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Paul Krugman’s Error Over Ocasio Cortez And The 70 – 80% Top Income Tax Rate

It’s always necessary to distinguish between Paul Krugman the exceptionally good economist and Paul Krugman the left leaning columnist for the New York Times as with this little story about Alexandria Ocasio Cortez and the idea of 70 to 80% top income tax rates. For as so often happens the columnist is not making the careful distinctions that the economist would. Or, if we were feeling a little more uncharitable, that the politically driven columnist wishes to shout “Yay My Side!” while ignoring those distinctions that the economist would make. This is something that makes economists sad for the the Paul Krugman who does the economics is truly excellent at doing so.

This is apparent here in talking about Ocasio Cortez:

[perfectpullquote align=”full” bordertop=”false” cite=”” link=”” color=”” class=”” size=””] The controversy of the moment involves AOC’s advocacy of a tax rate of 70-80 percent on very high incomes, which is obviously crazy, right? I mean, who thinks that makes sense? Only ignorant people like … um, Peter Diamond, Nobel laureate in economics and arguably the world’s leading expert on public finance. (Although Republicans blocked him from an appointment to the Federal Reserve Board with claims that he was unqualified. Really.) And it’s a policy nobody has ever implemented, aside from … the United States, for 35 years after World War II — including the most successful period of economic growth in our history. To be more specific, Diamond, in work with Emmanuel Saez — one of our leading experts on inequality — estimated the optimal top tax rate to be 73 percent. Some put it higher: Christina Romer, top macroeconomist and former head of President Obama’s Council of Economic Advisers, estimates it at more than 80 percent. [/perfectpullquote]

Well, no, Peter Diamond doesn’t think that. The Diamond and Saez paper is here and the important point to understand is this:

[perfectpullquote align=”full” bordertop=”false” cite=”” link=”” color=”” class=”” size=””]Thus, the distinction
between real responses and tax avoidance responses is critical for tax policy. As an
illustration using the different elasticity estimates of Gruber and Saez (2002) for high
income earners mentioned above, the optimal top tax rate using the current taxable
income base (and ignoring tax externalities) would be *=1/(1+1.5 x 0.57)=54 percent
while the optimal top tax rate using a broader income base with no deductions would be
*=1/(1+1.5 x 0.17)=80 percent. Taking as fixed state and payroll tax rates, such rates
correspond to top federal income tax rates equal to 48 and 76 percent, respectively.[/perfectpullquote]

The really important part being “no deductions”. This needs to be read widely. They mean that the existence of a different capital gains tax rate is a deduction – because it is possible to move income into capital gains. And so on – no deductions means the near abolishment of near all of the tax code other than just that top rate.

If we have a system with deductions – and it’s near impossible to imagine one without at least some say, for everyone except Americans, just leaving the country – the optimal top rate becomes that 54% on incomes, something that’s already achieved in most Blue States when local income taxation is included.

And the thing is the economist Paul Krugman would be very keen on making such distinctions. The columnist not so much. Pity.

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5 years ago

The other thing that bothered me about Krugman’s column was this comment that: “…when taxing the rich, all we should care about is how much revenue we raise. The optimal tax rate on people with very high incomes is the rate that raises the maximum possible revenue.” This should require an explanation of why we want to maximize revenue? It seems to suggest that government should be as big as it can get without taxation reducing revenues, ignoring any discussion of how big we actually want government to be or what we want it to do. He also blathers on… Read more »

5 years ago
Reply to  TD

That last is why the distinction is made between capital income (ie, CGT?) and labour income. The capital income being taxed less. And of course the moment you do that you’ve allowances in your tax system, meaning that that revenue maximising rate is that lower 54%…..

5 years ago
Reply to  timworstall

In the case of the successful second restaurant, the operating income will be taxed as ordinary income at the owner’s marginal rate (assuming a pass through tax entity). The capital gains might come years down the road if the business is sold one day. Under current tax laws much of such sale proceeds, if structured as an asset sale, would be taxed as ordinary income except for the portion allocated to goodwill. (speaking from the US)

5 years ago

Geoffrey Howe!! He got more tax from the rich by reducing the marginal rate to 60% There is a Laffer curve in every country – but it is not the same in each country so it is *theoretically possible* that Krugman is right for the USA but it is far from plausible. Unlike Geoffrey Howe, most Socialists are unwilling to pay 50% tax on thir income: when this was a major topic, the Conservatives to whom I listened were unhappy but willing to tolerate it while the Labour supporters wre not willing to do so – planning to emigrate their… Read more »

Jonathan Harston
Jonathan Harston
5 years ago

But if you set tax rates to maximise revenue, what do you do when you need (or want) more revenue? You’ve already set the tax rate to collect the highest possible amount, there is no way to collect any more.

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