Hill – Mankiw 9th Edn Chapter 8 – Application: The Costs of Taxation
Mankiw, N. G. (2021) Principles of microeconomics (9th ed.)
Principles of economics (9th ed.)
Mason, OH: South-Western Cengage Learning.
University of New Brunswick, Saint John campus
Saint John, New Brunswick, Canada
Chapter 8 – Application: The Costs of Taxation
Here are some things to consider when reading this chapter.
- The emphasis on the costs of taxation compared with the benefits of public expenditures
Textbooks can’t tell students what to think, but they do tell them what to think about. Some topics may be mentioned frequently and given extensive space, while others are briefly acknowledged and then ignored. The selection, placement, and attention given to individual topics is inescapably a matter of judgement on the authors’ part. Nevertheless, these choices have the potential to influence students’ attitudes about what’s important and what isn’t.
Chapter 8 is devoted to the costs of taxation – the extent to which taxes reduce the sum of consumer and producer surplus. This follows the examination in Chapter 6 of how taxes on the sales of goods are split between buyers and sellers, while reducing market exchange. Students will be reminded yet again of the efficiency costs of taxation in Chapter 12 as well as other criteria, such as equity, for judging a tax system.
Except for taxes on polluting activities, seen in Chapter 10, taxes are portrayed as a costly burden which must be borne to provide the benefits of public expenditures. However, the text provides little detail about what those benefits are. Unlike private purchases, where there is a clear connection between the payment and the good or service received, there is no direct link between most tax payments and the benefits public activities provide. Indeed, much essential public regulatory activity is so taken for granted that it is invisible, as mentioned in the previous Commentary.
True, Chapter 8 begins with a statement attributed to US Supreme Court Justice Oliver Wendell Holmes “Taxes are what we pay for civilized society.” (He actually wrote: “Taxation is the price we pay for civilization…”, but the sentiment is the same.) After looking at how taxes affect economic well-being, “we see how high the price of civilized society can be” (p. 151). The perception that students get about the costs of taxation is important in forming their judgements about the role of government beyond the bare minimum of protecting property rights as in laissez-faire. Real world governments make decisions that influence the distribution of income and wealth and determine what goods and services will be paid for by the public sector.
- “How big should government be?”
After asking this normative question, Mankiw writes: “The debate hinges on these concepts [elasticities and deadweight losses] because the larger the deadweight loss of taxation, the larger the cost of any government program. If taxation entails large deadweight losses, then these losses are a strong argument for a leaner government that does less and taxes less. But if taxes impose small deadweight losses, then government programs are less costly than they otherwise might be, which in turn argues for a more expansive government” (p. 158).
In his case study of the deadweight loss debate, Mankiw focuses on “the most important tax in the US economy: the tax on labor”. He explains that economists “hold different views about the elasticity of the labour supply” (p. 158). The view that the labour supply elasticity is low gets one paragraph of 76 words. “Some evidence suggests that this may be the case for workers who are in their prime working years and who are the main breadwinners of their families.”
The view that the elasticity is high and thus taxes on labour income are highly distortionary gets six paragraphs and 294 words. These describe people in particular circumstances where they could have a high responsiveness to changes in net of tax wages.
No explicit judgement about the balance of the evidence is given.
In his textbook, Labor Economics, Mankiw’s Harvard colleague George Borjas writes that estimates of labour supply elasticities vary widely from large and negative, to around zero, to large and positive. He describes the measurement difficulties involved and cites studies that try to determine which estimates are more credible. “These surveys suggest that the elasticity of male labor supply is roughly around −0.1… One would not be stretching the truth too much by claiming that the male labor supply elasticity is essentially zero. After all, most prime-age men work a full workweek every week of the year” (2020, p. 42).
The situation is not much different for women working full time. Borjas explains that “female labor supply responds to economic factors mainly at the margin of deciding whether or not to work, rather than at the margin of deciding how many hours to work once in the labor force.” He concludes that “the female labor supply elasticity, however, is not very large, perhaps around 0.2” (p. 48).
On balance, professional opinion favours a low elasticity of labour supply in aggregate, while recognizing that within that there is considerable variation across individuals depending on their circumstances.
- Top income tax rates and the Laffer Curve
Is it possible that top marginal income tax rates in a country could be so high that “some taxpayers may occasionally find themselves on the wrong side of the Laffer curve”? In that case, Mankiw writes: “Other things being equal, a tax cut is more likely to raise tax revenue if the cut applies to those taxpayers facing the highest tax rates”. (The general idea that tax revenues vary with tax rates is illustrated in the “Laffer curve” in Figure 6, p. 160, for the simple case of a tax on the purchase of a particular good.)
Indeed, it is possible that marginal tax rates for some very high-income recipients could be that high and set that way as a matter of deliberate policy. This is the claim of Emmanuel Saez and Gabriel Zucman, professors at the University of California, Berkeley, in their book The Triumph of Injustice. Statutory marginal income tax rates in the United States between the mid-1930s and the early 1960s varied between 80 to just over 90 percent (p. 35). In their view, the goal of “quasi- confiscatory” marginal income tax rates was to reduce the incomes at the top of the income distribution, even if it led to a reduction in their total taxable Income. The benefits: a reduction in pretax income inequality and thus a redistribution of economic power and discouraging actions that simply redistribute income away from others and towards high income recipients. They ask: “What’s the point of negotiating a $20-million salary, of earning millions by creating zero-sum financial products, of spiking the price of patented drugs, when out of any extra dollar earned, 90 cents will go the IRS [Internal Revenue Service]?” (p. 159).
As well, the standard discussion assumes that high-income recipients decide how much to work based solely on their marginal after-tax income. But the desire for status, power, the enjoyment of the work itself, and competition with others in similar positions can also motivate them; all tend to make their supply of work more inelastic.
If policymakers are unwilling to go ‘beyond Laffer’, they can estimate what marginal income tax rate on the highest incomes would maximize tax revenues. Saez and Zucman estimate this, but further details should wait until the Commentary on Chapter 12 “The Design of the Tax System”. For now, let’s note that to implement such a plan requires adjusting the tax code to minimize avoidance possibilities as well as cracking down on tax havens and the tax avoidance/tax dodging industry of financial institutions, tax lawyers and accountants.
Borjas, George (2020) Labor Economics, 8th edition, McGraw-Hill.
Saez, Emmanuel and Gabriel Zucman (2019) The Triumph of Injustice: How the Rich Dodge Taxes and How to Make Them Pay. W. W. Norton & Company.