Apparently, No One Thinks About Taxes Very Clearly, Which Is Bad For Standard Economic Theory

-- Posted by Neil H. Buchanan

There is an emerging category of news article that has become ubiquitous in the post-election period.  Call it the "Rich Folks Can't Believe What Happened, and They Don't Know What To Do Next" story.  Essentially, there is a big freak-out going on among the high-income people who believed the Fox News-iverse's narrative that Mitt Romney and Paul Ryan would easily win the election.  Those people are now suddenly confronted with the unbearable thought that their taxes might go up somewhat in the near future.  Many of them, apparently, do not know what to do now.

The news media has been filled with stories about companies announcing that they are laying people off in advance, just to be ahead of any tax increases that might be imposed.  Faced with the dreaded "Obamacare" implementation, other companies are cutting some employees off from all health care coverage.  Business media are filled with advice about how to pay taxes now, in order to avoid being stuck with higher taxes after January 1.  Given the relatively modest changes in play -- the top income tax bracket rising from 35% to 39.6%, for example, even if Obama does not compromise -- it really is a sight to behold, as the moneyed class tries to deal with the thought that the billion dollars or so that they spent to elect Romney/Ryan (and to buy the U.S. Senate) went for naught.

Last Sunday, the New York Times ran an article that was a rather standard version of this new category of Rich Folks Gone Wild news coverage. In "Investors Rush to Beat Threat of Higher Taxes," two reporters wrote about their interviews with various higher-income people who are worried about paying higher taxes.  It was the usual run of silliness, but one part of the article garnered an unusual amount of attention.  Here are the three-paragraphs in question:
     Kristina Collins, a chiropractor in McLean, Va., said she and her husband planned to closely monitor the business income from their joint practice to avoid crossing the income threshold for higher taxes outlined by President Obama on earnings above $200,000 for individuals and $250,000 for couples
     Ms. Collins said she felt torn by being near the cutoff line and disappointed that federal tax policy was providing a disincentive to keep expanding a business she founded in 1998.
     “If we’re really close and it’s near the end-year, maybe we’ll just close down for a while and go on vacation,” she said.
Some left-leaning media sources grabbed onto this anecdote, gleefully announcing that the chiropractor in the story clearly does not understand how taxes work.  Rachel Maddow did a full segment about the article on her show, and the Huffington Post ran a story mocking the supposed illogic of the Collinses (and people like them).  (Both links are available on the TaxProf blog here.)

So what is so risible about all this?  The idea that Maddow and HuffPo focused on is the difference between marginal tax rates and average tax rates.  Marginal tax rates are applied only to additional dollars of income, whereas average tax rates apply to all income.  Suppose that the tax rate is 10% on the first $100,000 of income, and the marginal rate then rises to 20%.  A person earning $120,000 would pay 10% on the first $100,000 in taxable income, and 20% on the next $20,000, for a total tax bill of $14,000.

If you do not understand that basic idea, then you might make a big error.  For example, consider someone making $99,000 in taxable income, and thus paying $9,900 in taxes, taking home $89,100.  They might think that earning an extra thousand dollars will kick them into a bracket where all of their taxable income is subject to a 20% rate, paying $20,000 in taxes and taking home $80,000.  Earning an extra $1000 in income leaves them $9,100 worse off than if they did not earn the extra money.  This is known in tax parlance as a "cliff effect," and it is why we use marginal tax brackets in the first place.

There really are people who make that error (which is an easy error to make, for anyone who has not learned the difference).  The HuffPo article cites a 2011 blog post from the liberal economist Dean Baker, who ridiculed a USA Today article that said this: "That raise actually might not be as good as it looks. The extra money is nice, but it could very well bump you into the next tax bracket, possibly leaving you with less money than you had before the raise."  This is a clear case of someone (in this case, a news reporter on the tax beat for a national newspaper) making a fundamental error confusing average and marginal rates.

The problem is that the Virginia couple in the NYT article did not make that error -- or, at least, there is nothing in the article to indicate that they had definitely done so.  What they say is that they are worried about crossing the threshold of a higher tax bracket, and they will go so far as to refuse to earn any additional money at all in order to avoid doing so.

It is easy to see why Maddow and HuffPo jumped to the conclusion that they did.  It could seem as though the Collinses are saying that they are afraid of losing money by making money.  What they really said, however, is not only not "cliff effect" thinking, but is fully consistent with the type of rational maximizing that is at the heart of economic orthodoxy.  In that theory, everyone responds to incentives, such that they will provide an additional amount of effort only if they will receive (net of taxes) enough money to make it subjectively worth doing so.  Everyone has a breaking point, such that I might work an extra hour for $19.73, but not for $19.72.

This is fully consistent with what Dr. Collins told the Times.  She did not say that she and her husband would shut down the practice at the end of the year to avoid being left with lower after-tax income, but only that they have decided that any rate above their current marginal rate (which is currently at most 33%) would make it not worth working any more than they already have.  They would rather go on vacation.  Bully for them!  Again, we do not know whether this is what they were thinking, but it might be.

If this sounds like a defense of economic orthodoxy, however, then you have not been reading this blog for very long.  In fact, this story helps to expose the ultimate weakness of the standard economic story.  If the Maddow/HuffPo version of the Collins story had been accurate, after all, the taxpayers' reaction would still not show that, in the HuffPo writer's words, "[t]his is a stupidity as persistent as it is avoidable. Ms. Collins, chiropractor from Virginia, is among the many people of affluence who have somehow survived without understanding how marginal tax rates work."

My point is that people who make this "stupid" error -- and it is an error, if people really think that they will end up with less money from a cliff effect, when there is no cliff -- can in fact be acting in ways that economic orthodoxy would tolerate, or even celebrate.  They could, for example, being "going Galt," simply refusing to work additional hours to pay taxes into a public kitty, when that public fails to appreciate the superiority of the Job Creators.  Or they might just hate President Obama, refusing to "let him win" by taking more of the taxpayer's gross income than the taxpayer thinks is fair.

Cutting off one's nose to spite one's face, in other words, is fully consistent with economic rationality.  Because that peculiar type of rationality requires only that people be trying to maximize their happiness, based on their subjective vision of their goals and values, it is not irrational (note the important double negative) to do what Dr. Collins might have been threatening to do -- or even for her and her husband to shut down their practice forever and become panhandlers.

That, as I (and many others) have argued repeatedly over the years, is both the great strength and the great weakness of modern economic orthodoxy.  If nothing is irrational, then nothing makes sense.  One can save the theory by doing what I described above: Confronted with seemingly irrational behavior, simply point out that the person did what they did, and then supply a story in which their actions make sense.  Famously, this logic has been applied to show that suicide is economically rational.

Making that move, however, drains the theory of all useful content.  We can say that the Drs. Collins, or even the cliff-effected versions of them, are Not Irrational.  Doing so, however, means that we have given up on the usefulness of orthodox economic theory actually to predict behavior, or to provide useful policy guidance.

For example, a recent study by the Congressional Research Service (CRS) became famous at the end of the Presidential election campaign, because it showed no statistical correlation between higher marginal tax rates on the highest incomes and reduced economic activity.  In response, the Republican staff of the Joint Economic Committee criticized the CRS study for failing to properly calculate the marginal tax rates that rich people really face.  Doing so carefully, the Republican document contended, is necessary to perform a valid statistical test of how people in fact respond to tax incentives.  (They were not, however, able to reverse the CRS's result.  They merely cast doubt on its method.)

Whether or not the Collins chiropractic office is an example of it or not, the Rich Folks Gone Wild run of news stories shows us that "properly" or "improperly" calculating marginal tax rates is not what appears to be going on here.  If there are people who are willing to shut down businesses because they are afraid that Obama is a property-confiscating Communist who will somehow get House Republicans to look the other way while he taxes the rich into oblivion, then we can say that those business owners are Not Irrational, in some trivializing sense of that concept.  We can also suspect, however, that an economic model that relies for its predictive power on the idea that people will respond "rationally" to tax changes is not a reliable guide to actual economic activity or tax policy.