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
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.