Of Lags and Caps: Possible Implementations of a Brandeis Tax

Last Monday, Aaron Edlin and I published a cri de coeur op-ed in the New York Times calling for a Brandeis tax, an automatic tax that would put the brakes on income inequality. This is the third  in a series of posts (the first and second posts are here and here) explaining more about our rationale and providing more details on how a Brandeis tax might be implemented. You can also listen to my hour-long interview on Connecticut Public Radio’s “Where we Live” here.

Of Lags and Caps: More Details About Possible Implementations of a Brandeis Tax
By Ian Ayres & Aaron Edlin

Remarkably of the hundreds of emails we received in reaction to our op-ed, almost no one questioned Brandeis’s idea that we can have great concentrations of wealth, or democracy but not both.  People questioned other aspects of our proposal, asking questions like (1) how would it work in a world of income bunching; (2) would people still have the incentive to work hard; and (2) is it fair to have very high tax rates on the affluent.

Our last post talked about alternative potential triggers.  Here we tackle some more detailed questions about implementation including how to trade off different kinds of distortions.

A Lagged Moving Average

Several commentators raised questions about the timing.  In our op-ed, we proposed that the IRS would announce in the midst of a tax year what the rate for one-percenters would be based on the Brandeis ratio of the past year.  On reflection, this implementation unnecessarily fails to give taxpayers adequate notice.  It would be unfair to only give a taxpayer notice on September that her marginal rate had increased.  A simple answer would be to have the one-percenter rate to be based on a moving-average of the last five-years of Brandeis ratios, and to have the IRS announce the one-percenter rate before the tax year begins.  So, for example, during the fall of 2020, the IRS would calculate the Brandeis surtax needed to keep the after tax Brandeis ratio in line for 2019 and average that information with the surtax for 2015-2018, to promulgate a rate that will apply to one-percenters in 2021.  The system would include averaging in zeros for years in which the Brandeis ratio failed to trigger.  Using a lagged-moving average gives taxpayers better and less volatile information on what their tax rate will be.  It means that the attempts to lean against inequality will be lagged – perpetually a step behind – but such a system would still take action against increases in inequality.  It would put the brakes on inequality rather than stopping it in its tracks.

Another modification worth considering for a Brandeis tax would be a reinvigorated system of income averaging. The 1% club is not fixed.  Until 1986, tax payers who earned a lot in one year could average their income over three years.  Now only fishermen and farmers and a few others can do that. Without income averaging, taxpayers with “bunched” income might really take a beating.  An entrepreneur who cashes out when the market is right might have the same lifetime income as an attorney, but might find herself paying a much higher Brandeis tax because so much of her life-time income is realized in the cash-out year.  Her profile is 97th percentile for 20 years and 99.5 for one year, while the attorney is 98th percentile for every year.  Under reinvigorated income averaging, taxpayers who normally fall below the one-percent cutoff would avoid the Brandeis tax by averaging their unusually high payday over ten years.  So we’d support averaging on both the tax-payer side and on the tax-trigger side of the equation.

Incentives to work

Some economists like Martin Feldstein always find that higher taxes lead people to work less.  Others disagree. Very few, if any, of these studies are however on the top 1% (or the top one-tenth of the one percent).1 

Do people in the top 1% ask themselves whether the $1000 or the $5000 that they make from an extra hour of work will buy them goods worth the work’s effort, as economists tend to model the matter? Or do these people work hard for intrinsic rewards? Or do they mainly glean satisfaction from earning more than others earn?

The first question inspired Ronald Reagan to lower the top tax rates.  He remembered a day back when he was a lad when he didn’t make that extra movie because tax rates were 90 percent.  To economists that represents a tragedy of inefficiency.  To movie fanatics, who have seen enough of his B rated flicks, it may have been a mercy.

But we doubt there is all that much reason to think Ronald Reagan’s reaction was either typical or tragic.  Our Cornell colleague Robert Frank has argued that rich people are largely motivated by status goods, and by relative status.  If so, they can be just as happy with less money so long as other rich folk have less money too.  If that is true, then taxing the rich is a free lunch.  Surely the government, even a wasteful government can use the money for something. (Hint:  reduce the long run fiscal deficit.)

High tax rates are also not a worry if rich people are motivated by intrinsic rewards. (Perhaps that applies more to real artists who must do art than to Ronald Reagan.)

More worrisome is the possibility that the rich would flee the U.S. if tax rates climbed too high.  This is possible, and would not be good.

In any event, we are not terrified about any of these possibilities.  The Brandeis tax is not dramatic.  In fact, it would not kick in at all unless inequality rose.  And even if the pretax Brandeis ratio rose to 50, we might only need 40 or 50% marginal rates at the top, depending upon what the median income earner pays in taxes.

And, if necessary to get passage, we would be happy to live with a cap on the Brandeis tax.  Because of concerns with work incentives or with moving income abroad, we might cap the maximum Brandeis tax at 50 or 70 percent.  Our larger point is not to deny the possibility that higher marginal rates can produce economic distortions.  But these possible distortions need to be traded off against the democratic distortions of living in a country with vast disparities in economic power. 

In 2010, Greg Mankiw wrote in the New York Times that Obama’s proposed tax-increase on incomes greater than $250,000 would make him work less

First, I have to acknowledge that the Democrats are right about one thing: I can afford to pay more in taxes. My income is not in the same league as superstar actors and hedge fund managers, but I have been very lucky nonetheless. Unlike many other Americans, I don’t have trouble making ends meet.

Indeed, I could go so far as to say I am almost completely sated. One reason is that I don’t aspire for much more than a typical upper-middle-class lifestyle. I don’t fly around on a private jet. I have little desire to own a yacht or a Ferrari. I own only one home, in which I have lived since 1987. Paying an extra few percent in taxes wouldn’t create a lot of
hardship.

Nonetheless, as Republicans emphasize, taxes influence the decisions I make. I am regularly offered opportunities to earn extra money. It could be by talking to a business group, consulting on a legal case, giving a guest lecture, teaching summer school or writing an article. I turn down most, but accept a few.

And I acknowledge that my motives in taking on extra work are partly mercenary. I don’t want to move to a bigger house or buy that Ferrari, but I hope to put some money aside for my three children. They will never lead lives of leisure, but I hope they won’t have to struggle to find down payments to buy their own homes or to send their kids to college.

Greg went on to conclude that increased taxes would reduce his marginal incentive to save for his kids.  But especially for one-percenters, like Greg, who care about their kids, we think they should also be asking whether they want their kids to be growing up in a world where the Brandeis ratio might escalate to heretofore unknown heights.  An irony, not lost on Greg, is that higher tax rates might actually lead him to be a better father.  As he wrote on his blog:

[If the Obama tax is passed,] 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.

Distinguishing Among the One-Percenters

Some commentators have pointed out that it would be inequitable for the merely rich – those barely in the 1% club with taxable incomes just above $330,000 per year – to face the same marginal Brandeis tax as the ultra rich.  Why should small business owners face the same inequality tax as those with taxable incomes of tens or even hundreds of millions of dollars per year?  This is a reasonable question, but it is hardly a devastating criticism of our central proposal for inequality-contingent taxation. It would be possible to structure an automated Brandeis tax that allowed for a progressivity within the 1% club.  For example, the maximum marginal-tax add-on might be a function of the number of medians for particular taxpayers.  If your taxable income is 10 times greater than the median household income, your Brandeis tax might be capped at 10% above the normal rate, whereas if your taxable income is, say 36 medians, you might be subject during periods of increasing inequality to a surcharge of 36%. 

Fairness of high taxes on the affluent. 

One of our more right wing colleagues thinks taxes amount to theft (beyond what is needed for police) and higher taxes on the rich are particularly irksome.  We find this a little bewildering.  It starts with a philosophical premise that we earn what we receive.  The labor theory of value may make a sense if we farm land that has been in our family for generations.  But in a modern economy it is puzzling.  The validity of “earning what we receive” is particularly tenuous amongst the many CEOs who constitute the 1% – as our colleagues Lucien Bebchuk and Jesse Fried describe in their book entitled “Pay Without Performance: The Unfulfilled Promise of Executive Compensation,” flawed management and poor oversight often contribute more to executive salaries than actual value-added.

Could Bill Gates or even Ayres or Edlin earn their living without the state to protect our persons, to enforce or contracts, to invent the internet (we don’t mean Al Gore), or to do any number of things?  Not the livings we enjoy.  John Rawls, one of the 20th centuries great philosophers, would say that most of what we earn is a surplus that we owe to society, for without society we could not earn it.  If the top one-percenters cannot claim to have been fully self-sufficient in their income, in what sense have they earned it, and why is it wrong for the state to take even a large share? 

Our take is that it may be either wise or unwise for the state to tax 50, 60, or 70 percent of income. But it is not theft.  It is not a priori wrong.  Elizabeth Warren got it right earlier this fall when she said “there is nobody in this country who got rich on his own.”

 

1A Gruber and Saez study finds:

the overall elasticity of taxable income with respect to changes in net-of-tax marginal rates is 0.4. That is, a 10 percent change in the marginal net-of-tax rate (that is, the difference between 100 percent and the marginal tax rate) leads to a 4 percent change in taxable income. Gruber and Saez demonstrate that this elasticity is primarily the result of a greater response by taxpayers with high incomes. *** They show that taxpayers with incomes above $100,000 per year (in 1992 dollars) have an elasticity of 0.57, much higher than the 0.4 result for the whole sample. *** These results are based on a study of the NBER’s panel of tax returns over the 1979-90 period.

But the study is largely based on pre-gilded age era and do not estimate the elasticity for people with taxable incomes of 36 medians.

 


Darrell

Incentive to Work? I don't understand why this is not challenged more. We are not talking cleaning toilets here - if the 1% can't be bothered to do more work, the 2% would be glad to step in, thus helping to achieve the income equality goal. For all the jobs being turned down - starring in B movie, talking to a business group, consulting on a legal case, giving a guest lecture, teaching summer school or writing an article - I am sure all these jobs eventually got done by someone almost as talented, so the economic loss would be quite small.

Paul

I am intrigued by this proposed tax, however I question a couple of specific assumptions:
1) You assume that it is fine for the government to waste money taken from the excess an individual makes, while hinting that it could be used to reduce the current debt load. I think it would be highly unlikely for the government to suddenly run out of things to fund and, finding a little extra cash on hand, pay down some extra debt. The proposed purpose of this tax seems to be the reduction of certain individuals income, not the funding of particular endeavors. Higher taxes on the rich may not be a priori wrong, but it is morally suspect to have the proposed end of this tax as just a new creative way to reduce the incomes of those who make more than they need.
2) You assume that the government is the best representation of society. John Rawls is right that we would not have much of what we have without the society in which we live. However to conclude that we ought to give more to the government in response is false. There are many ways to contribute to society, funding of government programs is in no way the primary way to do that.

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Bryce

Would some people choosing to work less cause an economic loss or allow for other workers to take that work on? Would this be a second benefit where the government doesn't have to redistribute wealth but instead would alter the incentives for people who've "have enough" to allow other citizens to earn more?

alex in chicago

This post completely dismisses any of the legitimate moral and economic criticisms of the Brandeis Tax without refuting them, they are simply dismissed. It is not a priori wrong, what moral justification do you use to come to that? Do rich people work less when taxed more? Well I have this study that says so, but I am going to flippantly ignore it because people have evolved substantially in 100 years. What? Do you know nothing about biology?

RGJ

I am sickened by this article. It is the nightmare of Atlas Shrugged come to pass. By even starting the conversation of accelerating the already criminal progressive tax structure in this country, we set a philospohical baseline for a debate that should be about fairness and equity. Why should success and effort and talent be punished by the theft of one's compensation by the govenrment. This article parses the basic morality by semantically tiptoing through the arguments: "at least Ronald Reagan didn't make another B movie".

The tipping point of a democratic society's demise is when 51 percent of the people derive more benefit from the government raising taxes than they do from the government lowering taxes. The US is shooting past that like a rocket.

The demonization of the people who create wealth -- and pay for the lower classes' safety net -- is something that should be discouraged by society's adults who aren't in tents in the nation's parks this year protesting nothing. The authors here are gleefully dreaming up scenarios of how to get at Other People's Money like bank robbers dreaming how to spend their loot.

Who is John Galt? Man up and get in the Top One Percent, don't plot ways to steal from them.

The fallacy of large numbers does not make the following less true:

“Let not him who is houseless pull down the house of another, but let him work diligently and build one for himself, thus by example assuring that his own shall be safe from violence when built.” -- Abraham Lincoln

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RGJ

Postscript to the Lincoln quote: And I believe it is fair to reasonably equate taxation to violence. If you don't pay property taxes, your home is seized -- torn down as far as you are concerned. If you don't pay income taxes, you are imprisoned. The government wields the same power of theft Lincoln is addressing.

Rob

Wow, Paul, you just said exactly what I said in response to another post. That is the key. Why are we giving so much attention to the rich (to punish them) instead of focusing on the poor?

Now, on the giving back to society thing, that is a valid point. But society is not one unit. Society is a collection of individuals. So every time I do something that benefits another individual, I am giving to society. That means every time I spend money, I am helping other members of society to have jobs and get paid. I bought a TV a month ago. That money went, indirectly, to several employers, who then used it to pay their employees. LG and Best Buy are two obvious ones, but distributors, makers of other parts, etc., all benefitted as well. I tithe at church -- this money supports many ministries that make a big difference to society. When I buy food, I am helping the workers at Aldi to have jobs.

Taxation is not the most efficient way to benefit society. Investing provides benefits to the companies that are invested in, who are able to employ people as a result of having this working capital. The only way any money earned does not go back to benefit society is if it is stuffed in a mattress. And not many people use that particular savings method.

It strikes me that the term equality is being hijacked. 50 years ago, there was a lot of talk about equal opportunity. This is the idea our society has thrived on -- any person should have the opportunity to excel and achieve.

But income equality is actually the opposite. Because when we regulate the outcome (i.e. the income), we are working against the opportunity.

If a government guarantees one, they automatically limit the other. Because people are unique, different people are differently motivated. And the great thing about our country as it was founded is that they did dream of freedom -- and this is only possible if we have equal opportunity. Of course, there were some problems, particularly slavery, at this time, but thankfully that got fixed.

But equality of outcome negates equality of opportunity. The Chinese talk about yin and yang. Balance. If you have the freedom to succeed, you also have the freedom to fail. This is what equal opportunity is. If you are unable to fail, then you do not truly have opportunity to succeed, because everything is dictated. Therefore, engineering outcomes squashes liberty. Opportunity, from day one, is what freedom truly is.

This is why many of us oppose socialistic policies -- they attempt to engineer outcomes, and every engineered outcome erodes opportunity. It may sound utopian, but the human spirit is crushed when its freedom is removed.

Income equality is a form of equality, but it is not a goal to move toward at the expense of liberty. Rather, we should be spending our time and energy working on helping those who are poor, so that they can take full advantage of opportunity, while not impeding upon the opportunities of the rich.

When the government determines the outcome before we even even begin, we remove motivation -- changing of outcomes is what motivates successful people, whether it be their own outcomes or those of others. When this freedom is gone, so is progress. We become little more than robots who cannot function without government to tell us what to do. Orwell showed an extreme example of this. But it is very possible. It won't happen in our lifetime, I don't think. But every step we take in that direction makes it harder to go back and change course down the road.

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Prentice

Very interesting.

One of the things I keep hearing is that if you tax the very rich, they won't use the money to create jobs. Apparently, they are not being taxed, yet they still do not seem to be using the money to create jobs.

The government may be very wasteful, from the Federal level all the way down to the local level, but they are also the only ones who build and maintain many major infrastructures, most notably our roads, bridges, etc.

It seems to me that if private sector are not creating jobs with their money in economics times such as now, it falls to the government to do so. Even ignoring areas like education and social services, many municipalities are laying off, or not replacing, police officers and fire fighters. Our local streets have pot holes, some are in desperate need of resurfacing and line painting, and our parks, state and local, are going without maintenance (and illicit marijuana growers are supposedly utilizing acres of our state parks, woe unto the unfortunate hiker who stumbles across such an encampment and gets shot).

If you're really rich, perhaps going to a national, state or local park is not on your list of fun things to do, but it is part of the infrastructure (loosely, possibly), and if the people on whose backs they make all their money are not safe because there isn't enough money for our society and governments to protect them, then eventually, there will be no workers to make the very rich able to stay very rich, much less become any richer.

I agree, if a Gates, or a Buffet, or any other person in the 1% are highly taxed, it is unfair. But if they are all highly taxed (in a reasonable fashion, as seems to be the argument in this article), they are still outrageously wealthy (at least to me :), and not only do not lose all that much, relative to each other, but potentially gain more in the near future as their loss in taxes shores up, and hopefully expands, the infrastructures upon which they build their wealth generation.

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RGJ

Let me ask everyone a question here.

Would you honestly even contemplate starting a company right now in America that actually made something? Do you have any idea how much paperwork and regulations and taxes and risk you have to take?

To create jobs? Can you see the roadblocks we have put up in the last half century to being your own boss, the American Dream? Has it really been watered down to 40 years of servitude and an IRA?

Forget about the One Percent. They are just the low hanging fruit to get in the door. Soon it will be the Five Percenters. Then the Ten Percenters. They are easy to vote out -- 90-10. Then the Net Worth Over A Million Percenters. Then anyone with a nice car.

First they came for the Communists, but I was not a Communist, so I said nothing.
Then they came for the Social Democrats, but I was not a Social Democrat, so I said nothing.
Then they came the trade unionists, but I was not a trade unionist, so I said nothing.
And then they came for the Jews, but I was not a Jew, so I said nothing.
Then they came for me, and there was no one left to speak for me.
—Martin Niemöller

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BILL

The thesis that any one persons income is based on the fact that there is a structural organisation already in place to provide a person a method to create income, and thus the structure is allowed to take what they decide is fair compensation for this structure, simply communism in a more elegant form..

Much like saying the structure of the capitalist system in the US exist because there is a planet called earth with customers all over the planet. Should we then assume all the structural components (Countries) dictate how much money the US can keep and how much we 'owe' them for having the structural mechanism in place for us to make money..

What baloney.. Just an elegant way of saying 'its our money, you can have what we think is appropriate'

Much like my current wife .. What is mine, is mine, what is yours is mine, and I will tell you what part you can have because we have this structural thing called marriage.

What BS..

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Justin Cidertrades

"
putting the brakes on income inequality
"

If division of labour creates more efficiency thus greater productivity thus greater GDP, would you suspect that diversity of income and assets-per-person-diversity might also have the same effect? During the Great Depression, prohibition created lot of wealthy thus powerful mobsters who were corrupting our political system. The tool then used was a progressive system of income tax brackets to break their hold on a mobster regime that was destroying our nation. Was the whiskey mob of yesteryear analogous to today's financial insiders?

Should we be taxing the wealth itself, the raw income? Or should we be adding surtax to shady activities? How could it be done? Tax heavy those industries that cause cirrhosis, lung cancer, auto accidents, and gambling losses? Sin tax? Could we take this approach a step further? A tax on rapid traders? A tax on Congressmen trading on inside information? A tax on hedge-funds resurrected by rogue government officials? Investment banks resurrected as *bank holding companies*?

U. B. Judge!

U. B. Volcker
!

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john king

Is the purpose to raise tax rates or optimize tax revenue? Sweden has tried numerous methods of extracting taxes at 90% and lost revenue. Reagan's flattening of the tax curve raised revenues. Italy was in the 1950's characterized as a "miracle" when the max rate was 25%. Now look at it 60 years later with a top rate of 43% imposed at €75k. The evidence that high marginal rates can lower revenues is all over the place. As a cynic i would welcome your Brandeis exercise if only to prove it here once again.

russell

the entire backbone of this tax is "to each according to his need, from each according to his ability."

not sure i'd want to base my 2011 social construct on something that's been over the past 100 years completely and thoroughly discredited as a viable option. you should be embarrassed to publish such an article.

Dan H

The problem is not the effect of taxes on the rich themselves, obviously. The rich will be okay, obviously.

The problem is that we are building (or have already built) a welfare nation, a nation where some enormous proportion are dependents of the State.

Every welfare nation that come before has collapsed because of its welfare dependency, or in the case of Europe is in the process of collapse.

Incentives matter, and you at the Freakonomics blog should understand this most of all. Very disappointing.

The biggest problem of all is that almost all of spending today is on welfare spending, handouts. This was not the case a generation or two ago, when we had Nasa, the Interstate Highway System, the Cold War and the like, i.e. spending that was genuinely for the whole public.

jimbo

How many of the people that earn >>$300k each year are in that category for many years during their careers? I know for me, I am not. I earn about $200k a year right now (and thus, this isn't a complaint whatsoever), and that might increase at about 3-5% a year or so, unless I change jobs, or we sell our company.

If the latter happens, then I could (emphasis on could) net about $1.7M after the sale, and that would be the amount taxed. If the income tax was say 90% (or 70% or even 50% at the federal level), then it probably wouldn't be as worth it to me to put in the time - weekly travel away from my family, ridiculous hours, intense stress, etc.

Maybe there is someone else who would "step up" into the void, but I have to imagine as the earning potential goes down then the competition goes down as well.

I know this is anecdotal, but it is something I've thought about. When I look at the potential sale, I'm thinking about the tax implication.

And, if the taxes stay where they are now, and I do get that payday (which may be 2-3 years away), then after that, I'll have college funded, a huge increase in retirement savings, and a paid off house (I'm like Mankiw, I really don't need a lot of fancy stuff). I won't need or really want to do it again...

I have no evidence, but I do wonder how many entrepreneurs, sales people, and others who get one big payout, and then slow down a bit.

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Dana

What I see, quite frankly, is some rather flawed philosophy. Taxes are not theft; they are slavery, in that others own a portion of our labor. Is slavery a priori "wrong"? Well, as a student of history, I would have to say that, personally, I am uncertain;- but in any case, Lincoln defined slavery with these words: "You work, I'll eat."

I fail to see why "earning what we receive is particularity tenuous"; - place either an earned, or, an unearned nickel in the bank at .1% interest and there is capital gain; who amongst us discards capitalism to earn all, who does not capitalize? Even those who labor hope to realize gain, a "profit," in proportion to their personal evaluation of the value of their labor. We are all capitalists; and it's all so evolutionary.

In reference to "fair," I would say this: If we are to label all tax a social enterprise, or an equal opportunity resource to the benefit of all, then would it not be more fair to tax in proportion to what is derived? Why should the rich pay more if they derive less from the social resource? Some might argue that the rich benefit from favorable legislation, perhaps this is so; and for everyone who gains there are others who lose, if this were not the case there would be no need of "favorable" legislation. Perhaps "fair" is to be found here; - to be fair, those who derive more, of any form, should contribute more. And therein suddenly I realize the inner voice of "theft," as in "I contribute not of my free will, without my consent, and I derive NOTHING." To be progressively fair, contributions should be in proportion to what is the benefit derived.

I would also like to add that I am not "far right" and I am not partisan; I have nothing to gain from politics.

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Dana

Ok, so where's the edit button?