Are taxes irrelevant?

Because many academic economists are partisan Democrat, and because Democrats want to raise taxes on the rich, there is a push by economists to claim taxes in practice doesn’t harm output.

There is no consensus regarding the importance of taxes. Macroeconomist who study countries generally believe taxes are quite harmful, while micro-economists who study individuals typically find that taxes are only moderately harmful.

The standard micro study compares changes in behavior after a tax-reform, e.g comparing the behavior of those who got larger tax cuts with those who got smaller ones. There are problems with this method.

1. You have large measurement error/random chance whenever measuring income, which might make it harder to detect true response. I think this problem is worse for individual-level than country-level analysis, since for countries randomness gets evened out by aggregating.

2. Adjustment cost and time lags are important. People don’t just quit their job if you raise their tax rate by a couple of percentage points (often temporarily); as such decisions are made based on long term consideration. Raj Chetty addressed adjustment costs, finding much larger negative effects of taxes on income and hours worked.

3. Taxes on others affect you. For instance, firms and unions will set the standard workweek in a plant for everyone in part based on average taxes, not just yours. Another example is that if low-income workers are highly taxed, the rich will be less likely to specialize by buying domestic services and working more. The standard micro-model doesn't detect the multiplier effect of taxes in these examples, since it can only compare individuals with each other, missing group-level effects.

4. The straw-man account of how taxes influence behavior are the most amusing. Obviously humans are not robots who maximize each decision with perfect knowledge. But even with bounded-rationality, incentives affect human behavior. This can for example be through rough rules-of-thumb, observing others around you, change of norms regulating work-ethic, or information imbedded in culture and tradition.

In a society with weakened incentives for work, a part of the population will eventually take the hint and work less, even if they don’t go around calculating the exact marginal tax rate using excel-sheets. This kind of aggregate level dynamic wherein the welfare states gradually changes society is impossible to detect using the standard methodology in public finance.

Note that this point doesn't only apply to taxes, but to all economic behavior. Economists arguing that taxes do not influence behavior since people are not perfectly rational are being inconsistent when they go to their micro-class and teach their students that the price of apples clears the apple market.

5. Another illogical but common argument is the incremental fallacy, related to Zeno's paradoxes: “ha ha, it is silly to think that a tax increase of 1% changes anyone's behavior”. By this reasoning any price hike that is done in tiny incremental steps has no effect, regardless of the total magnitude of the ultimate increase!

You can easily make the same flawed reasoning about selling a car. Just raise the price in 1 dollar increments, and you can double the price without losing sales, because no one cares about an extra 1 dollar when buying a car, right?

For these reasons and more, it may be that the standard micro-studies underestimate the harmful effect of taxes. Macro studies that compare taxes, output and hours worked over time between countries find stronger effect, though obviously that method has its own problems.

Liberal economists Pickety and Saez are noted advocates for raising marginal taxes. They have created another valuable dataset of top marginal tax for 18 countries from 1975. Ironically, their own cross-country-cross-time data contradict the notion that taxes are irrelevant.

This is a graph of changes in the top marginal tax rate 1975-2008, combined with growth in per capita income from the OECD. Countries that cut taxes more had higher growth. The p-value is 0.033, so the correlation is statistically significant.



Its dangerous to interpret cross-country correlations as causality, so the graph should be interpreted with caution. It may be that growth causes tax cuts or that tax cuts correlate with generally improved economic policy driving growth. The correlation hardly singlehandedly proves taxes matter, but as part of a wider set of evidence it is interesting.

P.S

The way tax-cuts are measured is the percentage increase in take-home pay (e.g For Sweden, the top marginal tax rate declined from 87% to 74%. Take-home pay per dollar earned increased from 0.13 to 0.26, an improved inventive to work of roughly 100%). If you instead measure raw tax-cuts, so 13 percentage points in the Sweden-example, you get roughly the same graph, with a p-value of 0.058.

Cutting entitlements works

In welfare states the official unemployment rate tends to underestimates total joblessness, since many jobless are in early retirement, sick leave, labor market programs etc.

The Social Democratic government in Sweden got into trouble for exploiting insurance programs such as sick-leave and early retirement to hide unemployment. Reinfeldts center-right government took power by promising to reduce Total Joblessness (“Utanförskap”). They made entitlement less generous while reducing tax rates, making it more attractive to work rather than live off welfare.

Riksdagens Utredningstjänst (the equivalent of the Congressional Budget Office) recently calculated total hidden unemployment in Sweden since 2006, finding that joblessness actually declined during the economic crisis.

As a share of the 16-64 population, Total Joblessness (“Utanförskap”) declined from 26.7% December 2006 to 24.6% December 2011.

The employment rate of this age category also increased during the period. Considering that employment rates fell sharply in the OECD during this period, it is impressive that the Swedish numbers managed to go against the stream. Making it less attractive to live off the state instead of working led to reduced dependency on welfare, as predicted by economic theory.

Cherry-picking Europe

I write in The American about Europe. The left likes to evaluate the European welfare state by cherry-picking the 3-4 most successful examples, all in the North. This obscures the failure of larger welfare states in southern European. Italy, France, Spain, Portugal and Greece have economic policies which are at least as left-wing as Northern Europe, with less favorable outcomes.

Are Welfare Recipients mostly Republican?

Paul Krugman is in puzzlement, having observed that Red States get more welfare funding, while Republican voters oppose the welfare state. He portrays Republicans as “Moochers” who are either hypocritical or too stupid to know their own best interest.

But as we know, states do not vote, individuals do. There is only a paradox if Republican voters receive welfare at above average rates while voting against it. From the Gellman-paradox we know that the low-income voters who drag down the Red States average tend to vote disproportionally for Democrats. Republican voters earn significantly more than Democrats, even though Red state earn less than Blue states.

Krugman reports no individual level data, so let me. The Maxwell Poll has detailed information about welfare use. The data is from 2004-2007. During this period in these polls a plurality of voters supported Democrats. I will graph the two-party vote, more data is at the end.


Hardly surprising, we see that in a two-party split, 60-80% of welfare recipients are Democrats, while full time Workers are evenly divided between parties.

You have similar results in this recent NPR-Poll. Among the Long Term Unemployed, 72% of the two-party support goes to Democrats.

It appears that once more common sense is right and the impression left by the New York Times wrong. Indeed, people who live off the government disproportionally support Democrats.

Given that Krugman is aware of the Gellman-Paradox, he should have reported the individual level data first instead of wasting everyone’s time with state-level aggregation that we already know is wrong. Instead he acknowledged that state level data is probably wrong (to get cover), then goes ahead and relies on the wrong method anyway, since it produces the results he wants. The false impression that Republicans use more welfare is already spread around the internet by liberals who still trust Krugman.

Appendix:

Share of Recipients of each program that self-identified as supporters of Republican party in 2004-2007 Maxwell Poll:

Gov. Subsidized Housing 12%
Medicaid: 16%
Food Stamps: 20%
Unemployment Compensation: 21%
Welfare or public assistance: 22%
Disability benefits from government 25%

Thoughts on current Swedish and American politics

The Swedish Social Democrats historically tended to get around 40-45% of the vote. Currently they are polling at 23%. Today, they elected a new party leader.

Though the content of the ideologically is diametrically opposed, I think there are important structural similarities between the Social Democrats in Sweden and the Republican party in the U.S.

Both countries are politically polarized, with tribal wars between the right and the left. Both parties are out of power.

In both cases, their opponents have taken control of the elite making institutions in their respective country, the left here in America and the right in Sweden. Because of this, the quality of the leadership available to the Republican and Social Democrats has declined, both in terms of competence and character.

The Swedish Social Democrats chose two low-quality leaders, Mona Sahlin and Håkan Juholt.

The Republicans have chosen or considered had a string of low quality candidates, including George W Bush, Sarah Palin, Donald Trump, Herman Cain, Michele Bachman, Rick Perry and now Newt Gingrich.

When the enemy elites takes over and subverts institutions such as the media or universities, your side naturally becomes hostile to elites in general. This has happened both in the U.S and in Sweden. In both cases, political defeat paradoxically can make the situation worse, since the leaders are blamed, the party closes inward, and since ideological purists gain influence.

Consequently the decision making quality of the grassroots declines. Wiser Republicans believe Mitt Romney is a far superior choice than Gingrich, but are no longer trusted by many voters. Similarly the adults in the Social Democratic party realized early that Håkan Juholt was a drag, but were not initially able to force him out.

In a country engaged in tribal war along political lines, elite who take over institutions have little qualm in abusing their power. For the better part of a year, the Swedish media engaged in mass-hysteria against Håkan Juholt and the Social Democrats. His mistakes were amplified and hammered on, and toward the end the poor guy couldn’t say anything without it turned into a “scandal” by the media. I must say I admire Juholt’s personally by not letting the prejudicial hostility of the press break his spirit. Juholt managed to win most debates during this storm of animosity.

Similarly the American media is mobilizing for political war against their enemies. Reading the New York Times in the plane yesterday, more than half of the “news” articles were thinly disguised leftist propaganda, most containing factual or analytical errors from an economist point of view.
Let me give just one simple example. When comparing the taxes paid by rich investors such as Warren Buffet and Mitt Romney, corporate taxes are simply ignored by the NYT.

Warren Buffet paid almost $1.6 billion in corporate taxes last year alone. Mitt Romney’s tax rate would be twice as high if corporate taxes that he pays were taken into account.

The effective corporate tax rate in the U.S has been estimated at 27%. That means that if you pay 15% in capital gains taxes, your true tax burden taking double taxation into account is 38%. This is a simple and virtually irrefutable point known to most economists, but ignored almost entirely in the debate around the tax rate of the rich.

Björn Wallace and I have termed the tendency of politicians to hide the true tax rate on individuals through indirect taxation and misleading labeling regarding incidence as Fiscal Obfuscation.

These comical biases survive because the elites in the American media and the elites in American academia favor the left.

Another similarity between the Swedish Social Democrats and American Republicans is that demographic change is working against both parties. In Sweden, the working class is shrinking and losing their class-identity. Whereas young Swedes two generations ago aspired to change the world through progressivism, today they aspire to purchase and renovate an apartment in central Stockholm.

In the U.S, politically motivated Democrats and ideologically motivated libertarians managed to shift the American political center of gravity to the left through low-skill immigration policy.

Among non-hispanic white Americans, today 55% are positive towards “Capitalism” and 35% negative (+20%). Among Hispanics, 32% are positive and 55% negative (-23%). Similarly while 68% of whites are negative towards “Socialism” and only 24% positive, Hispanics are evenly divided (49% vs. 44%).

It will be very difficult for a pro-capitalist Republican party to survive in a country that through immigration is becoming increasingly anti-capitalist. Despite what for example Bryan Caplan claims, there is no evidence that Hispanics are pro-capitalism and only vote Democrat because of Republican immigration policy.

Neither party’s situation is entirely hopeless. Today the Swedish Social Democrats choose a new party leader, Stefan Löfven. The decision to replace Juholt out was reportedly made by the party elders. From the little I know Löfven is competent and widely respected. He started as a welder and worked himself up to the leader of the most powerful union in the country.

Because American parties are more democratic (in the sense than voters have far more input in who becomes the candidate), the leadership quality problem is even worse among Republicans. It remains an open question whether the Republicans will choose Romney, the most accomplished guy running for President in 20 years, or Gingrich, probably unelectable and detested by most people who worked closely with him.

In both Sweden and the United States, while the elites tilt, the belligerent tribes themselves are equally sized, which means ultimately anything could happen. This makes tribal politics exciting as the favorite spectator sport for nerds like me. Though I may have stretched the parallels a bit, I think you learn more about the politics of both countries by analyzing them together.

Wrong Juholt: Sweden is still more equal than U.S in 1980s

Increasingly, newspapers have “Fact-check” sections where they attempt to adjudicate political controversies.

The problem with is that very often, the people who write these articles are journalists, not the arbitrates of the objective truth. But since people trust the newspaper as giving them fact rather than subjective opinion, this becomes a problem when the fact-check itself requires fact-checking.

A couple days ago the leader of the Social-Democratic party argued that Sweden today has higher income inequality than the United States in the middle of the 1980s.

The right-of-center daily SVD has a “Fact-Check” of this claim, and concludes that the Social Democrats are mostly right in their claim that Sweden is as unequal as the U.S was in the mid-1980s.

But the OECD tells a different - and in my view more plausible - story.

Here are international Gini-data from the OECD. The higher the Gini-coefficient the higher income inequality. Since the state taxes the rich and subsidizes the poor, inequality in both countries is lower after taking taxes and transfers into account.

The U.S Mid-1980s Before Tax and Transfers 0.436
The U.S Mid-1980s After Tax and Transfers: 0.337

Sweden Late-2000s Before Tax and Transfers: 0.426
Sweden Late-2000s After Tax and Transfers: 0.259

Even before tax and transfers, Sweden is still slightly more equal. (At any case we should we ignore the effect of the welfare state, since the discussion is precisely about government policy?)

SVD was sloppy in it's “Fact-Check”.

Here is the Gini-coefficient of disposable income 1975-2008, again from the recent OECD report "Divided We Stand: Why Inequality Keeps Rising".


Note, as my brother Nima Sanandaji did, that income inequality was also rising in Sweden during long periods of Social-Democratic rule, for instance 1994-2006. There has been a secular rise in Inequality in most OECD-countries. Likely the cause is common changes in the global economy (globalization, rise in the premium for human capital) rather than the fault of any particular government.

The American Federal Debt

The President doesn’t control the economy, and should not be blamed for things out of their control. The deficit is however one the components of the economy where the president has lots of direct control. Even this controll is far from complete, presidents can be lucky or unlucky. For instance the deficit declined during the 1990s IT-boom when Clinton was president and was increasing rapidly when Obama took over following the 2008 crash, in both cases having little to do with their actions.

Though the debt numbers alone do not tell how much credit or blame the president deserves, they are interesting. Data from The White House 2012 President's Budget. Since the figure is for the end of the year and the President takes office one month into the year, they correspond well with tenure.


During 20 years of the presidencies of Reagan, Bush I and Bush II, the federal debt as a share of GDP increased by a cumulative 43% of GDP. During the 4 first years of the Obama presidency, it has increased by 36% of GDP.

This is how the Presidents rank in terms of development of the Debt/GDP ratio per year of tenure:

1. Clinton -1% per year
2. Reagan, Bush II: +2% per year
3. Bush I: +3% per year
4. Obama: +9% per year.