Paul L. Caron

Tuesday, October 28, 2008

Mankiw: True Marginal Rate Is 93% Under Obama (83% Under McCain)

Greg Mankiw (Harvard University, Department of Economics), My Personal Work Incentives:

Here is a question that you may have been thinking about: How do the different candidates' tax plans affect Greg Mankiw's incentive to work? ...

Let me try to put each tax plan into a single number. Let's suppose Greg Mankiw takes on an incremental job today and earns a dollar. How much, as a result, will he leave his kids in T years?

The answer depends on four tax rates. First, I pay the combined income and payroll tax on the dollar earned. Second, I pay the corporate tax rate while the money is invested in a firm. Third, I pay the dividend and capital gains rate as I receive that return. And fourth, I pay the estate tax when I leave what has accumulated to my kids.

Let t1 be the combined income and payroll tax rate, t2 be the corporate tax rate, t3 be the dividend and capital gains tax rate, and t4 be the estate tax rate. And let r be the before-tax rate of return on corporate capital. Then one dollar I earn today will yield my kids:


For my illustrative calculations, let me take r to be 10 percent and my remaining life expectancy T to be 35 years.

If there were no taxes, so t1=t2=t3=t4=0, then $1 earned today would yield my kids $28. That is simply the miracle of compounding.

Under the McCain plan, t1=.35, t2=.25, t3=.15, and t4=.15. In this case, a dollar earned today yields my kids $4.81. That is, even under the low-tax McCain plan, my incentive to work is cut by 83% compared to the situation without taxes.

Under the Obama plan, t1=.43, t2=.35, t3=.2, and t4=.45. In this case, a dollar earned today yields my kids $1.85. That is, Obama's proposed tax hikes reduce my incentive to work by 62% compared to the McCain plan and by 93% compared to the no-tax scenario. In a sense, putting the various pieces of the tax system together, I would be facing a marginal tax rate of 93%.

The bottom line: If you are one of those people out there trying to induce me to do some work for you, there is a good chance I will turn you down. And the likelihood will go up after President Obama puts his tax plan in place. I expect to spend more time playing with my kids. They will be poorer when they grow up, but perhaps they will have a few more happy memories.

(Hat Tip:  InstaPundit, PrawfsBlawg.)


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As Theodore demonstrates, this is why many academic economists aren't particularly good at understanding real-world tax practices.

Posted by: Tim | Oct 31, 2008 6:17:50 PM

I would guess that Mankiw does not have to do that much heavy lifting beyond his obligations to Harvard to generate extra income. Yes, the marginal rate for the extra income might be a little higher but cutting and pasting is not heavy work - it's easy money, if someone will pay for it. Compare this to a stevedore working a double shift, where real heavy lifting may be involved.

Posted by: Shag from Brookline | Oct 30, 2008 4:57:19 AM

Greg Mankiw's choices when it comes to work are quite a bit more complex than he suggests. As a full time professor, teaching and scholarship are his job 24/7. He is already paid by Harvard to do the scholarship that may reward him with the additional spiffs of book royalties and honoraria, and is further expected to publish and give talks, as a result of his efforts.

His salary (much of which is in the form of tax favored benefits), is an all or nothing affair. His publishing royalties and honoraria rates are largely a product of the quality of his scholarship, not its quantity. Indeed, better paying scholarship may actually take less time to turn into income, because he will have to deal with fewer rejection letters. And, if he were weighing quality v. return so minutely, he probably wouldn't be in academia at all. If he wants to not work, he loses his salary, the royalties and the honoraria, in all likelihood, solving his tax problem, but creating other problems.

An all or nothing situation, where income depends upon the market and not a person's marginal efforts, are not unusual. The other common situation is one in which a business owner must choose between paying personal and self-employment taxes on one hand, and corporate and shareholder level taxes on the other.

Mankiw also clearly isn't spending much time with his financial planner. While their is little relationship between the amount of his efforts and his marginal return, he has far more control over the taxation of his investment returns. Municipal bonds, or a buy and hold strategy with stocks, could eliminate all income taxes, or all capital gains taxes, respectively. A buy and hold strategy with stocks, moreover, makes sense if one plans upon leaving it all to the kids.

Of course, municipal bonds get a lower return, and dividends on the stock portfolio would be taxed, but tax impact on these investments is far less than he suggests. Also, if he wished, he could assemble a quite profitable "I hate America" portfolio of companies that pay no U.S. corporate level income taxes, which would greatly impact his alleged marginal tax rate without having much of an impact on his overall investment return.

The amount of money he can transfer through gift and estate tax planning, moreover, is on the order of $5-7 million each to two children, if full use of exemptions for himself and a spouse, and leveraging tools are utilized. Those are transfer levels at which many testators start to care more about leaving a legacy than about enriching their children whom they fear they may corrupt with sloth. Legacies are usually charitable and tax free.

Posted by: ohwilleke | Oct 29, 2008 11:19:18 AM

Bottom line is the total *effective* rate in this perfect storm which will never occur.

And just the other day, you linked to an article that identified that the average corporate effective rate was in the mid teens.

And estate tax reform is a subsidy for people to lazy or cheap to do a little estate planning. I don't believe in subsidizing laziness in the well-off.

Posted by: marginal rates out of the margins again | Oct 29, 2008 6:13:27 AM

Does Mankiw's model have a touch of Alan Greenspan's Rand-iness?

Posted by: Shag from Brookline | Oct 29, 2008 3:53:34 AM

Sorry, but this is really misleading.

Among the assumptions Mankiw makes:

(1) All investments are made after tax. (Most Americans make most of their investments pre-tax.)
(2) Taxpayer's only option is to invest in C corporate stock. (Many other options are available; the availability of such other options, in turn, makes the supply of shareholder capital relatively elastic, which drives down the portion of the incidence of the C corporate tax borne by shareholders. See (4) below.)
(3) All C corporate income is taxed at an effective rate equal to the maximum nominal corporate rate. (We know this not to be true. Start with international deferral, accelerated depreciation, and expensing, and go on from there.)
(4) 100% of the incidence of the C corporate income tax is borne by the shareholders. (Best estimates I've seen suggest that the additional rate actually borne by shareholders is on the order of 5%.)
(5) The effective rate of taxation on corporate shareholder investment should be computed without taking into account the time value of money. (Ridiculous. Deferral is 90% of the game.)
(6) All accrued gains are recognized. (Remember basis step-up?)

In addition, by personalizing the computation, he assumes but does not disclose that:

(7) Taxpayer is already in the top individual bracket.
(8) Taxpayer's estate will already exhaust the unified credit.

Assumptions (1) through (6), although highly questionable, dramatically affect his computed effective rates. In addition, the ordinary reader is highly unlikely to understand that Mankiw's results apply only to folks who meet assumptions (7) and (8).

Posted by: Theodore Seto | Oct 28, 2008 1:49:20 PM