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Modern Monetary Theory and Taxing the Rich

I don’t consider myself an MMTer, but there is a basic Keynesian concept which has been associated with MMT, which is both true and important. For the federal government, taxes are not about raising revenue, taxes are about reducing consumption to prevent inflation.

The point is that the federal government does not need taxes for revenue, since it can just print money. It instead taxes to create the room in the economy for government spending. This view is sometimes wrongly taken as a “get of jail free” card, where the government can spend whatever it wants without worrying about raising revenue.

That could be true in a deep downturn. However, if the economy is near its full employment level of output, where additional demand will lead to rising inflation, we are pretty much back in the world where we need taxes to offset spending. Any major increase in government spending will lead to higher inflation, unless we have higher taxes or have some other mechanism to reduce demand in the economy.

We can of course argue about how close the economy is to its full employment level of output. This is not easy to determine and the mainstream of the economics profession has badly erred on the high side in arguing that we were near full employment, when in fact the unemployment rate could (and did) go much lower.

But leaving the argument about where we hit full employment aside, we still have the basic truth that when we are near full employment, we do need higher taxes to offset additional spending. A small qualifier is worth adding here. We have a $20 trillion economy. We don’t have to worry about inflation because we spend another $2 billion or $5 billion a year on some program we think is important. (That would be 0.01 percent to 0.0025 percent of GDP.) We do have to worry about inflation if we want to spend another $200 billion a year on a big education or health care program.

Okay, but those points aside, how should we think about proposals to tax the rich from a MMT perspective. First, we know we can raise more money by taxing the rich, so if the point is to raise revenue, that is where the money is.

But we know the point of taxes is not actually to raise revenue, the point is to reduce consumption to decrease demand in the economy. Here’s where the story looks less good. Suppose we tax away 70 percent of the income over $10 million a year of our Silicon Valley billionaires and Wall Street high flyers, instead of the current 37 percent.

Do we think this additional tax bill will reduce the number of times Bill Gates or Jeff Bezos goes out to dinner? Will they take fewer vacations or buy fewer cars, planes, and yachts? While I’m sure the effect will not be zero, especially for lesser billionaires or mere hundred millionaires, taking another $70 billion a year in taxes from these people will not have nearly as large an impact in reducing consumption as taking $70 billion out of the pockets of low and middle income people. (This is just the flip side of the argument that if we want to stimulate the economy in a downturn, a tax cut will be far more effective if it is directed towards people at the middle and the bottom of the income distribution, than people at the top.)

This means that in terms of creating room for government spending, higher taxes on the rich will not go very far. In fact, the story is somewhat worse if we think about it closely.

When we impose high marginal tax rates on the rich, we give them very large incentives for evasion/avoidance. If the marginal tax rate is 70 percent, they get to keep an additional 70 cents of every dollar that they can legally or illegally keep from showing up on their tax return. This is a very large incentive to find ways to hide income.

I know that the proponents of high marginal income taxes and wealth taxes are convinced that they can prevent large-scale avoidance and evasion. I am skeptical.

I’ll make two points here. First, they have never been very successful in the past. Whenever the United States or other countries have imposed very high taxes on the rich, the revenue collected has been much less than a straight arithmetic calculation would suggest. In France, which had a wealth tax on the rich not very different than what is being suggested by Senator Warren in its base rates (it includes a variety of loopholes), the country collected an amount equivalent to 0.2 percent of GDP. Warren’s staff projects that its wealth tax will collect more than 1.0 percent of GDP.

When the U.S. had marginal tax rates of 70 percent before the Reagan tax cut and 90 percent before the Kennedy tax cut, few people were paying anything close to this share of their income over the cutoff points. They found ways to hide their income.

While we can say the problem in the past was a lack of political will, the simple logic is that high tax rates give people large incentives to avoid taxes. Let’s take the 70 percent tax rate proposed by Representative Ocasio-Cortez. (Actually, if we add in the Medicare tax and state and local income taxes in high tax states like CA and NY, rich people would face a marginal tax rate close to 85 percent if there was a federal income tax rate of 70 percent.) As noted above, a rich person saves 70 cents of every dollar that he or she can successfully hide from the I.R.S.

If a rich person has to spend 69 cents on accountants and tax lawyers to find a way to hide a dollar of income, then they come out ahead. It is reasonable to assume that many rich people will do exactly this. They will be prepared to spend large amounts of money to escape their tax liability, because the payoff from doing this is so large.

To give some recent examples of ways to avoid/evade taxes, prior to the 1986 tax reform it was common for rich people who had privately held corporations to keep their money in the corporation rather than pay it out to themselves as wages or dividends. After the reform, which lowered the top rate from 50 percent to 28 percent, much more of this money was paid out to individuals. This corresponded to roughly a 2.0 percentage point increase in the share of national income going to the richest 1.0 percent.

Rich people can minimize their payments on a wealth tax by shifting their assets into hard to price items like expensive real estate, valuable paintings, and antiques and jewelry. They can also keep companies as privately held, with no clear market price, for longer periods of time.

The response, that we will increase the resources available to the I.R.S. to police the tax law, is not altogether reassuring in this respect. Suppose we have rich people spending up to 69 cents to shield a dollar of income. Then we have the I.R.S. devoting billions of dollars of additional resources to catch the cheats. Certainly the I.R.S. will never spend anywhere near as much in trying to catch rich tax evaders as the rich will spend in trying to evade taxes, but the government’s spending adds to the resources used up in trying to tax the rich.

Again, if the point of taxation is to reduce demand in the economy, we are going in the wrong direction. We are encouraging the growth of a large tax avoidance/evasion industry, which adds to demand in the economy, even if produces nothing of social value. And, we are requiring the government to devote additional resources to try to limit illegal practices and presumably work to change tax avoidance practices that are legal.

Just to be clear, this is not an argument against taxing the rich. The current I.R.S. budget is a bit over $11 billion annually or less than 0.3 percent of the federal budget. Even if we were to double it or triple the I.R.S budget to better enable it to crack down on tax cheats, it would still be small change compared to what we can get by taxing the rich.

However, when we think about approaching the maximum revenue raising tax rate, that folks like Saez and Diamond put at 70 percent (when we factor in state and local income taxes and the Medicare tax, it would be slightly more than 50 percent as a federal income tax rate), the revenue raised by going the last 5 percentage points or so is likely to be far more than offset by increased resources going to tax avoidance/evasion and its detection. In other words, we are increasing the use of resources by pushing the tax rate to this level, not freeing up resources for government spending.

I would contrast the issues here with the impact of a financial transactions tax (FTT), my favorite tax on the rich. The main way people would avoid a well-designed FTT is by trading less. This means that we would have fewer resources used in shuffling financial assets back and forth in a way that adds nothing to economic output and may even lead to lower output as a result of destabilizing effects from speculation. A FTT would definitely free up resources for other spending.

Again, the purpose of taxing the rich goes beyond raising revenue. When someone like Howard Schultz, with no political experience and little knowledge of policy, can be treated as a serious candidate for president simply because he is a billionaire, this is a real problem for democracy. And, there are plenty more Howard Schultzes running at the state level for governor or Senate. More importantly, these people play an enormous role in determining which candidate can get elected even when the billionaires are not themselves running.

So attacking levels of inequality that undermine democracy is a very worthwhile goal. I prefer other routes than just relying on taxation, but insofar as we using taxes for this end, we should be clear that our goal is not primarily raising revenue, or reducing demand in the economy, as is the case with other taxes.

This post first appeared on Dean Baker’s Patreon page.