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 20^th 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.