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.
Uneasy Money 
All savers are not equal. All types of earning are not equal.
Once again, the point of low rates is not to get the financial sector running your money.
The point of low rates is to get entrepreneurs to take giant frigging risks, and to get MORE people deciding to be entrepreneurs.
This is a VERY different proposition, it is the real deep Main Street Rotarian base -the big fish in small ponds.
It is not the doctor in small towns, or the lawyers in small towns, who sock away cash from rent seeking and pile it into the market.
We want guys who lay in bed at night trying to think of crazy new shit people will buy, desperate to drive their prices lower, etc. to BE FAVORED by us over everyone else.
Let’s all admit that does not happen. it doesn’t happen with taxes, it doesn’t happen with regulations.
Imagine the world where the oly tax free capital gain isn’t 1031’s it is moving profits from one SMB to another without any tax consequence.
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@David,
I’ve thought along the same lines, more or less but in a more crude fashion about the marginal returns from financial speculation. In my own mental construction, I think of the marginal tax cuts of the 2000s and the 1920s. Maybe there’s something to the idea that marginal tax cuts lead, accompanied by other factors obviously, to unproductive speculation and may have contributed to the old boom/bust cycle prior to the Great Depression.
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Julian, I am not sure if I am making myself clear. I have nothing against speculation. I am saying that the research that speculators engage in to become better speculators is a waste because their gains come entirely at the expense of someone else. I guess you could say I am in favor of uninformed speculation.
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Julian would that effect only be on the delta? By that I mean is it a short term result due to a change in the tax rate rather due to the level of taxation. Same for David’s idea, will the profit eventually be squeezed out of finance?
On the idea of too many smart people going into Finance, I think that a similar argument could be made that Excessive licensing in medicine leads to too many smart people becoming Doctors.
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Morgan, I am not talking about saving; I am talking about income from labor. You see only one big thing; that makes you a hedgehog. I see many small things; that makes me a fox.
Floccina, Eventually the profit should be squeezed out of any industry, but that is only a long-run tendency and depends on freedom of entry and stuff like that, so I don’t know if that is going to happen so soon. Besides profits going to zero would not eliminate the difference between the social and private benefit from the production of useful financial information.
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As a physicist who has had friends and acquaintances lured to the financial sector, this story is plausible. Finance is a huge attraction for the top graduates of our top universities. Just look at how the big firms recruit at Ivy League institutions. At the same time, through the 1990s, there was a large disinvestment in basic science funding by the government, leading to people trained in science not being able to continue their careers. It is much the same today. But again, these are just stories. We need numbers.
Morgan, the other way to encourage entrepreneurs to take big risks such as starting a small business, is to have a strong social safety net. In Scandinavia, a failed small business will not leave you ruined. There is unemployment insurance for all and universal health care to cushion the fall and help a person become gainfully employed again, quickly. Certainly these could be alternative mechanisms to encourage entrepreneurial risk taking.
Part of the attraction of high after-tax income for a person is the economic security it provides. Strong social insurance can provide similar economic security.
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“high marginal tax rates operate to reduce the incentive to misdirect resources”
David, usually I like your columns, but I find this statement utterly bizarre. Are you saying the profit motive misdirects resources? After all high MTRs are levied on profits, and if high MTRs reduce misdirected resources, then you must be arguing the profit motive increases misdirected resources, right?
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Also, low inflation, not low MTRs, has increased the size of the financial sector since 1980. That’s because credit metrics are applied to nominal variables, i.e., PITI/wages, int-expense/EBITDA, or int-expense/tax-revenue, and the personal, corporate, and governmental levels, respectively.
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Finally, I’ve had the exact opposite theory, that capital gains taxes have fostered bubbles. That’s because incumbent asset owners are reluctant to sell into bubbles and take the tax hit. They rationalize their ownership based on tax deferral, EMH, transaction costs, and so forth. Bubbles, by definition, mean that ALL owners of a particular asset class have embedded unrealized tax liability. I’ve seen it myself, three times, with tech company investors in 1999, home and condo owners in 2004-2007, and commodity owners in 2008.
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I read that telco entrepreneurs are building new fiber pathways between financial centers because traders will (they hope) pay a premium for slightly (like 1ms) lower delay.
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Enourmousturnip, Thanks for your comment. I totally agree that we need number; I am just telling a story that seems plausible, but I have no way of knowing whether it is relevant to our experience.
Steve, Sorry, but you are misunderstanding me. I am not blaming the profit motive. However, profits are an optimal guide to the allocation of resources when private and social costs and benefits are properly aligned. I am suggesting, based on Jack Hirshleifer’s classic article on the social and private value of information, that there is a systematic overvaluation of information by the financial sector because it allows them to earn trading profits which reflect not the addition of value to society but losses extracted from less knowledgeable traders. All (or almost all) the resources expended in acquiring such informational advantages are a social waste.
About bubbles, I repeat what I have said several times already. My point has nothing to do with bubbles. It is a systematic misallocation of resources. I am not asserting that assets are being mispriced.
Max,Someone commenting on my previous post on this topic brought up the same point. It is a good example of how resources are being wasted in the pursuit of socially useless informational advantages.
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“I am not blaming the profit motive. However, profits are an optimal guide to the allocation of resources when private and social costs and benefits are properly aligned.”
Yes, but this has nothing to do with the MTR, as the MTR taxes profits, not externalities.
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Steve, Sorry I don’t understand. The marginal tax rate applies to all income, including income from labor.
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Your argument requires that moving better brains into finance produce a sufficient increase in returns that it leads to growth in the sector – the textbook notion that higher returns will lead to new expansion in the sector to the point that excess rents are driven out. That is a stronger argument than the more conventional one, which is that moving brains to finance depletes the stock of brains available for more socially useful endeavors such as science, engineering and stand-up.
The argument that finance has impoverished the socially useful parts of the economy is illuminated by you tax argument, though. It does make sense that take-home pay is a stronger incentive to those who are not initially all that interested in whose-check-is-bigger than is gross pay. presumably have less of it.
In the end, though, the rule-of-thumb is that you get less of something if you pay less for it. If we paid everybody with an interest in socially non-useful finance less, there is reason to think there’d be less of it.
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“We want guys who lay in bed at night trying to think of crazy new shit people will buy, desperate to drive their prices lower, etc. to BE FAVORED by us over everyone else.”
We do not want that. At least, those who believe that the function of markets, under a reasonable set of limits, produce the most efficient economic outcomes. The WHOLE POINT of allowing markets to determine outcomes is that we don’t impose Morgan’s Randian preferences or my preference for Ambrosian chant over pop.
Steve has said you are doing a hedgehog thing. I’m afraid I must disagree. The point to a hedgehog is that it “knows one thing”. Your argument that we ought to prefer some actors in the economy over others suggests that you don’t know what you think you know – unless you think you know some form of state-ism.
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kharris, I don’t really get your distinction between “higher returns will lead to new expansion in the sector to the point that excess rents are driven out” and “moving brains to finance depletes the stock of brains available for more socially useful endeavors such as science, engineering and stand-up.” Also did I deny “that you get less of something if you pay less for it?”
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I would argue that global pressure to create more dollars (primarily from China since they needed dollars as collateral to expand their own untrusted currency) coupled with runaway leverage enabled by deregulation of banks (and failure to regulate derivatives) were the biggest factors leading to the expansion of the financial sector.
It is also very plausible that the diversion of brain power to finance and away from science and math reduced US innovation and productivity and could be a major cause of the low real GDP of the last decade or so.
I think that unbalancing the federal budget has been the biggest impact from lower tax rates.
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kharris, denying the paramount importance of entrepreneurs gets you less socially useful endeavors.
These two paragraphs directly contradict each other:
“We do not want that. At least, those who believe that the function of markets, under a reasonable set of limits, produce the most efficient economic outcomes. The WHOLE POINT of allowing markets to determine outcomes is that we don’t impose Morgan’s Randian preferences or my preference for Ambrosian chant over pop.”
and then
“In the end, though, the rule-of-thumb is that you get less of something if you pay less for it. If we paid everybody with an interest in socially non-useful finance less, there is reason to think there’d be less of it.”
ONLY technical innovations improve the lot of man.
Let me unpack that a bit. The massive catch up of the third world occurred because since the 1980’s the US ran far out in front of everyone else on communications technology after casting off the yoke of gvt. regulation.
The $6 per month 3G unlimited cell phone in Thailand uses radios that no longer have a “just invented” premium. As a result, three years from now the penetration of the same technology in Africa will be $3 per month.
Android tablet computers that offer total Internet mastery now $100 will be $50, and then $25.
I work daily with guys in Pakistan, Ukraine, Lithuania, China and that’s this month. All of those guys are under 30 and speak English and laugh at the same goofy web links on Reddit, a site spilling over with socially redeeming value, in fact a real reason SOPA went from fast track by the powerful to dead in literally days.
As long as gvt. says out of the way, in 40 years, those guys living elsewhere will be 70 and everyone in their country will be future forward version of them today.
College based signalling falls over when geeks are the highest order. What matters is what you can invent and bring to market that everyone else loves.
Guys like me can and will remake the Federal, State, and Local govt. into a web platform that needed 75% less public employees, and make most people incredibly happy with gvt.
Legislation could be written online, everyone will have a guaranteed living income and everyone will be required to work for a private sector boss trying to get more out of them on a daily basis.
The future will always happen, the question is how quickly we get there, and technology is what gets us there quicker.
Income inequality is meaningless. What matters is how many new drugs are out of patent 12 years from now so the lower class have better lives 12 years from now.
The immediate PROBLEM is a tax policy that DISFAVORS entrepreneurs, and NO lack of health care doesn’t matter here. The same $500K a year for an entrepreneur gets taxed more than it does for guys in Fortune 1000, finance or real estate.
So the best and brightest WERE going into finance, and they are now just starting to come back into my world. But in a short period of time we got a housing crash.
What we need is a business cycle that stacks one dot.com growth period on another, just get everything running online, get everyone tapped into it, and get out of the way.
Healthcare and education are both going to get Napstered and Amazoned in the near term as well, unless guys like you with a technocratic penchant for regulation get in the way.
If you want to be socially valuable learn to code.
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Magnificent. I think your hypothesis is by far best economic explanation (that I have seen so far) confirming the sentiment shared by many, many people, me included, who intuitively see significant structural problem of US economy in the fact that financial sector occupies way too large share of it.
However, doesn’t this hypothesis, if true, have somewhat problematic implications for Market Monetarists? Their favorite tool for fighting demand shortfall is monetary stimulus, channelled into the economy through financial sector. But doesn’t such stimulus, while it indeed boosts aggregate demand, disproportionately benefit, well, financial sector? Thus making structural problems even worse? My intuition says that it does, but as non-economist I am now unable to produce clear argument for that hunch (maybe later). In EU, where I live, latest actions of ECB certainly seem to benefit banks more than anybody else.
Is there a case to be made for boosting demand not by shovelling banks with money, but rather by, for example, building infrastructure or shovelling poor people with money? Which would be paid, after output gap is closed, from taxes levied on rich people, preferably rich people working in financial sector? In other words, fiscal stimulus?
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Bill, I don’t see why creating dollars to satisfy a Chinese demand to increase their dollar holdings has any implications for the size of the US financial sector.
Morgan, Do you think that there has been an influx of ex-finance guys into the dot-com sector?
Ales, Thanks for your kind words. I am afraid that I don’t see any relationship between using monetary policy as a macroeconomic tool and an increase in the size of the financial sector.
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Late to this but…
Low marginal tax rates also make volatile incomes more attractive. E.g. if you pay 0% on the first $20k, 10% from $20k to $40k, 20% from $40k to $100k and M% on every dollar over $100k, you will pay less taxes earning $100k five years in a row than if you earn $50k, $75k, $100k, $125k and $150k and the higher M is, the more your total tax obligation increases with the volatility of you income.
So, low marginal tax rates might encourage more people to go into finance where variable bonuses are big part of total compensation. Just the same, low marginal tax rates might also encourage more people to start businesses rather than take a steady paycheck working for someone else. Or the compensating differential story here might play out. (I doubt it and the post gives no strong reason to suppose that people wouldn’t actually prefer to work in finance rather than in engineering.)
What do you think is most likely?
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This is to Morgan Warstler post #1
Its not rich people who are the major driver of economic growth it is science, without science we’d still be in the stone age. It isn’t finance people who move money and assets around who expand living standards its science.
This idea that we all need to bow down to “rich” people because we’re all stupid and only people making millionaires can do anything is absurd. The farmer (who does a valid good service) isn’t a genius he just got lucky and had parents who gave him capital.
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