Optimal tax theory – could it be more interesting than it sounds?

May 4, 2012

What should the maximum rate of tax be? I must admit that I would have guessed that anything above about 40% might be a disincentive to generate more income. I also thought that most economists would probably say something similar. So I was rather surprised to learn that some very eminent economists suggest that much higher rates are ‘optimal’. Peter Diamond (winner of the Nobel Memorial Prize for Economic Science in 2010) and Emmanuel Saez (winner of the John Bates Clark medal for economics in 2009) consider optimal tax theory where the objective is to maximize social welfare constrained by the response of individuals to paying or avoiding tax. Their findings are summarized in the Abstract of their 2011 paper

First, very high earners should be subject to high and rising marginal tax rates on earnings. Second, low-income families should be encouraged to work with earnings subsidies, which should then be phased-out with high implicit marginal tax rates. Third, capital income should be taxed.

They suggest that the marginal tax rate should rise to over 70% for incomes in excess of around half a million US dollars (if I have understood their numbers correctly), and similarly for capital gains. Some of this tax should then be redistributed to those on low incomes to encourage them into work. This maximum tax rate is not so far out of line with the proposals of the French socialist Presidential candidate Francois Hollande who has talked about a 75% tax for incomes above one million euros. But higher taxes are not generally that popular (see for example some of the comments to this BEC news report on M. Hollande’s ideas or this Wall Street journal article on Diamond and Saez). A common response is that higher taxes destroy growth, punish success and are easily avoided by moving overseas leading to a brain drain. So how could it be that such ‘high’ taxes are ‘optimal’? First the rich, well at least those that really create wealth, can still avoid paying the high rate by reinvesting in their business and investment is good for growth. Second the higher incomes generated at the lower end also generate more economic activity leading to higher incomes for the rich too. Recent historical data supports these ideas as reported by the Wall Street journal. Since 1945 there is a correlation between higher growth and higher taxes. What happens in France on Sunday and what happens next will be fasciniating to watch!


A sustainable future?

April 14, 2012

In this blog I will attempt to make the case that sustainability should always be high on our list of priorities when making any decision.

The case for sustainability is made succinctly and powerfully by the quote attributed to the Liverpool born economist Kenneth Boulding (1910-1993),

Anyone who believes exponential growth can go on forever in a finite world is either a madman or an economist.

The fact that the earth and its resources are finite provides us with a simple guiding principle which should feed into all our decision making.

Or is it that simple? For example, not all growth is resource based but if we restrict ourselves to resources first. Take oil. It is clear that there is a finite amount of oil (at current usage there will not be much left 100 years from now) but what criterion should we use to decide whether to burn it now or save some for later? The answer of course is a bit of both. We cannot stop using oil tomorrow but we have to reduce our dependence. To some extent this has begun to happen and economists would argue that the market will tell us how much to use and set the price accordingly.

But we learn from history that markets do not produce a soft landing. The free market is intrinsically unstable, extracting as much profit as possible for as long as possible eventually triggering a crash where everyone suffers. To avoid such future shocks we need to be more proactive in our management of resources.

We have to overcome our innate short termism and adopt a longer term prospective. Our problem is that most of the structures that organise our society, business and politics, are too short term.

Our one hope is to convince our politicians that sustainability is so important that a long term strategy is essential. History will eventually show that they were right and give them the credit for being ahead of their time in steering us towards a sustainable future. There are encouraging signs that this process has begun. Particularly in enlightended societies such as Denmark where the government has pledged to create all its energy from renewables by 2050. The US and UK have involved people that understand the issues in their energy policy. The US Energy Secretary, Steven Chu is a Nobel Laureate in Physics, and in the UK the Cheif Scientific Advisor to the Dpeartment of Energy, David MacKay is also a Physicist and author of the superbly quantitative Sustainable energy – without the hot air. Still sustainability seems to be far less discussed in mainstream politics and the media than related issues such as debt and climate change. The argument for say wind turbines is often made in terms of preventing climate change. However for those outside the scientific community the arguments are too complex and one has to accept as a matter of faith that climate change is happening and it is going to be bad. I think the sustainability argument is easier to follow. Oil reserves are finite and they will run out. As oil becomes scarces it will become more expensive and societies dependent on imported oil will be compromised. We can argue about when this will happen but not if. Consequently it makes sense to begin to prepare now and get ahead of the curve. The early adopters will be the future leaders.

First post!

March 25, 2010

The colour of the sky!