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.

 

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  1. Justin Cidertrades says:


    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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  2. john king says:

    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.

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  3. russell says:

    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.

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  4. Dan H says:

    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.

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  5. jimbo says:

    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.

    Well-loved. Like or Dislike: Thumb up 5 Thumb down 0
  6. Dana says:

    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 says:

      Ok, so where’s the edit button?

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    • James says:

      “Some might argue that the rich benefit from favorable legislation, perhaps this is so…”

      I’ll argue that, considering the rich as a class, this is not the case, and that in fact the rich are more often the target of unfavorable legislation. Of course there are some wealthy individuals & groups that play the political game & derive benefits from purchased legislation, but this is exactly equivalent to claiming that because gangs draw their members from the poor, then all poor people must be gang members.

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  7. caleb b says:

    Is there any thought that higher taxes actually CAUSE income inequality?

    I make around $60k a year in a southwestern state. That is pretty good income ’round here, but in New York, I’d need to make almost double that to have the same standard of living. In part, this is due to higher rents and general costs, but also in part it is due to higher State and City income tax.

    Of course, this discussion is about the highest 1%, so my salary does not qualify, but you see my point. Look at where salaries are the highest on average – it is the same places where the cost of living is the highest. A part of this higher cost of living is higher taxes – both on property and on income.

    So a marginal 1-percenter living in NYC on 330k/yr is not the same as the 99-percenter living in Plano TX making 165k/yr.

    How much income inequality is a results of higher taxes as opposed to other factors, such as higher demand for labor, living desirability (Miami), specific skill set (Silicon Valley), etc?

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    • RGJ says:

      I see your point, sort of. Federal income taxes fall the same, though. State income taxes may vary a bit if you look at the highest and compare to those with none.

      But in most cases I think you’ll see something of what you pointed out — NYC has a lot of overhead….sewers to cops. My township is twice the size of Manhattan and we have 22 cops.

      However, I live in NJ, the most taxed state in the union, and most of it in property taxes. And seventy percent of that in schools. And the lions share of that in absolutely outrageous teachers contracts. And 100 percent of that from unions.

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    • Dana says:

      There are definitely thoughts of income inequality as the result of higher taxes. In fact, it is the very impetus for posts such as these – the rich have no compassion for the poor, the current social justice agenda is a middle class ideal, but they themselves are unwilling to bear the necessarily unfair and unequal burden.

      It’s really a rather sad state; those such as Obama see income equality as “reparations”; those who favor the illegal see them as refugees rather than invaders. And those such as Buffett who encourage higher taxes, see it as a means to profit.

      In NY, the average income is NOT 330k or even 165k; it’s less than 65k. The tax burden does create inequality; there is far greater profit to those who opt for social services – in NY our social services provide far more than the average national income, non-inclusive of education or medical care; even the homeless sex offender here receives a minimum of 36k a year.

      Does the tax burden create income injustice? Most definitely. This is a world of politics and political agendas… the social agenda is a far more expedient means of ensuring the vote.

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  8. beowulf says:

    Ian, I like where your head is at, but instead of IRS definition of income (which is bent out of shape in all sorts of ways by Congress) you should stop and consider the Haig-Simon definition of income:
    “value of all consumption in a given year plus the change in net worth.” The vast majority of the income of the Forbes 400 is from capital gains and yet realized capital gains are taxed at only 15% while unrealized (or “accrued”) gains are not only untaxed they’re unmeasured unless and until the estate tax (a one-time net asset tax) is levied.

    Its inequitable enough that a surgeon making $400,000 a year in earned income pays a 35% rate and an investor making $400,000— or $400 million– in long-term capital pays either 15% or 0%. The inequity would be compounded if the surgeon’s tax rate is dramatically increased under a Brandeis tax while leaving accrued gains untaxed. Its premature to talk about a Brandeis tax until after we have a Vickrey tax. Nobel Prize winning economist (and proto-Supercruncher) William Vickrey thought THE failure of our tax code was the failure to tax unrealized capital gains.
    “Nothing short of full taxation of such gains, including those accrued at the death of the taxpayer, can be accepted as an adequate solution. Any less than this means a continuation of a wide open avenue of tax avoidance that completely frustrates any attempt at equitable progression of the tax burden and seriously interferes with the efficient functioning of the economy.”

    Vickrey’s solution was to tax capital gains retrospectively. Capital gains would be taxed (at ordinary income tax rates) when asset sold or owner died with an interest charge tacked on for each year asset was held. The simplest way from here to there is strike “26 USC 1(h) Maximum Capital Gains Rate ” and replace with, “26 USC 1(h) Vickrey Tax”:
    “Notwithstanding any other provision of law, if the taxpayer disposes of a capital asset then the rules of Subsection 1271(1) shall apply to any gain recognized on such disposition in the same manner as if such gain were an excess distribution in respect of stock in a passive foreign investment company.”
    http://www.law.cornell.edu/uscode/html/uscode26/usc_sec_26_00001291—-000-.html

    That would take care of unrealized capital gains, stepped-up tax basis on inherited assets and the sub-ordinary income rates on capital gains (and dividends) in one fell swoop. Wouldn’t be the worst idea to include Mitt Romney’s proposal to exempt families earning less than $250k from the capital gains ta– errr, Vickrey tax. I’m a fan of MMT economics myself so I think the economy is dramatically overtaxed already so I’d make this tax reform Grover Norquist-compliant by using whatever CBO projects in additional revenue to cut ordinary rates across the board to make it revenue neutral.

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