Contra Saez, Piketty et al., in a world in which ideas drive GDP, maximizing the welfare of the middle class and below requires a lower, not higher top tax rate

Taxing Top Incomes in a World of Ideas. Charles I. Jones. Journal of Political Economy, Aug 2022. https://doi.org/10.1086/720394

Abstract: This paper considers top income taxation when (i) new ideas drive economic growth, (ii) the reward for successful innovation is a top income, and (iii) innovation cannot be perfectly targeted by a research subsidy—think about the business methods of Walmart, the creation of Uber, or the “idea” of Amazon. These conditions lead to a new force affecting the optimal top tax rate: by slowing the creation of new ideas that drive aggregate GDP, top income taxation reduces everyone’s income, not just income at the top. This force sharply constrains both revenue-maximizing and welfare-maximizing top tax rates.

Abstract of a 2019 version, which refers to Saez by name: This paper considers the taxation of top incomes when the following conditions apply: (i) new ideas drive economic growth, (ii) the reward for creating a successful innovation is a top income, and (iii) innovation cannot be perfectly targeted by a separate research subsidy --- think about the business methods of Walmart, the creation of Uber, or the "idea" of Amazon.com. These conditions lead to a new force affecting the optimal top tax rate: by slowing the creation of the new ideas that drive aggregate GDP, top income taxation reduces everyone's income, not just the income at the top. When the creation of ideas is the ultimate source of economic growth, this force sharply constrains both revenue-maximizing and welfare-maximizing top tax rates. For example, for extreme parameter values, maximizing the welfare of the middle class requires a negative top tax rate: the higher income that results from the subsidy to innovation more than makes up for the lost redistribution. More generally, the calibrated model suggests that incorporating ideas as a driver of economic growth cuts the optimal top marginal tax rate substantially relative to the basic Saez calculation.

[Some can admit to the unavoidability of going downwards, to a less rich world, if we want to redistribute and have no upper class...: Revolutionaries in societies that used 1/4 as much energy as we do thought communism right around the corner; let's get the abundance that matters (everyone be free to pursue learning, play, sport, amusement, companionship, & travel) https://www.bipartisanalliance.com/2019/05/revolutionaries-in-societies-that-used.html]

1. Introduction

This paper considers the taxation of top incomes when the following conditions apply: (i) new ideas drive economic growth, (ii) the reward for creating a successful new idea is a top income, and (iii) innovation is broad-based and cannot be perfectly targeted by a separate research subsidy.

The classic tradeoff in the optimal taxation literature is between redistribution and the incentive effects that determine the “size of the pie.” But in most of that literature — starting with Mirrlees (1971), Diamond (1998), Saez (2001) and Diamond and Saez (2011) — the “size of the pie” effects are relatively limited. In particular, when a top earner reduces her effort because of a tax, that reduces her income but may have no or only modest effects on the incomes of everyone else in the economy.

In constrast, I embed the optimal tax literature in the idea-based growth theory of Romer (1990), Aghion and Howitt (1992), and Grossman and Helpman (1991). According to this literature, the enormous increase in living standards over the last century is the result of the discovery of new ideas — perhaps by a relatively small number of people. To the extent that top income taxation distorts this innovation, it can impact not only the income of the innovator but also the incomes of everyone else in the economy.

The nonrivalry of ideas is key to this result and illustrates why incorporating physical capital or human capital into the top tax calculation is insufficient. If you add one unit of human capital or one unit of physical capital to an economy — think of adding a computer or an extra year of education for one person — you make one worker more productive, because these goods are rival. But if you add a new idea — think of the computer code for the original spreadsheet or the blueprint for the electric generator — you can make any number of workers more productive. Because ideas are nonrival, each person’s wage is an increasing function of the entire stock of ideas. A distortion that reduces the production of new ideas therefore impacts everyone’s income, not just the income of the inventor herself.

A standard policy implication in this literature is that it may be optimal to subsidize formal R&D, and one could imagine subsidizing research but taxing top incomes as a way to simultaneously achieve both efficient research and socially-desirable redistribution. Instead, we consider a world with both basic and applied research. Basic research uncovers fundamental truths about the way the world works and is readily subsidized with government funding. Applied research then turns these fundamental truths into consumer products or firm-level process innovations. This is the task of entrepreneurs and may not be readily subsidized as formal R&D. Think about the creation of Walmart or Amazon.com, organizational innovations in the health care and education industries, the latest software underlying the Google search engine, or even the creation of nonrival goods like a best-selling novel or the most recent hit song. Formal R&D is a small part of what economists would like to measure as efforts to innovate. For example, around 70% of measured R&D occurs in the manufacturing industry. In 2012, only 18 million workers (out of US employment that exceeds 130 million) were employed by firms that conducted any official R&D. 1 According to their 2018 corporate filings, Walmart and Goldman-Sachs report doing zero R&D.

The idea creation and implementation that occurs beyond formal R&D may be distorted by the tax system. In particular, high incomes are the prize that motivates entrepreneurs to turn a basic research insight that results from formal R&D into a product or process that ultimately benefits consumers. High marginal tax rates reduce this effort and therefore reduce innovation and the incomes of everyone in the economy. Taking this force into account is important quantitatively. For example, consider raising the top marginal tax rate from 50% to 75%. As we discuss below, in the United States, the share of income that this top marginal rate applies to is around 10%, so the change raises about 2.5% of GDP in revenue before the behavioral response. In the baseline calibration, such an increase in the top marginal rate reduces innovation and lowers GDP per person in the long run by around 6 percent. With a utilitarian welfare criterion, this obviously reduces welfare. But even redistributing the 2.5% of GDP to the bottom half of the population would leave them worse off on average: the 6% decline in their incomes is not offset by the 5% increase from redistribution. In other words, unless the social welfare function puts disproportionate weight on the poorest people in society, raising the top marginal rate from 50% to 75% reduces social welfare.

We consider various revenue- and welfare-maximizing top tax rate calculations, first ignoring the effect on innovation and then taking it into account. For a broad range of parameter values, the effects are large. For example, in a baseline calculation, the revenue-maximizing top tax rate that ignores the innovation spillover is 92%. In contrast, the rate that incorporates innovation and maximizes a utilitarian social welfare function is just 22%. Moreover, if ideas play an even more significant role than assumed in this baseline, it is possible for the optimal top income tax rate to turn negative: the increase in everyone’s income associated with subsidizing innovation exceeds the gains associated with redistribution.

Importantly, however, the point of this paper is not to estimate “the” optimal top income tax rate. Such a calculation involves many additional considerations documented in the existing literature (reviewed below) that are omitted from the analysis here. Instead, the point is that future work aimed at calculating such a number will certainly want to explicitly consider the effects of top income taxation on the creation of new ideas. They appear to be quantitatively important.

The remainder of the paper is organized as follows. After a brief literature review, Section 2 lays out the steady-state of a rich dynamic growth model and considers the top tax rate that maximizes revenue, along the lines of Diamond and Saez (2011) and others. Section 3 then considers the tax scheme that maximizes the welfare of the “bottom 90%” or the median voter (they are the same people here). This turns out to matter quantitatively: the planner cares about distorting the creation of ideas not merely because it affects the revenue that can be earned by regular workers, but because it affects their consumption and economic growth directly. This setup is especially convenient for two reasons. First, it yields a nice closed-form solution. Second, it allows us to remain agnostic about the source of the behavioral tax elasticity for top earners: whether this comes from an effort choice or an occupational choice or from something else is irrelevant; we just need to know the elasticity.

Section 4 goes further and finds the tax system that maximizes a utilitarian social welfare function. While this objective function is obviously of interest, the solution does not admit a closed-form expression. In addition, we must be explicit about the nature of the behavioral tax elasticity for top earners, which makes the model less general. Section 5 discusses additional results and extensions, including empirical evidence on growth and top income taxation. Finally, Section 6 builds the full dynamic growth model that nests the simple model as a special case in the steady state.