Taxes and Incentives

Two recent stories in the WSJ dramatically illustrate once again that people respond to incentives. And taxes are incentives.

The first story suggests that one reason LeBron James might have chosen to go to Miami is to avoid the punitive taxes in the other places he was considering—especially Ohio and New York. The income tax rate in Ohio is just over 7%, and the rate in New York is set to become a whopping 12.85%. Florida’s income tax: zero. For someone about to make approximately $100 million in salary over the next five years, that amounts to a $7 million and a $12.85 million premium just for the privilege of living in Ohio or New York, respectively. I’m sure James’s first concern was basketball, but he’d be a fool not to consider these huge tax differences; and James is no fool.

Some Cleveland fans are pretty upset with James’s decision, pointing out that they were offering him $4 million per year more than what Miami offered. But even with that extra money, James would still end up about $1 million per year in the hole if he stayed in Ohio—solely because of the taxes. Some people in New York are suggesting that disappointed fans might direct some of their ire toward Albany, which has engineered the tremendous penalty for living in the state of New York.

The second story relates that with the federal estate tax set to resume at much higher rates as of January 1, 2011, people who are wealthy face the perverse and agonizing incentive of contemplating whether to commit suicide before the end of the year so that their heirs do not face a tax bill that could come to millions of dollars. As one 81-year-old Iowa businessman puts it: “You don’t know whether to commit suicide or just go on living and working.”

The tax disappeared in 2010, creating an incentive to live, but its return in 2011 is creating, as actual people in affected situations are putting it, a “death incentive.”

It is not exactly news that people respond to incentives, or that the tax structure creates a system of incentives in response to which people will alter their behavior. Just because a new tax being proposed does not affect you does not mean it affects no one. As William Graham Sumner argued, every dollar that the government raises through taxation is a dollar taken from someone, somewhere. You may not know the person from whom it is taken, and you may not care about him; he is effectively a “forgotten man.” But he labors under the burdens we place on him.

I suspect that some base motives are involved in our desire to tax the rich. When listening to people argue for such taxes, one often detects a faint whiff of—what is it? Is it envy and jealousy? Is it selfishness? Greed? These are not motives to be proud of. But let us not try to convince people to stop feeling these base instincts. Instead, let us remind ourselves that successful people make our lives much better. The spillover effects of successful people’s achievements come not from skimming ever larger portions of it and putting it in others’ pockets, but instead from the goods, services, and wealth they produce that we all, in turn, can enjoy.

People will always respond to incentives, so it is pointless to assume—as politicians and many in the public seem to do—that people’s behavior will not change no matter what the tax structure is. If you raise taxes on millionaires, they will go elsewhere; this has been proven over and over again.

These considerations lead me to suggest a different tack. Let’s put the fact that people respond to incentives to work for us, instead of working against it. If your state is struggling with its finances, consider, instead of raising taxes, lowering them the more people make. Perhaps institute a maximum threshold: once your income reaches a certain level, no taxes at all. If New Jersey, for example, did something like that, potentially thousands of disaffected wealthy people would flock there from the surrounding states, which would have all sorts of beneficial consequences. It might reverse New Jersey’s currently bleak demographic trends, and, given Laffer-esque effects of lower taxes, it might actually help it address its more-than-bleak fiscal situation.

That might also encourage us not to deepen social division by resenting those wealthier than we are, but rather to appreciate what they do for us and thus increase social cohesion and a sense of community. We might thus all be better off.

And—who knows?—we might even get a good basketball team.

7 thoughts on “Taxes and Incentives

  1. I don’t see anyone in the second article actually considering suicide rather than using it as an extreme case. Killing yourself to make your heirs richer has got to be the single stupidest reason ever for suicide anyway.

    As for exempting the rich from taxes, come on. I assume you mean this as a joke. In the first place, not all rich–oh, sorry “successful”–people enrich our lives. I don’t think we’re particularly enriched by the heads of financial institutions that did poorly and went bankrupt, but they’re still rich. Exempting the rich from taxes would not cause people to envy and resent them less, particularly when poor and middle class people paid their tax bills–which because the government would still be taking money, would go up.

    And of course, successful rich people aren’t the only ones who make our lives better. The people who drive garbage trucks certainly make our lives better. Should we exempt them from taxes?

    Yes millionaires move in response to tax incentives, but there are numerous other factors as well. I don’t know if you’ve been to NYC lately, but there are plenty of rich people.

    And if the goal is to create incentives, why not raise the estate tax to 100%? Even if the original successful person has benefited us all, that doesn’t mean the heirs have.

  2. James Otteson said:

    {Instead, let us remind ourselves that successful people make our lives much better. The spillover effects of successful people’s achievements come not from skimming ever larger portions of it and putting it in others’ pockets, but instead from the goods, services, and wealth they produce that we all, in turn, can enjoy.}

    Ah..yeah. This no doubt includes those at the TBTF banks who brought us this crisis and now their algorithmic High Frequency Trading, which is simply skimming profits, to other traders cost. And their other shenanigans. And there are many other ways of making money, to the ultimate sorrow of the rest of us. Casinos come to mind.

    Many of the rich have brought great benefit. But they should be eager to pay taxes, never mind that of all people, they benefit the most, disproportionately the most, from the system. They already control our venal government, which simply borrows from them rather than have the spine needed to collect from them the necessary taxes.

    And how long before our well mannered middle class figures out that they owe their soul to the company store, 16 tons, and that they, and their government, will never be out of debt. To the rich.

    Suppose, as seems to be happening with the increased disparity of wealth, the rich end up with all the money? Then what? And the fact that already such a high proportion of taxes comes from them is actually a bad sign.

    As for LeBron, is that $100 milliion going to be invested in Miami, to Miami’s benefit, or scattered about the country, to Miami’s loss?

  3. Thank you for your comments, Bill and Charles. A couple clarificatory notes.

    First, many of the problems you both point out are not the result of wealth but the result of government protection of special privileges, special subsidies, etc. There is no doubt that many wealthy people have contributed to the recent economic downturn, but one way to address (not solve) that problem is, for example, not to bail them out when they take risks.

    Second, when I speak of “successful” people who become wealthy, I mean of course those who become wealthy by productive means. So I am specifically excluding people who become wealthy through theft, fraud, or other parasitic means.

    Third, no system is perfect, since every system deals with fallible, and sometimes vicious, human beings. The question is which system or set of institutions is relatively better than others. My argument about incentives addresses itself to this question. I am not attempting to design the kallipolis.

    And fourth, I think you greatly underestimate the good that wealth does for everyone in a society, especially the poor. One of the best things one can do for the poor is to create the conditions for becoming rich. Millionaires do not walk around with all their money in their pockets.

    1. A few observations.
      1. I think folks are upset as much about the “how” as the “what” of LeBron’s decision. Wouldn’t a press conference suffice? He could have said “I love this city and the fans and am sorry to be leaving” instead of calling the attention of the entire country on ESPN to the fact that Cleveland will now do without its (likely) highest paid individual citizen.
      2. The arguments around tax discrimination lead, from a mathematical standpoint anyway, to the flat tax argument. Practically speaking, the political barriers to compete tax scheme overhauls are insurmountable…too many accountants and lawyers (and lobbyists) make money from the existing tax codes, so don’t look for it to get any simpler any time soon.
      3. Last I checked, all people in business — rich or poor — can profit unscrupulously, to the detriment of others. The only difference between day traders manipulating markets and bank clerks taking pencils home is scale. In all cases, someone else pays the price.
      4. I would imagine there are studies surrounding whether or not wealthy people give more to charity when they are taxed less? Do case studies exist for this? Absent any, could one not examine the average charitable giving for the wealthiest New Yorkers and compare to that of say the wealthiest Floridians?
      5. Finally as a New Jersey native I can tell you that no amount of tax reform or wealth attraction can counter the damage done by union leadership, esp. the teachers union. There are many many factors at work here but the union is in my view the “biggest rock in the jar”
      6. More on estate tax later (sometime before I die)

  4. “That might also encourage us not to deepen social division by resenting those wealthier than we are, but rather to appreciate what they do for us and thus increase social cohesion and a sense of community.”

    – The lions will lie down with the lambs, and the homeless of Manhattan will hobnob in the Hamptons, eh?

  5. Professor,

    I would raise a few questions in response to your article.

    1. You write “As William Graham Sumner argued, every dollar that the government raises through taxation is a dollar taken from someone, somewhere. You may not know the person from whom it is taken, and you may not care about him; he is effectively a “forgotten man.” But he labors under the burdens we place on him.”- Isn’t it also true though, that this person benefits from the services the government provides? We are not taxing slaves- this ‘forgotten man’ can access each and every service available. In a loose hypothetical, consider the services which you receive every day from the Federal government. The Interstate Highway system- applying for a Passport- the protection of the Military etc etc. If it were possible to really tabulate how much you receive from the government some people would probably pay more than they receive, but if you spread it over a lifetime, I’m not so certain. Granted, that’s a very large assumption in that last sentence, but Hedge Fund managers do receive services which they pay for in taxes.

    2. On that last point, why would you advocate for no taxation above a certain level? Again, everyone receives services from the Government. The reason the homeless don’t pay taxes is because they don’t have any money. They do receive many government services without question. Hedge Fund managers [sorry to demonize Hedge Fund managers, but if you have a better example, let me know] don’t need food stamps, but they still drive on roads, seek relief in courts, enjoy the protection of the police etc etc. And hey- some day, maybe they will need food stamps. Life is funny like that.

    3. You write “Instead, let us remind ourselves that successful people make our lives much better. The spillover effects of successful people’s achievements come not from skimming ever larger portions of it and putting it in others’ pockets, but instead from the goods, services, and wealth they produce that we all, in turn, can enjoy”– I would concede that productive people do help our society progress- However, would you say that someone making $20 Million a year has made our society 20 times “better” than someone making $1 Million a year? Consider this- What is the local economic impact of having a resident earning $2 million a year, versus someone making $15 million per year vs someone making $75 million per year? Does the increase in individual wealth in those examples really increase the wealth for the surrounding community? How many more locally produced widgets can someone by? If the top 10 on the Forbes list moved to NJ, and did not pay any taxes- how much capital would they actually infuse in the local economy?

    4. At the risk of being rude, I could not disagree more with the notion that not taxing the wealthy at all would reduce the societal divisions between the classes. I will also not indulge your readers with a rant about class warfare either. Though I will say this- The guy who invented the Pet Rock only needed to make one. Then he paid someone $5.25 an hour to make the next 1 million. I would say that the production of goods and services is a give and take between the forces of capital and production, with each benefiting from each other in different ways.

  6. John, honest disagreement is never rude–so no worries!

    The impetus behind my somewhat fanciful thought experiment was an interest in following out the logic of “people respond to incentives” a bit further than we usually do. So, my idea was that not taxing (or perhaps reducing, rather than raising) taxes above a certain point would not be simply a gift to people already wealthy, but would instead provide a significant incentive for people to create more wealth.

    There are plenty of ways to collect necessary fees to provide proper government services other than income taxation. Now, you and I might disagree about what constitute “proper government services”–I don’t think the federal government should be providing food stamps, for example. Putting that aside, however, I think you underestimate the extent to which growing wealth in a society contributes to the well being of everyone in it, including especially those in the lower income brackets. So it is not the mere presence of a millionaire next door that makes us better off; it is all the things he is doing with his money that does. Buying things is only part of it, and a less important part at that; consider in particular what the saved and invested portion does.

    I would also not disagree that the government can, and indeed often does, provide significant benefits to people; nor would I disagree that the wealthy in a society, like everyone else, can use and enjoy these benefits. None of that by itself justifies government provision of them, however. The question is always: “In comparison to what?” In other words, what would things be like if the government did not provide them, and how would that state of affairs compare to what we have now? That question is usually much more complicated and difficult to answer than we are inclined to think. Our natural bias toward the status quo ante–our tendency always to prefer whatever we have now over any alternative–should not prevent us from exploring other options with open minds.

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