 at 10:37 pm

i remember Hayek said something about the progressive tax similar to this, which i agree:

Progressiveness favors the mediocrity and punishes long-term investment in human capital.

Put into the housing context, there must be someone out there spending most part of their life being poor and working on a life-time achievement, and hope someday he will become the star, to win a Nobel price, to write a bestseller, to sell a company to Microsoft etc, and then he can have his own castle. But progressive taxes punish these people.

Ian October 16, 2007 at 3:40 am

Enough fodder for political tinkering already!! Simply demand that your Federal legislators co-sponsor, and then enact, the FairTax. The research is impressive as to how much better off we'll all be without a tax code our politicians use to control (coerce) citizens' behavior: The Tax Code has become a "tinkerer's paradise" for 53% of the lobbyists who game it in Washington DC. It's a lucrative business, and the U.S. TAXPAYER pays for ALL of it in higher prices (i.e., a hidden tax which is incomprehensible to the average working person).

Prices after FairTax passage would look similar to prices before FairTax – not "30% higher" as opponents contend – competition would see to it. So, the FairTax rate (figured as an income-tax-rate-non-comparative, sales tax) on new items would be 29.85% (on the new, reduced cost of items because business isn't taxed under FairTax – thus lowering retail prices by 20% to 30%), or 23% of the "tax inclusive" price tag – this is the way INCOME TAX is figured (parts of the total dollar).

The effective tax rate percentages, that different income groups would pay under the FairTax, are calculated by crediting the monthly "prebate" (advance rebate of projected tax on necessities) against total monthly spending of citizen families (1 member and greater, Dept. of HHS poverty-level data; a single person receiving ~$200/mo, a family of four, ~$500/mo, in addition to working earners receiving paychecks with no Federal deductions) Prof.'s Kotlikoff and Rapson (10/06) concluded,

"…the FairTax imposes much lower average taxes on working-age households than does the current system. The FairTax broadens the tax base from what is now primarily a system of labor income taxation to a system that taxes, albeit indirectly, both labor income and existing wealth. By including existing wealth in the effective tax base, much of which is owned by rich and middle-class elderly households, the FairTax is able to tax labor income at a lower effective rate and, thereby, lower the average lifetime tax rates facing working-age Americans.

"Consider, as an example, a single household age 30 earning $50,000. The household’s average tax rate under the current system is 21.1 percent. It’s 13.5 percent under the FairTax. Since the FairTax would preserve the purchasing power of Social Security benefits and also provide a tax rebate, older low-income workers who will live primarily or exclusively on Social Security would be better off. As an example, the average remaining lifetime tax rate for an age 60 married couple with $20,000 of earnings falls from its current value of 7.2 percent to -11.0 percent under the FairTax. As another example, compare the current 24.0 percent remaining lifetime average tax rate of a married age 45 couple with $100,000 in earnings to the 14.7 percent rate that arises under the FairTax."

Further, per Jokischa and Kotlikoff (circa 2006?)

"…once one moves to generations postdating the baby boomers there are positive welfare gains for all income groups in each cohort. Under a 23 percent FairTax policy, the poorest members of the generation born in 1990 enjoy a 13.5 percent welfare gain. Their middle-class and rich contemporaries experience 5 and 2 percent welfare gains, respectively. The welfare gains are largest for future generations. Take the cohort born in 2030. The poorest members of this cohort enjoy a huge 26 percent improvement in their well-being. For middle class members of this birth group, there's a 12 percent welfare gain. And for the richest members of the group, the gain is 5 percent."

Aaron January 7, 2008 at 3:20 am

And now there is a trend for smaller homes being made just for the elderly that don't have as many kids and don't want the hassle of a big yard. So it looks people can make their own choices about house size after all and are not slaves to some arms race.

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