Sunday, October 25, 2009

Taxes Increase Productivity for Rich People

The Official Economist Dogma on taxes is that they discourage work and innovation. It seems to make sense because you get less money for the extra work you do (progressive taxation means the better you do, the higher a percentage of your income is taken away by taxes).

And, certainly, if the absolute amount of money gained is the goal, progressive taxation would seem to discourage more work and innovation.

But any economist will tell you that money is not utility. Utility is what people (in theory) optimize. Utility is how much a dollar is worth to you. Clearly the first $30k or so you earn - which provide you with basic food and shelter - will be worth more to you than the $30k that pushes you up to 1000030$.

So, one positive effect of taxing the hell out of rich people is that it makes them value the actual marginal wealth increase MORE than if they weren't taxed. At least in some cases.
If Rich makes $1MM and is taxed down to, say $500,000 actually retained, how much more is an extra dollar of after tax income worth to him? How much more might that retained dollar be worth than the dollar that would push his income to $1,000,001?

Obviously it's not worth the $500,000 he lost to taxes (vs retaining all $1,000,000).

Or is it? What is the utility of a $1 to someone who doesn't need it.

A popular mantra amonth billionaires (if you don't mind adding a few zeroes to the example), is that they don't care about the money for spending. It's about keeping score!

If everyone is in the same tax boat, then the billionaire who is taxed an an extreme rate may actually end up with a better "score" in comparison to his fellow players for a dollar retained than he would have been had he not been taxed at all.

This assumes the "utility" of earning an extra $1 when you're income is much lower (due to taxes) is increased by more than the marginal tax rate. That seems clearly to be true.
For a billionaire who is keeping score rather than using his money, the utility is in topping your peers. But if you tax him/her down to the point where the money is ACTUALLY SPENT --- aside from being better for the economy (money is spent rather than invested), the $1 is worth a heck of a lot more. Actual spending utility is clearly hugely more valuable than "keeping score."
Ask anyone who doesn't have everything they want! Misers excepted.
The savings rate in the US would tend to suggest miserliness is not a wide spread problem.

SO: Taxing the hell out of billionaires increases the marginal utility for them of an extra $1 and should incent them to produce more.
(This does raise a Prisoners' Dilemma type problem. The Billionaires only want higher taxes if all Billionaires - against whom they compare scores - also get taxed. All agree to taxes and get the benefit of improved utility or none do).

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