Thursday, September 04, 2008

When economists talk about taxes

In the previous post I tried to make sense of the candidates' tax plans. Prominent economists support both candidates and wrote both plans (McCain plan required less writing).

And smart people can disagree. Marty Feldstein co-authored one of the pro-McCain editorials I linked yesterday, and today in the WSJ there is a pro-Obama rebuttal letter written by Jeffrey Liebman, who co-teaches an economics course with Feldstein at Harvard (check out the updated action on Greg Mankiw's blog). You can also see Obama's chief economist debate McCain's on CNBC.

While there's an accounting debate about who pays more, and an economic debate about where the incidence/burden lie, the debates on economic/tax policy always boil down to this question:
Do we focus on growing the size of the economic pie as large as we can, hoping that everyone's share increases as it grows; or do we focus more on equitably dividing up the pie rather than focus so much on its growth?

As mentioned previously, Obama doesn't like the term "redistributionist," and seems to understand the nuances of both sides of the debate. McCain is focused on growing the pie as large as possible but seems sympathetic to altering the division of the pie from time-to-time.

One principle of economics is that people respond to incentives.

If you tax people at a higher marginal rate, they will have less incentive to work. If you know the government will take 50 cents of every additional dollar, you have less incentive to work than if the government took only 34 cents. (That's the exact argument against Obama increasing taxes for the top 2 tax brackets).
These wealthy people are primarily the entrepreneurs who own/operate businesses that employ millions of Americans. They chose their career paths responding to the incentive of profit/reward. When you take away some of that profit/reward, they're less likely to expand their businesses in attempts to make more profits. College students are less likely to pursue those careers as opposed to other careers because they might be able to keep more of their dollar if they earn less, and be better off.

The corporations these people own/manage are also taxed at a rate relatively higher than other developed countries. Ordinarily this would reduce the incentive to generate greater revenue and reduce incentives of businesses from other countries setting up shop here. However, they find ways around the taxes through loopholes, or state subsidies and tax breaks for foreign companies. McCain wants to cut these corporate taxes, Obama would raise them in most cases.

So, Obama's plans reduce the incentives of certain (wealthy) people to work harder.

Taxes on dividends, capital gains, and estates create disincentives to save (which reduces the amount of investment). For most Americans, this isn't changed much- dividends and capital gains will be taxed less than they were in 2003. But for some, the disincentives will be high-- meaning people will have an incentive to consume for today rather than save and create greater economic opportunities tomorrow. McCain generally opposes dividend/capital gains taxes and would leave them unchanged from current levels.

So, Obama's plans tend to reduce the incentives of certain (wealthy) people to save.

Obama's plan (and if you listen to Jason Furman in the CNBC debate above) is all about "the middle class." $1,000 in emergency energy refunds, $500 payroll tax credit, doubling the Hope college credit, eliminating capital gains tax on small businesses, etc. It's essentially a wealth transfer. Grow the middle class, make them better off by taxing those who make > $250,000. A good way to win an election is to give benefits to 99% of Americans by taking them away from the top 1%.

Some economists view this as a bad role for government, others as a natural role of government. You have to decide for yourself what matters.

However, the estimates that Obama's plan adds $3.4 trillion to the debt, and McCain's increases the debt by $5 trillion also bring up a question:

Which plan will end up costing us the most in the long run? John McCain's current plan would cost us more in the long run. By giving us benefits while keeping taxes low, we put the country further into debt. This is a debt that our children will have to pay-- eventually through higher taxes. No President has ever reduced the size of government. Not Reagan, neither Bushes, nobody (at least in the 20th century). I'd like to believe that McCain can, but with the huge increase in entitlement spending that's going to start soon, there's just no way. Can our economy continue to grow faster than government expands to help us pay for the larger government? In the face of growing global crisis, I'm not sure.

So, do you want a plan that gives everyone more incentives to work and save, or a plan that lays a greater burden on the wealthy to provide greater benefits for the less-wealthy?

Do you want a plan that distributes wealth more "equitably" in the eyes of the distributor while trying to keep the debt low, or a plan that provides for more economic freedom at the expense of our children's future wealth? It's not an easy question.

The answer to your question depends greatly on what you demand from government. What do you want your government to do for you?

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