The Agony and the Ecstasy of Paul Krugman

In a series of recent posts, Paul Krugman argues--correctly, in my view--that raising the top marginal income tax rates is unlikely to have a substantial impact on work incentives. Unfortunately, he relies on some terrible data to make his point.

Krugman writes:

[We] have pretty good evidence on the (small) actual incentive effects of changes in top tax rates, enough to suggest that the optimal rate is in the 70-80 percent range — which is where it was in the 1960s, a decade of very good economic performance.

Here's the relevant graph:

Why is this so unbelievably misleading? 
Let’s start with the optimal tax rate.

Krugman doesn’t cite the 70-80 percent figure, but he seems to be referencing this recent paper by Christina and David Romer, which estimated “an optimal top marginal [income tax] rate of around 76 percent.”

It's important to note that the Romers’ study relies on data from the 1920s and 1930s, so the external validity already seems questionable. Other studies have produced dramatically different results using different data and methodologies.   

Either way, the Romers are careful to qualify their findings. They point out that their analysis only looks at ordinary income, and not capital gains:

One important complication in these calculations involves capital gains, whose tax treatment varied greatly over the interwar period. To address this issue, we exclude capital gains from our definition of income, and focus on the relationship between taxable income exclusive of capital gains and marginal rates on non-capital-gains income . . . . Excluding capital gains is standard in studies of tax responsiveness, both because they often reflect the timing of realizations rather than current income and because they are often taxed differently than other types of income (Saez, Slemrod, and Giertz, 2012).

All of this is pretty damning to Krugman’s analysis, whether or not he pulled his numbers from the Romers' paper. If it's true that excluding capital gains is “standard in studies of tax responsiveness,” then anyone claiming to have knowledge of the "evidence" on the top tax rates should be aware of this fact.

Of course, it seems clear that Krugman is invoking the Romers' work. Not only does the 76 percent figure fit his claim perfectly, but Krugman’s follow-up post specifically links to Christina Romer’s NYT op-ed about her findings.
In other words, the "evidence" that Krugman is citing seems to be based around a study that ignores capital gains, a common practice when estimating optimal marginal income tax rates. Yet Krugman goes on to compare the 70-80 percent figure against another study conducted by Piketty and Saez, which looked at changes in total income--including capital gains--from 1960 to 2004.

How can Krugman justify making this comparison? He doesn't say. 

To back up his claim, Krugman would have to show that tax rates on ordinary income  (excluding capital gains) have decreased dramatically between 1960 and 2004, since this is the kind of income on which the Romers and others have focused. But as Piketty and Saez point out, that isn't really the case.  

From Piketty and Saez:

[T]he larger progressivity in 1960 is not mainly due to the individual income tax. The average individual income tax rate in 1960 reached an average rate of 31 percent at the very top, only slightly above the 25 percent average rate at the very top in 2004. Within the 1960 version of the individual income tax, lower rates on realized capital gains, as well as deductions for interest payments and charitable contributions, reduced dramatically what otherwise looked like an extremely progressive tax schedule, with a top marginal tax rate on individual income of 91 percent. The greater progressivity of federal taxes in 1960, in contrast to 2004, stems from the corporate income tax and the estate tax.

This isn’t the only problem with Krugman’s analysis. In fact, his entire comparison is apples-to-oranges. The Romers' study--and almost every other study of optimal income tax rates--looks at marginal tax rates (the rates that people pay on their last dollar of income), while the Piketty and Saez paper shows effective tax rates (the rates that people pay on their total income). This seems like a pretty elementary error for a Nobel laureate.

We’re left with this: Krugman almost certainly referenced a paper on the incentive effects of raising marginal tax rates on ordinary income. He then compared it to a paper on the changes in effective tax rates on total income, including capital gains, between 1960 and 2004. This is not a consistent comparison, no matter how you spin it. 

None of this means that Krugman is wrong about raising marginal income tax rates on the wealthiest Americans or reforming the corporate income tax structure.  

But let’s not forget that Krugman is a pundit who routinely bemoans the intellectual dishonesty of his opponents. If nothing else, he should be able to make his points without fudging the numbers. 

The Buffett Rule: Q & A

What is the Buffett Rule?

The Buffett Rule is a tax reform championed by President Obama that would equalize the treatment of capital gains and “ordinary” income for Americans earning above a certain threshold. Capital gains are profits received through the sale or transfer of a capital asset, such as stock or real estate. Currently, capital gains income is subject to a lower top marginal tax rate than ordinary income. This tax policy is intended to encourage private investment. The top rate for “ordinary” income is 35 percent, while the top rate for long-term capital gains is 15 percent.

How long has capital gains income received preferential treatment through the tax code?

Since the 1920s, capital gains have been taxed at a substantially lower rate than other forms of income, except for a brief period in the late 1980s. A detailed historical comparison of the top marginal tax rates on capital gains and ordinary income can be found here.

What is the purpose of the Buffett Rule?

President Obama has cited two main reasons for instituting the Buffett Rule: to enhance vertical tax equity and to reduce the federal debt.

As the president argued in his State of the Union address:

“If you make more than $1 million a year, you should not pay less than 30 percent in taxes . . . . Do we want to keep these tax cuts for the wealthiest Americans? Or do we want to keep our investments in everything else, like education and medical research, a strong military and care for our veterans? Because if we’re serious about paying down our debt, we can’t do both.”

How much would the Rule help to reduce the debt?

In a recent column in the Washington Post, Robert Samuelson did the math and found that the Buffett Rule would do very little to help reduce the long-term deficits that are adding to the national debt. Samuelson explains:

“In September, the Congressional Budget Office estimated the 10-year deficit at $8.5 trillion. The nonpartisan Tax Foundation estimates that a Buffett Tax might now raise $40 billion annually. Citizens for Tax Justice, a liberal group, estimated $50 billion. With economic growth, the 10-year total might optimistically be $600 billion to $700 billion. It would be a tiny help; that’s all. ‘The purpose of the Buffett Rule is not to close the deficit gap,’ Buffett has said. Hard choices remain, in part because existing deficit estimates already assume steep defense cuts.”

Why do some believe that the Buffett Rule would do little harm to private investment?

A big question on the minds of policy wonks is whether the Buffett Rule would have any serious impact on economic development. The preferential tax treatment of capital gains is believed by many economists to promote private investment and drive long-term growth in the economy.

Proponents of the Buffett Rule argue that it would have little dampening influence on private investment. They believe that the substitution effect—in which people shift away from capital investment as it becomes relatively more expensive—is likely to be offset by an income effect, where people invest more to compensate for the reduction in their after-tax earnings. Whether the Buffett Rule would weaken private investment really depends on the relative magnitudes of the income and substitution effects. And it’s very difficult to know what those would be given the lack of empirical data on this subject. A 2011 report by the Congressional Research Service (CRS) also appears to endorse the view that a Buffett Rule would have little impact on private savings and investment:

“Behavioral theories of saving emphasize the role of inertia, the lack of self-control, and the limit of human intellectual capabilities. To cope with the complexities involved in making saving decisions, individuals often use simple rules of thumb and develop target levels of wealth. Once their target level of wealth is obtained, many individuals suspend active saving. Saving rates have fallen over the past 30 years while the capital gains tax rate has fallen from 28% in 1987 to 15% today (0% for taxpayers in the 10% and 15% tax brackets). This suggests that changing capital gains tax rates have had little effect on private saving.”

This may indeed be the case, but the empirical evidence provided by CRS seems fairly weak for two reasons. First, the important question is not whether the capital gains tax rate has fallen, but whether the rate has fallen relative to the rate on ordinary income. Second, correlation does not imply causation.

Why do some believe that the Buffett Rule would help raise national investment?

Even if the Buffett Rule did weaken private investment, many advocates contend that it would increase public investment by reducing federal deficits. Thus, the Rule’s net impact on national investment could be positive if it strengthens the federal budget without substantially altering the behavior of households and business. This line of reasoning assumes that all revenues derived from the Buffett Rule would be used to address the deficit crisis rather than to pay for cuts in government spending, which is the preference of many conservatives.

As Matt Yglesias explains:

“If you do what the Bush administration did and reduce taxes on investment income purely by borrowing money, it’s extremely difficult to see how that’s supposed to increase overall investment. By contrast, if you finance your capital gains tax cut by reducing [public assistance] benefits, it’s hard to see how that wouldn’t increase overall investment. To be sure, you’d be stealing food out of the mouths of poor children to offer a regressive tax cut, but the net impact will be to increase the national savings rate.”

Why do conservatives have a problem with the Buffett Rule?

Putting aside facile claims about “class warfare,” there are a lot of reasons why smart conservatives are concerned about the impact of the Buffett Rule.  

In his most recent column, David Frum points out that the capital gains tax distorts transfers of ownership that could be extremely beneficial in many cases. He writes:

“If Joe can run the company better than Jane, if Jill can make better use of the corner of Main and Elm than Jack, then we want to see ownership of that company or that corner transferred as expeditiously as possible to the higher and better user. That’s why we encourage transparent and efficient markets for capital assets. A capital gains tax is a tax on the transfer of control of assets. If that tax is set too high, it can discourage even the most glaringly urgent transfers of control. Under Joe’s management, the value of the company may rise 30%. But if the capital gains rate is set at 50%, then the transaction from Jane to Joe will not occur—and everybody will be worse off.”

In addition to this, wealthy folks who earn most of their income as dividends and capital gains—and thus pay a lower top marginal rate—also bear the burden of corporate taxes. The numbers stated on Warren Buffett’s tax returns do not accurately reflect his effective federal tax rate. In fact, an analysis of effective tax rates by the Tax Policy Center suggests that, on average, the U.S. tax code is highly progressive when corporate taxes are taken into account.

Though tax avoidance has become a serious problem with certain corporations, many fair-minded conservatives argue that the correct solution is to fix the corporate tax structure rather than to raise taxes on capital gains. Frum notes:

“A light rate of capital gains is premised upon a well-functioning corporate income-tax system. The US corporate income tax system is anything but. Even very highly profitable companies often pay no tax at all. But it’s the corporate income tax system, not the capital gains rate, that is the problem here.”

Are there any other reasons to be skeptical of the Buffett Rule?

One final cause for concern among policy-oriented conservatives is that the Buffett Rule will further encourage corporations to use debt financing rather than equity financing. In the wake of a financial crisis exacerbated by debt leveraging, this seems like a dangerous notion. Manhattan Institute economist Josh Barrow writes:

“Because interest is taxed only once and profits are taxed twice, corporations take on more debt than they would in absence of the tax distortion. The distortion is mitigated by the fact that dividends and capital gains are taxed at lower rates than interest income. Because the Buffett Rule would raise capital gains and dividend tax rates and, in many cases, lower the effective tax rate on interest, corporations would face even more incentive to overleverage themselves.”

What are some alternatives to the Buffett Rule?

For those who care about vertical tax equity but want to encourage private investment, the best revenue-increasing options seem to be the imposition of progressive consumption tax or the elimination of regressive federal tax expenditures, such as the home mortgage interest deduction. Both of these solutions would do far more to increase revenue than the Buffett Rule, but—unfortunately—both options seem far less politically viable.

Corporate Lobbying and Research Methods

I’m a big fan of NPR’s Planet Money blog, but this recent post on the rate of return from corporate lobbying is pretty indefensible.

The author, Alex Blumberg, cites a 2009 study from the University of Kansas, which found that corporate lobbying for the American Jobs Creation Act (AJCA) yielded a return on investment of approximately 22,000 percent. Among other things, the AJCA allowed companies to bring back profits from offshore divisions at a one-time reduced tax rate.

Naturally, many multinational corporations found AJCA exceedingly lucrative, but the important question is whether their lobbying efforts were actually successful. Is the fact that the law was passed evidence enough?

The key challenge in studying the impact of lobbying is trying to figure out what would’ve happened in the absence of these efforts. Would the outcome have been the same, or would lawmakers have come to a different conclusion?

Research methodologists call this kind of thinking “counterfactual causal analysis” because it first considers what would’ve happened without the intervention (no lobbying) and then compares this hypothetical to the present condition (lobbying). It’s complicated stuff, and it’s the kind of thing that makes real-world analysis so difficult.

So, how did University of Kansas researchers derive their counterfactual scenario? Well, they didn’t.

As Blumberg explains:

Raquel Alexander and Susan Scholz calculated the total amount the corporations saved from the lower tax rate. They compared the taxes saved to the amount the firms spent lobbying for the law. Their research showed the return on lobbying for those multinational corporations was 22,000 percent. That means for every dollar spent on lobbying, the companies got $220 in tax benefits.

The implicit assumption in Alexander and Scholz’s research is that the money spent on lobbying had a decisive impact on the ultimate passage of AJCA. In other words, the money was not squandered courting legislators who were already inclined to support the AJCA, or who failed to support the legislation in spite of lobbying efforts.

It’s certainly possible that this is true. Lobbying efforts from large corporations with deep pockets are likely to have some influence over lawmakers, given the nature of American electoral politics. And if these efforts were decisive in the case of AJCA, then the 22,000 percent return on investment is pretty astounding. That magnitude is worth considering as a pure thought experiment, if nothing else.

But whatever value the 22,000 percent figure may have in informing the debate over corporate lobbying, there’s an obvious problem with any research design that presumes what it’s trying to prove. As I’ve written before, not all research is good research. Well-respected news organizations like NPR should do a better job explaining the potential shortcomings of different research methodologies rather than simply regurgitating findings.

The bigger issue, of course, is that researchers must be more willing to acknowledge possible flaws in their methodology. While reporters may lack expertise in research design, there’s really no excuse for academics attempting to pass off weak studies as providing definitive results.

And, unfortunately, that is exactly what seems to be happening in this instance.