TheMoneyIllusion ? A common mistake in tax analysis
Many progressives like to point to the fact that labor supply curves are backward bending.? That is, people tend to work less as countries get richer.? Leisure is a normal good.? That?s all true.? But then they forget that this backward-bending curve?is not an income-compensated labor supply curve, and hence has no bearing for aggregate tax analysis.? Here?s Paul Krugman:
This is not a crazy position: ?backward-bending? labor supply is a staple of economics textbooks, because income effects work against substitution effects. Raise my wage rate, and the payoff to working more increases; but I also get richer; and one of the things people consume more of when they get richer, other things equal, is leisure. So a higher wage could lead either to a rise or fall in labor supply, and a lower wage similarly could work in either direction.
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But this argument applies just as much to the rich as to the poor. And strange to say, you never do find conservatives arguing that we shouldn?t worry about higher tax rates on the rich, because they?ll just work harder to be able to afford those luxury goods; or that a higher inheritance tax probably expands work effort, because it would force the Paris Hiltons of this world to go out and get real jobs.
Funny how that works.
It would be funny if true, but in fact his comments are slightly misleading.? A tax increase doesn?t have any first order effect on national income.? (Even if it does reduce national income, that?s not much of an argument for higher tax rates.)? Thus the standard assumption in public finance is to use income-compensated labor supply curves.? This means higher tax rates will unambiguously reduce national income, as all you have is the substitution effect.
I presume Krugman would respond that he?s making an argument for income effects within some sub-groups, such as the rich.? But that doesn?t?strengthen Krugman?s argument very much, for three different reasons:
1.? What matters is aggregate employment.? In recent years the problem of falling labor force participation is increasing concentrated among the non-rich.? At a minimum, Charles Murray is right about that.
2.? The Paris Hilton example actually works the other way.? With a 90% tax rate on the rich (as in the 1950s) there was little incentive for the wives of wealthy people to work.? They had little incentive to work.? As rates came down, labor force participation of women in high income families increased.? I don?t even know if Paris Hilton is married, but if you are one of those people who?so driven by envy that you are obsessed with seeing that sort of woman ?get a job,? high MTRs for the rich is the last thing you should be rooting for.
3.? Supply-siders claim that higher MTRs for the rich won?t raise much revenue, as they?ll just find more loopholes.? I don?t completely buy that argument, but there?s certainly some truth to it.? For instance, the huge fall in MTRs for the rich between the 1950s and the late 1980s didn?t seem to cost revenue, but we don?t really know if this is because the lower rates on the rich caused their REPORTED pre-tax incomes to rise sharply, or whether they rose for some other reason (in which case the tax cuts did cost revenue.)? Conversely the 1990s works in progressives favor, but we don?t know if that was helped by an exogenous tech bubble.
To summarize, supply-siders are not obsessed with getting the rich to work longer hours.? They want Americans to work more, save more, and invest more.? And to the extent they make that labor supply claim for tax cuts for the rich, it?s using an income-compensated assumption, i.e. the Laffer curve.? You may not buy that argument, but Krugman has not found any logical inconsistency in supply-siders touting Murray?s findings.
PS.? I?m no dogmatic libertarian.? I?m fine with a progressive payroll tax, plus luxury taxes on these sorts of homes:

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Source: http://www.themoneyillusion.com/?p=13068
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