Monday, October 11, 2010

Higher Taxes = Fewer Tom Cruise Movies?

One of the big questions making the rounds on the cable news talk shows is the effect of the proposed tax law changes on the economy.  For those who are unfamiliar with the issue, when President George W. Bush passed his tax cuts during his first term, many of those cuts came with an expiration date of 12/31/2010.  Now that this date is almost upon us, Congress is debating whether or not to extend these cuts, adjust them, or let them expire.  President Obama's proposal is to extend the Bush tax cuts for everybody except the most wealthy individuals.  People making over $250,000 a year would see their highest tax rate rise from 35% to 39.6% (which is what they were under the Clinton Administration).

The core of the debate is whether or not raising the taxes on the richest Americans would hurt our fragile economy.  Harvard professor N. Gregory Mankiw recently wrote a piece for the New York Times in which he argues that higher taxes on the rich will give the rich an incentive to work less:

"Maybe you are looking forward to a particular actor’s next movie or a particular novelist’s next book. Perhaps you wish that your favorite singer would have a concert near where you live. Or, someday, you may need treatment from a highly trained surgeon, or your child may need braces from the local orthodontist. Like me, these individuals respond to incentives. (Indeed, some studies report that high-income taxpayers are particularly responsive to taxes.) As they face higher tax rates, their services will be in shorter supply."

It's a pretty bleak picture, isn't it?  Higher taxes on the rich will mean it will be harder to get an appointment with a doctor, less likely that you will see your favorite performer in concert, and worst of all, fewer Tom Cruise movies.  The horror!  Write your Congresspeople and tell them that the "poor" rich need lower taxes so that they can continue to make Hollywood blockbusters.

The only problem is that his argument makes no sense.

Professor Mankiw's argument is that rich people will be turn down opportunities to make money because the government is taking a larger share of their earnings.  However, he neglects a basic economic concept known as opportunity cost.

Let's create an example that goes one step further than the Professor Mankiw's.  Let's assume that the tax rate is going to rise from 50% to 60%.  Now let's assume that Dr. Surgeon makes $10,000 per surgery.  In this example, Dr. Surgeon's take home income will drop from $5,000 to $4,000 when the tax rate rises.  Will Dr. Surgeon decide to perform the surgery?  In order to determine this, we have to look at her next best option.  Her next best option is to not perform the surgery, stay home, and make $0.  Under these circumstances, performing the surgery would be her best financial choice.  In fact, performing the surgery would be her best financial choice regardless of what the tax rate is.

This illustrates the concept of opportunity cost.  Opportunity cost is what you give up by not taking your next best option.  In this example, Dr. Surgeon's next bet option is to make nothing, so the opportunity cost of performing the surgery is $0.  Now one could argue that at some point, Dr. Surgeon is going to limit the number of surgeries that she does because she wants more free time, less stress, or for some other non-monetary reason.  However, these quality of life decisions aren't affected by the tax rate, generally speaking.  Yes, maybe if the government got 99% of her fee, she might consider working less.  However, back in the real world, we are only talking about seeing tax rates rise from 35% to 39.6%; this isn't high enough to make much of a difference in Dr. Surgeon's decision making process.

The bottom line here is that Professor Mankiw's argument makes little logical sense given the circumstances.  There won't all of a sudden be a shortage of surgeons if the Bush tax cuts are reversed for high earners.  On the other hand, maybe fewer Tom Cruise movies wouldn't be such a bad thing after all.

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