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Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Saturday, October 20, 2012

Posner, Becker on Luck, Wealth, and Taxation

Richard Posner, Luck, Wealth, and Implications for Policy:

Liberals and conservatives tend to disagree about the role of luck in financial success, the former thinking it plays a very big role, the latter thinking it plays a small role: that instead financial success is largely attributable to talent and hard work. Taken to its extreme, the second position is the one that was espoused by the radical libertarian Ayn Rand.

The economic significance of the disagreement has mainly to do with taxation. Taxing success that is attributable to pure luck does not have disincentive effects, and so is a cheap away of financing government. Taxing success that is attributable to hard work may induce a substitution toward leisure, reducing money incomes, and taxing financial success attributable to talent may induce some talented people to substitute activities that generate substantial nonpecuniary income (apart from leisure), which may not be socially as productive as business. Beyond the economic concern, however, is an ethical one that is particularly acute in a society, such as ours has become, in which there is great inequality of income and wealth.

I don’t find any merit to the celebration of the tycoon by Ayn Rand and her followers. I think that ultimately everything is attributable to luck, good or bad. ... In short, I do not believe in free will. ...

If this is right, a brilliant wealthy person like Bill Gates is not “entitled” to his wealth in some moral, Ayn Randian sense. But it would be ridiculous to infer from this that the government should take his wealth away from him and scatter it among the poor, on the theory that the only difference between Gates and a poor person is that one is lucky and the other is not. But the reason that it would be ridiculous is that it would have terrible incentive effects, not that it would violate some deep sense of human freedom.

The effects of heavy taxation of wealth may depend in part on the kind of luck that generated the wealth that is now to be taken away and given to someone else. There may be different effects from taxing wealth that results primarily from personal qualities, such as IQ and ambition, and taxing wealth that is unrelated to such qualities — inherited wealth, for example, or wealth obtained by winning a lottery, or, a subtler and more important example, wealth resulting from financial risk taking unguided by real insight (or, it hardly needs noting, from antisocial activities such as crime). Heavy taxation of earned wealth is likely to induce many able and energetic people to increase their leisure activities relative to productive work — but to induce other such people to increase their work effort relative to leisure in order to preserve or augment their wealth in the face of the heavy taxation. Heavy taxation of unearned wealth is more likely to have the second than the first effect, because, lacking talent, such people will have to work hard (to work, period — maybe they were living off their inherited or otherwise bestowed wealth and not working at all) in order to maintain a decent standard of living, lacking as they do the talent of the wealthy people who earned their wealth rather than having it fall into their laps. ...

So there is in my view nothing “unfair” about heavy taxation of wealth, but there are practical objections. One is that the wealthy have sufficient political influence to pepper any new tax law with loopholes that will enable wealthy persons to minimize their tax liability. Another is that the additional tax money raised will be squandered on unproductive governmental activities, including handouts that reduce recipients’ work incentives. This objection would disappear, however, if the proceeds of additional taxes on the wealthy were earmarked for reducing the federal deficit....

Federal tax law is riddled with deductions and exemptions that are loopholes in the sense that they have no social product. An example is the mortgage-interest deduction, which incentivizes people to own rather than rent their homes — and why encourage home ownership? Another example is the exemption of employer-paid employee health benefits from federal income tax, which encourages excessive expenditures on health care. Some taxes, such as the corporate income tax, cause distortions, as does treating dividends and interest differently by allowing interest but not dividends to be deductible by corporations. Reform of the tax code would be preferable to raising taxes on anyone, but the major loopholes and deductions and exemptions are sacred cows, leaving changes in tax rates and spending levels as the only feasible methods of achieving fiscal discipline.

Gary Becker, Luck and Taxation:

I do not believe that differences in value judgments are the main source of the disagreement among economists over how much to tax individual with different levels of wealth and income. These value judgments include beliefs about how much of high incomes are due to good luck, whether high-income individuals “deserve” their incomes, or whether there is “free will”. Such considerations, however, may be more important among the general public since, for example, they may not want to tax heavily a Steve Jobs or Brad Pitt because they admire these (and some other) successful individuals and their accomplishments.

For economists, differences in views on what the tax structure should be and on other policies mainly come down to different beliefs about how taxes and other policies affect behavior. For example, economists who support much greater taxes on higher income individuals believe that higher taxes will not much affect how hard these individuals work, their propensity to start businesses, or other kinds of behavior. On the other hand, other economists, including me, believe that high marginal tax rates not only discourage effort and other choices by those being taxed, but also affect the form in which they take their incomes. These adjustments include increases in non-taxable perquisites, such as greater use of a company’s plane, hiring expensive accountants and lawyers to search for loopholes in the tax code, converting income into capital gains when these gains are taxed at lower rates, and investing abroad if the income earned there is taxed at lower rates.

Unfortunately, the empirical evidence accumulated so far does not conclusively support either approach. That is, it is unclear how large is the effect of higher income taxes on the behavior of richer individuals. The relevant evidence is growing, but so far different perceptions of these effects prevent the resolution of the sharp differences in opinions among even a-political economists on the damage done by high marginal income tax rates.

The important point for our discussion is that beliefs about the importance of good or bad luck in determining high or low incomes is not usually the decisive source of differences in attitudes about tax rates and other public policies. For example, one may correctly believe that luck has a major role in determining the genes, education, and other opportunities of highly successful individuals, and yet believe as well that high tax rates on their income and wealth would induce major changes in their behavior. Conversely, one can believe that luck is unimportant in determining success, and at the same time believe that high tax rates on rich individuals would little affect their behavior. And, of course, various other combinations are possible about the relation between the role of luck in achievement and induced responses to taxes and other policies. ...

My conclusion is that even though luck plays a huge role in determining genes, family, education, and other determinants of success or failure, this does not imply very much about the desirable tax rates and other public policies.

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Posner's uber-pragmatic approach misses a critical point: taxation of inherited wealth will discourage productivity of the TESTATOR. There is simply no financial incentive to work hard in the later years of life (which is a common practice among the wealthy) if it is impossible to pass the fruits of such labor to one's children. Inheritance taxes (aside from their negligible impact on revenue) encourage taxpayers to die broke.

The only credible point raised by Posner is that tax hikes should be earmarked toward deficit reduction.

Posted by: Max | Oct 23, 2012 8:11:37 AM