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Monday, January 30, 2012

Frank: Higher Taxes Help the Richest, Too

New York Times, Higher Taxes Help the Richest, Too, by Robert H. Frank (Cornell University, Johnson School of Mannagement):

If wealthy taxpayers would be happier to drive slightly less expensive vehicles on better roads, why are so many of them vehemently opposed to the higher taxes needed for improved infrastructure? One possible explanation is that they suffer from a simple cognitive illusion when they think about how higher taxes would affect them.

If you pay higher taxes, you obviously have less money to spend on what you want. So the prospect of a tax increase naturally inclines people to think that they’ll be less able to satisfy their desires.

But once incomes rise beyond a modest absolute threshold, many of the things that people want are what economists call positional goods. These may be things that are inherently in short supply, like gorgeous waterfront property; or things whose value depends heavily on context, like precious stones or sure-footed sports cars. Because positional goods are in short supply, they go to the highest bidders. The tendency to overlook that fact distorts how people think about the effects of higher taxes.

The cognitive illusion occurs because most financial setbacks that people experience in life stem from events that affect them alone. They may suffer health emergencies, for instance, or problems at work. Marriages may fail, jewelry may be stolen, and floods may damage homes. In each case, the effect is to limit the ability to bid for positional goods.

Because an overwhelming majority of financial setbacks occur for such idiosyncratic reasons, it’s natural to think that the income decline from higher taxes would have similar effects. But a tax increase is different. It affects all participants in the bidding for positional goods. And because it leaves everyone with less to spend, it has essentially no effect on the outcomes of those contests. The same paintings and the same marina slips end up in the same hands as before.

(Hat Tip: Marty McMahon.)

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Except when the bidding is done in international markets, so bidders not subject to U.S. taxes are bidding, and when changes in tax rates will certainly have some distributional effects (as is one of the goals of the current administration), and when the government purchases positional goods.

Posted by: Jeremy LaMrouex | Jan 30, 2012 12:27:51 PM

Jeremy is right. I think it is true that wealthy taxpayers may overestimate the burden of higher taxes and underestimate the benefits. But the argument this article makes does not completely hold up in a global economy.

Posted by: Anon | Jan 30, 2012 4:31:28 PM

The rich wouldn't mind having their taxes raised if they thought they were getting a reasonable deal. But the author's premise is flawed: Raising the taxes will not result in better roads. It will result in more wasted money.

Now, I suspect most wealhty people would be happy to have effective tax rates raised across the board. Perhaps 2-3% on the masses, and then 3-4% on the wealthy. This dramatically increases the tax base, and indeed a big focus can be made on debt and infrastructure.

But just asking the rich to pay pre-Bush rates only pulls in $70B, which is pocket change. Not enough to improve infra, not enough to pay down debt. Not enough to do anything interesting, let alone fix potholes.

Thus, the flawed premise.

Posted by: alan dean | Jan 30, 2012 5:20:03 PM

Right, Alan. $70B is peanuts. Far better to lay off teachers, defer highway maintenance, cut food stamps, etc. In fact, since $70B is so tiny, let's cut the middle class's taxes by that much too.

Posted by: GaryD | Jan 31, 2012 4:21:12 AM

"Higher Taxes Help the Richest, Too"

A better argument than the positional one is that the richest have higher demand for public goods, just as they have higher demand for everything else. This increased desire means that if there were a flat tax, the rich would want a higher rate for everyoen than the poor would, if the spending is for public goods (if is for transfers to the poor, things are different).

The rich might favor an increase int eh top marginal rate that would be used to finance more opera houses and SEC investigators and national park luxury hotels, for example.

Posted by: Eric Rasmusen | Jan 31, 2012 1:12:28 PM