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How High Should Taxes Get on the Wealthy?

New York Times columnist Paul Krugman points to a new paper arguing that taxes on the top earners should be set at levels that maximize the revenue collected from them.

He writes:

Mark Thoma sends us to the new Journal of Economic Perspectives paper (pdf) on optimal taxes by Peter Diamond and Emmanuel Saez. It’s a tough read (I’m still working on it myself), but there’s one discussion that I think helps make a useful point about current political debate.

In the first part of the paper, D&S analyze the optimal tax rate on top earners. And they argue that this should be the rate that maximizes the revenue collected from these top earners — full stop.

Why? Because if you’re trying to maximize any sort of aggregate welfare measure, it’s clear that a marginal dollar of income makes very little difference to the welfare of the wealthy, as compared with the difference it makes to the welfare of the poor and middle class.

So to a first approximation policy should soak the rich for the maximum amount — not out of envy or a desire to punish, but simply to raise as much money as possible for other purposes.

Now, this doesn’t imply a 100 percent tax rate, because there are going to be behavioral responses – high earners will generate at least somewhat less taxable income in the face of a high tax rate, either by actually working less or by pushing their earnings underground. Using parameters based on the literature, D&S suggest that the optimal tax rate on the highest earners is in the vicinity of 70%.

There are lots of problems with this idea. But I want to focus on how it looks from the perspective of modern monetary theory (MMT), the school of economics that pays very close attention to how government spending, taxing and borrowing actually operates.

One of the key insights of the MMT school is that government’s that control their own currency do not fund their operations with tax dollars. All government spending is really done with newly created dollars. Dollars collected in taxes are not spent, they are destroyed in order to prevent too many dollars from circulating.

This idea is a bit confusing at first so I’ll expand on it a bit.

When the U.S. Treasury Dept. writes a check, it is cleared by the Federal Reserve. The Federal Reserveclears this check by entering a deposit amount in a digital spreadsheet that represents the amount of money held by the bank in which the check’s recipient deposited it.

Obviously, the federal government conducts tons of transactions. In fact, it is the largest financial transactor in the world. There are lots of complicated operations that go on every day related to this process, made all the more complicated because the Treasury now deposits almost of all of its fund with private banks. It then has to estimate each day what funds it wants to withdraw from the private banks and deposit with the Federal Reserve, so that the Federal Reserve can clear payments on government obligations.

But the reason for this is interesting and important. The Treasury deposits tax receipts in the private banking system because without those deposits, too much cash would be drained from the system. That is, too much cash would sit on deposit at the Fed and banks wouldn’t have the liquidity they need to service customer needs.

The operational aspects of this are very complex. You can read about them in this paper from the Federal Reserve.

But the main thing to know is there is no necessary tax constraint on the Federal Reserve crediting a bank with payment from the Federal government. Banks can be credited regardless of whether the Treasury has collected funds through borrowing or taxes or not at all because all crediting the banks means is increasing amounts on digital spreadsheets. When money has no commodity backing — that is, when the amount of money isn’t limited by some real link to, say, gold — there’s no connection between money collected and money spent.

There’s not a bunch of stuff sitting somewhere that the government needs to move around when it collects taxes or spends.

Taxes, then, don’t really “fund” government spending in any real sense. In fact, it’s easier to think of taxes as a way of government destroying excess money. If the government didn’t levy taxes on people, the newly created money would just represent an increase in the money supply. This would raise the danger of rising prices because the money supply would be inflated.

So the argument Krugman raises to justify a “soak the rich” tax policy is inapplicable. We don’t need to “raise as much money as possible for other purposes.” Because we don’t need to raise money at all.

But what should be the tax policy for the top earners from an MMT perspective? I think the answer would arise from three questions. First, who can best afford to have their wealth destroyed to combat inflation? Second, who benefits most from money creation, and therefore deserves to pay more to combat its benefits? Third, how much money do we need to destroy through taxes to avoid inflation?

The answer to the first question is exactly the same as Krugman’s answer to his question. The marginal dollar at the upper end of the income spread is worth less to those that earn it than those at the bottom end. So they can “afford” to have their wealth destroyed.

The answer to the second question actually points to a subset of the same group. In the modern economy, financial institutions tend to be the primary and secondary beneficiaries of government spending and money creation. Highly leveraged institutions benefit from inflation.

Banks see deposit inflows. And it just so happens that the financial sector produces a lot of the people in the top income brackets.

But the third question — how much do we need to tax to prevent unwanted inflation — undermines the entire study Krugman is pointing to. If the goal isn’t revenue maximization but inflation management, the entire matter changes. It’s commonplace that the wealthy often save greater proportions of their income, which means that additional income earned is less likely to lead to increasing prices. The marginal dollars of top earners are less inflationary than marginal dollars at the bottom income brackets.

In short, the modern monetary theory school — which is often portrayed, even by its advocates, as a progressive branch of economics — may justify far lower taxes for the wealthy than the Krugmanite approach.

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