Quick summary of the zillionaires’ externality
In my National Post column this week I wrote about a new research paper called “Taxing Top Incomes in a World of Ideas” by Charles I. Jones at Stanford University’s Graduate School of Business. It’s a reasonably straightforward, if pretty technical, contribution to the economics literature on optimal income taxation, a field whose modern incarnation Oxford’s James Mirrlees (1936-2018) kicked off in the early 1970s, a contribution for which he won the Nobel Prize in 1996. But Professor Jones’ paper has a surprising kicker. It shows that under not obviously unreasonable assumptions the optimal top income tax rate can be negative 25 per cent—in other words, not a tax at all in the usual sense but a 25 per cent subsidy for every extra dollar earned at the top of the income distribution. In today’s “woke” world, with its focus on the presumed social injustice of virtually any inequality, it’s hard to imagine a more shocking research conclusion.
In essence, optimal income taxation is simple. How much of a gain in overall well-being can you achieve by taxing high-earners, who presumably value an extra dollar of income not that much, and redistributing the revenue to low-earners, who presumably value it more—all the while taking into account the effects of both the tax and the redistribution on effort and production. Unfortunately, what’s simple in essence becomes difficult in practice. Introduce even a little complexity and things can get hairy.
Some recent contributions to this literature have assumed there’s no big effect on production even from high top marginal income tax rates. The reason is that lots of people at the top supposedly are earning rents, an income they don’t actually need in order to induce them to continue doing what they’re doing. (Sidney Crosby would probably still play hockey even if his income was just $1 million a year rather than the $20 million-plus he apparently makes in salary and endorsements.) Not surprisingly, if you do assume there’s a big component of rent—basically unearned income—in top incomes, the optimal income tax your model generates can be quite high. Some well-known studies we may hear about in the upcoming federal election and the U.S. 2020 presidential election put the optimal top rate above 80 per cent.
Professor Jones’ twist on this literature is to argue that at least some zillionaires produce very big “positive externalities,” that is, benefits for which they do not receive compensation. Sergey Brin and Larry Page each made a fortune out of Google, but by any reasonable accounting the benefits Google produces are far greater than the advertising revenue it generates—even if you net out some of the negatives the search engine also creates. The same for people like Bill Gates and Steve Jobs—the benefits they’ve created greatly exceed the money they personally made from their discoveries and inventions, even if they each did make a tonne of money.
In short, in our world of ideas a small group of people have had a hugely disproportionate impact on overall well-being. Encapsulating the lessons of “endogenous growth theory,” Professor Jones argues this is typical of the modern era: “a relatively small number of researchers is responsible for the bulk of economic growth for the last 150 years!”
OK, so innovation can produce big positive externalities. That’s hardly news. Why don’t we just subsidize R&D—which we do a lot, in fact—and leave it at that? The answer is that there’s a lot more to innovation than formal R&D. As Professor Jones puts it,
Formal R&D is a small part of what economists would like to measure as efforts to innovate. For example, around 70% of measured R&D occurs in the manufacturing industry. In 2012, only 18 million workers (out of US employment that exceeds 130 million) were employed by firms that conducted any official R&D. According to their 2018 corporate filings, Walmart and Goldman Sachs report doing zero R&D.
Yet Walmart, certainly, and Goldman Sachs, arguably, has each revolutionized the way business is done in its corner of the economy. In Walmart’s case there have been clear social benefits; in Goldman Sachs’ maybe not so much. In general, the danger Professor Jones points to is that the “idea creation and implementation that occurs beyond formal R&D may be distorted by the tax system.” The main distortionary mechanism? “High incomes are the prize that motivates entrepreneurs to turn a basic research insight that results from formal R&D into a product or process that ultimately benefits consumers.” These geese don’t lay golden eggs unless they get to keep some of them.
The interesting twist in this argument is that positive externalities are usually an idea favoured by the Left to justify public subsidies for education, vaccination, culture and many other things. In Professor Jones’ paper they justify what at the moment is possibly the least Left policy imaginable—lower tax rates for top earners.
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