Saturday, August 22, 2009

Supply-Side Weirdness

Matthew Yglesias comments here on what Matt rightly describes as "Supply-Side Weirdness From Greg Mankiw".  Matt's comments are a good read, but I also found the highlighted part, and Mankiw's and Matt's reaction to it, curious. 
In the three decades after World War II, when the incomes of the rich grew more slowly than those of the middle class, the top marginal rate ranged from 70 to 91 percent. Mr. Piketty, one of the economists who analyzed the I.R.S. data, argues that these high rates did not affect merely post-tax income. They also helped hold down the pretax incomes of the wealthy, he says, by giving them less incentive to make many millions of dollars.
So the marginal tax rate in the three decades after World War II was high and the pretax incomes of the wealthy were lower.  That I understand, but the lack of incentive doesn't make sense to me.  Let's say the owner of some enterprise in a low tax environment employs 1000 workers, each of which add $1000 worth of value by their labor in the course of a year.  The owner is making then $1 million, which is sufficient for this particular business owner.  Let us assume also, that like most people, this individual is not working the absolute greatest degree he is capable.  He is effectively taking some of the value he could add to the business in leisure time.  Perhaps he is at the firm 40 hours a week, but is doing only about 30 hours of actual work.  He could employ more people, and thus make more money, but he is, as I say, taking some of the money he could be earning in lower stress or leisure time.  I imagine that this circumstance is not that unusual.

Now let us assume that the tax environmnet changes so that his costs go up and each worker is only adding $500 per year and the owner's profit decreases to $500,000 per year.  Still a tidy income, most folks can live comfortably on that, but he would like to enjoy the higher income as well.  I'm no economist, but it seems to me that one obvious solution would be to expand the amount of work he is doing by employing more people.  If he could increase the number of employees to say 1500, and take on the extra work the management of these extra employees would require, then his income increases from $500,00 to $750,000.  Not the $1 Million he was making, but somewhat closer.  The cost to the owner is the extra hours of work or the extra stress during the 40 hours that he his at the firm. 

Now it is true that in this scenario he is not incentavised to make the million dollars he has making in the lower tax regiem, but he is incentavised to do more work and produce more stuff. That incentive would seem to me to be more productive toward general economic prosperity than the regime where it was easy to make millions. 

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