Last week, Tom Baird responded to an email he received from a critic who made the claim that higher taxes on the wealthy is “regressive,” not “progressive.” Mr. Baird respectfully reproduced the full email before responding it. His responses, however, contain a variant of the common broken window fallacy, among other problems.
1) “We are the wealth/job creators that help all Canadians enjoy the standard of living they have.”
This compelling slogan is a fundamental axiom of right-wing ideology. It is compelling because it contains a degree of truth: successful businessmen typically do work hard, employ others, and contribute more than most to the economy, so perhaps it is unfair to deprive them of the fruits of their labour.
But are businessmen truly the sole or primary “creators” of wealth and jobs? A counterargument, popularized recently by Elizabeth Warren, is that our public institutions also play a basic role in producing prosperity. A successful businessman depends on a legal/justice system to enforce laws and contracts. He depends on infrastructure like roads, ports, electricity, and running water to produce his products and bring them to market. He depends on schools to train an educated workforce from which he hires labour – indeed he was most likely educated in public school himself. Consider how our hard-working businessman would have fared if he were born in rural Uganda and then ask yourself whether he created his wealth all by himself. No man is an island and no man becomes wealthy all on his own. Taxes play a vital role in maintaining the public institutions that make prosperity possible.
This is the “You didn’t build that” argument, popularized last year by both Elizabeth Warren and President Obama. The argument is that, if the government did not provide certain public goods and services, businesses would not be able to thrive. It is true that, without roads, courts, ports, utilities, etc, markets would not be able to thrive. However, the argument ignores the fact that businesses, through their startup costs and market operations, do pay for all these things.
Startup costs include the value of the benefits that come with starting a business under the conditions from which the benefits are derived. When a prospective business owner buys property alongside a road, for instance, the market price of the real estate includes the value of the direct access to the road. If the state did not provide and maintain roads and other things that benefit commerce, businesses would have to pay for them themselves. The more business owners spend on startup costs and maintenance, the less money they have to invest into their operations and to save for future expansions. The result of these reduced investments and savings is that the business produces less, which in turn means lower supply, thus higher prices charged to their customers. For the purpose of illustration, consider a pizza restaurant.
Suppose there is pizza restaurant that does not have direct access to a road. Customers must park some distance away and walk to the restaurant. Suppose, now, that the state decides to build a highway right past this restaurant. The highway brings a huge increase in revenue to the business. This revenue allows the owner to add on to his building, buy a larger pizza oven, and hire some staff. As a result, he makes far more pizzas than before, he enjoys a higher standard of living, and many travelers are able to enjoy his pizzas as they pass through.
In this example, the restaurant owner is paying for the highway with pizza. A tax increase, justified by the claim that the road benefited the owner, reduces the restaurant’s ability to satisfy the needs of travelers who stop at the restaurant. This reduced output also forces the owner to charge higher prices for the pizzas, which means that potential customers with lower income may have to forgo the pizzas altogether.
2) The basic reasoning behind progressive taxation is the “law of diminishing marginal utility“; an extra thousand dollars makes a much bigger difference to a poor person than to a rich person. In fact, studies have shown that beyond a threshold, more income makes very little difference to happiness. For the very wealthy, earning money becomes about status and keeping up with the Jones’ rather than about improving material well-being. All else being equal, transferring money from the rich to the poor will increase overall welfare.
This argument still ignores the opportunity costs of the taxes. It is true that increasing taxes on a wealthy person, to a certain extent, does not reduce the taxpayer’s standard of living. They continue to consume as much. What they decrease is their savings and investment. Mr. Baird’s claim that the extra money that the wealthy do not consume is just “about status” ignores the economic benefit of the saving and investment by the wealthy taxpayers. Their investments create jobs and increase the production of valuable goods and services, which improves the standard of living of everyone. Additionally, their savings provide the incentives and ability for other investors to invest in the development of future products. Higher taxes mean lower standards of living and restricted economic growth.
3) Of course, all else is not equal. If we raise taxes on top earners, won’t that discourage them from working hard? In fact, the answer is ambiguous because of “the income effect“: if taxes are raised, this makes high earners poorer, which makes each additional dollar more valuable, which helps encourage them to work harder. Some researchers have argued that public welfare is optimized at top marginal tax rates above 70%, as was recently implemented in France. There are of course some practical problems with this level of taxation (e.g. tax avoidance), but reducing work incentives is not necessarily one of them. Even if you believe tax rates have a strong effect on work incentives, raising tax rates for the rich allows you to lower them for the poor and middle class, which would further boost their incentives.
Again, raising taxes on top earners has little effect on the wealthy taxpayers’ standards of living. The effect is on their investments and savings, which may not affect the lives of the rich, but it certainly affects the lives of the beneficiaries of their investments and savings. These beneficiaries include workers and consumers throughout the economy, since the market is a highly complex web of exchange.
4) It is also questionable whether the work done by high income earners is really such a benefit to society. We’ve all seen how highly paid Wall Street types were payed [sic] big bucks to devise clever ways to explode the economy. Perhaps that ingenuity would have been better directed toward different ends. Some research finds that creative people are more productive when they are motivated by a sense of purpose in their work, rather than by financial rewards.
It should be obvious that the market environment in which Wall Street operates is not a free market, and that some of what they do is harmful to the economy and would be worthless in a free market, but given that non-market conditions exist, people are paid big bucks to do things that do not seem valuable. It is often very difficult to tell whether a certain activity would be performed in a free market, or how profitable it would be. Some supporters of a free market believe that capitalism itself may not exist in a free market, but in the present U.S. economy, the stock exchange plays a very important role. If Mr. Baird is claiming that shareholders and speculators are not providing valuable investments for which they should be rewarded, then he is ignoring the value of a major means of resource allocation. Shareholders and speculators choose to invest in certain enterprises based on their perceived value of those enterprises. This allocates funds into the enterprises in which they are expected to create the most value for the economy.
5) Luck also plays an important role in financial success. People who enter the labour force during a recession suffer lasting damage to their career. And lets not forgot the importance of being born into a wealthy and influential family.
6) There is also the argument that inequality is directly harmful to public welfare in a number of ways. Research has found that unequal societies suffer from higher levels of crime, mental illness, stress, distrust, diabetes, and more. Unequal societies may also be detrimental to democracy, diminish class mobility and equality of opportunity, and stifle innovation.
As mentioned earlier, the U.S. economy is not a free market. Government interventions and the Fed create booms and busts, and regulations, corporate welfare, patents, and other policies create income disparity and inequality of opportunity. Those born into wealthy families still must learn to use their wealth wisely, or else they lose it. Some may argue that they do not do any “real” work and, therefore, do not deserve their wealth, but they still provide valuable market signals through their consumption, investments, and savings, and they do enable production through their investments and savings. When they do not use their inherited money responsibly, they lose their wealth. As Jeremy Weiland said, "Let the free market eat the rich."
Markets reward the creation of value. Unfortunately, those who support progressive taxation focus only on value created directly by labor. They ignore the value of investments and savings, without which, an economy cannot grow. Since saving and investment by the rich improves the standard of living of everyone, including the poor, and since all taxes reduce the amount of private savings and investment, all taxes are, as Mr. Baird’s critic said, “regressive.”