Why Low Marginal Tax Rates Might Have Harmful Side Effects ...

My post last week about marginal tax rates has received a fair amount of attention on the web, being mentioned by Noah Smith last week and today by Andrew Sullivan and Kevin Drum.? (Drum, by the way, was mistaken in suggesting that I intended to link reduced marginal tax rates with the financial crisis; I was talking about a long-run, not a cyclical, effect.)? As a couple of commenters on that post noted, I didn?t fully explain why reducing marginal rates would have led to such a big expansion of the financial sector. Kevin Drum raised the point explicitly in his post. After quoting a couple of passages in which I explained why reducing marginal rates on income might have led to the expansion of the financial sector, Drum registers his conflicted response.

Count me in! I?m totally ready to believe this.

Except that I don?t get it. It?s certainly true that marginal tax rates have declined dramatically since 1980. It?s also true that the financial sector has expanded dramatically since 1980. But what evidence is there that low tax rates caused that expansion? Does finance benefit from lower taxes more than other industries, thanks to the sheer number of transactions it engages in? Or what? There?s a huge missing step here. Can anyone fill it in?

So Drum wants to know why it is that reducing marginal rates might have caused an expansion of the financial sector. Obviously multiple causes may have been working to expand the financial-services sector; I was focusing on just one, but did not mean to suggest that it was the only one.? But why would reduced marginal tax rates have any tendency to increase the size of the financial sector relative to other sectors?? The connection it seems to me is that doing the kind of research necessary to come up with information that traders can put to profitable use requires very high cognitive and analytical skills, skills associated with success in mathematics, engineering, applied and pure scientific research. In addition, I am also positing that, at equal levels of remuneration, most students would choose a career in one of the latter fields over a career in finance. Indeed, I would suggest that most students about to embark on a career would choose a career in the sciences, technology, or engineering over a career in finance even if it meant a sacrifice in income. If for someone with the mental abilities necessary to pursue a successful career in science or technology, requires what are called compensating differences in remuneration, then the higher the marginal tax rate, the greater the compensating difference in pre-tax income necessary to induce prospective job candidates to choose a career in finance.

So reductions in marginal tax rates in the 1980s enabled the financial sector to bid away talented young people from other occupations and sectors who would otherwise have pursued careers in science and technology. The infusion of brain power helped the financial sector improve the profitability of its trading operations, profits that came at the expense of less sophisticated financial firms and unprofessional traders, encouraging a further proliferation of products to trade and of strategies for trading them.

Now although this story makes sense, simple logic is not enough to establish my conjecture. The magnitude of the effects that I am talking about can?t be determined from the kind of simple arm-chair theorizing that I am engaging in. That?s why I am not willing to make a flat statement that reducing marginal income tax rates has, on balance, had a harmful effect on economic performance. And even if I were satisfied that reducing marginal tax rates has had a harmful effect on economic performance, I still would want to be sure that there aren?t other ways of addressing those harmful effects before I would advocate raising marginal tax rates as a remedy.? But the logic, it seems to me, is solid.

Nor is the logic limited to just the financial sector.? There is a whole range of other economic activities in which social and private gains are not equal.? In all such cases, high marginal tax rates operate to reduce the incentive to misdirect resources.? But a discussion of those other activities will have to wait for another occasion.

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