Friday, June 20, 2008

Stifling the "Educated-Take-All" Economy 

Mark Perry titles his post "It's an 'Educated-Take-All' Economy", with a graph showing the returns to education for median family income. Quoting a news article first (in italics):
Barack Obama said that he was trying to put together tax and spending policies that dealt with two challenges. One is the competition from rapidly growing developing countries, like India and China. The other: the U.S. becoming what he called a "winner-take-all" economy, where the gains from economic growth skew heavily toward the wealthy.

...Wouldn't one way for Obama to solve this "problem" be to have the government shut down all American colleges and universities, eliminate all federal funding for higher education, or have the government put limits on the number of students attending college?

There is rising income inequality, but the inequality is due to the increasing gains to education over time. It's not so much that the "rich are getting richer and the poor are getting poorer," as much as it's "the college-educated are getting richer in an Information Age Global Economy, and the high school dropouts are staying the same or getting poorer."
So is it possible to use the tax code to correct for income inequality that is the result of educational differences? And is it desirable? When we've debated the creation of public funds for higher education financial aid through scholarships, one issue was the tax rate on human capital formation. Should the tax system be changed to raise the tax rate on human capital formation through education, as it appears a President Obama would do? Note that his plan includes higher marginal rates on the wealthy compared to McCain, as much of the revenue going to lower-income households are in the form of credits rather than rate cuts. More highly progressive systems are, in fact, a means of taxing human capital. Maybe he'd be better off just taxing height.

Larry Lindsay
notes this morning that the combined effects of the Obama tax proposals would move the entrepreneur earning more than $250,000 per year would see a rise in his marginal tax rate to 53% from 37.7%. Obama thinks the entrepreneur will simply take it in the shorts. Lindsay says, not quite:
One of the lessons from the disastrous economics of the 1970s and the subsequent Reagan tax cuts is that everyone � particularly entrepreneurs � responds to incentives. If you take away 10% of a high earner's after-tax income at the margin, he will cut his taxable income by at least 4%. At the margin, this taxpayer now takes home 62.3% of his earnings, a figure that will drop to 47% under the Obama plan. According to a widely accepted economics rule of thumb, the entrepreneur's taxable profit would drop by 11.2%.

Now consider how the Obama plan would affect the taxes paid by such an entrepreneur with a taxable profit from his business of $500,000. Under current law, he would pay $27,148 in Social Security and Medicare taxes, plus $142,969 in personal income taxes, for a total of $170,117. If the taxpayer did not change his behavior at all, under the Obama plan he would face a $31,000 Social Security tax hike and a $11,494 hike in his personal taxes � or a 25% tax hike. But, if the taxpayer responds as the economic models predict, his taxable profit would drop to $444,000. His Social Security and Medicare tax bill would still soar to $51,580. But his income taxes, even with a higher tax rate, would drop to $132,882 for a total of $184,462.

In other words, Sen. Obama is planning on a combined series of tax hikes to produce $42,000 in tax revenue, but consensus economic modeling suggests the government's net take would rise only $14,000.
See also J.T. Young from earlier this week. But even that is a short-run analysis. What is the incentive for someone to study for the higher-income majors in school if we raise the rate of taxation on human capital formation by 25%? With smaller cohorts of new workers coming into the labor force in the future, each worker will need to be more productive to fund current Social Security and Medicare liabilities. The Obama tax plan stifles the incentive to be educated in fields that are highly productive. People don't luck into MBAs and law degrees or medical research (though perhaps Mrs. Obama thinks so) ; they do so in pursuit of their dreams, of which Mr. Obama would like 53%.

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