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Sunday, January 8, 2012

Thorstein Veblen and the 90 percent tax bracket

by John MacBeath Watkins

For at least three decades, a major theme in our public discourse has been that setting lower tax rates will make high earners work harder and invest more. But the economy thrived when taxes were as high as 90 percent on the top earners, and continued to thrive when it was 70 percent. The economy has expanded no more rapidly since top marginal rates started falling in the 1980s than it did when top marginal rates were much higher, as the chart at left shows. In fact, this is not the first time we've seen this pattern. Tax top rates to pay for World War I peaked in 1918 at 77 percent and in 1929 hit a low of 24 percent. In 1932, we hit the bottom of the Depression and the top rate rose from 25 percent to 63 percent. What happened after that? The economy got better, probably because Franklin Roosevelt effectively devalued the dollar. The tax rate on the top earners didn't seem to be a factor.

How could this be?

One clue comes from the way the rich react when they fear their taxes might be raised. On Dec. 7, 2011, CNBC reported that Jamie Diamond, CEO of JP Morgan Chase, told an investors conference, "Most of us wage earners are paying 39.6 percent in taxes and add in another 12 percent in New York state and city taxes and we're paying 50 percent of our income in taxes."

This cannot be true. For one thing, the top marginal rate is now 35 percent, and it's only charged on the portion of Diamond's income that is above $379,151. Of course, to a man who makes something like 23 million a year, that first $379,151 is peanuts, so I guess it's understandable that he'd forget that's taxed at a lower rate, but the guy is supposed to be a whiz at numbers, so how could he be wrong about the rate he's paying on most of his income?

Enter Karl Smith, Assistant Professor of Public Economics and Government at the School of Government at the University of North Carolina at Chapel Hill. He suggests that what we are seeing is a different set of incentives than those economists have generally looked at:

The lesson I would take is as follows. Profit or consumption maximizing incentives are just incredibly weak. We think we see consumption incentives in the general populace but we are really seeing status seeking. Folks earn or consume more in an effort to raise their status relative to others.
However, at very high income/status levels this has odd results. When Jaime Dimon or Leon Cooperman say that what they really want is to be loved, they mean it.
In other words,  Thorstein Veblen was right, the rich are status seekers more than money maximizers. Our current system allows them conspicuous consumption in the form of private superyachts instead of company yachts, but it's still all about the status.

But is there any real evidence of this? Smith says he sees it all the time:


This makes perfect sense if you note that Jamie (Diamond) doesn’t care about his tax rate. He cares about his taxes being raised. He cares about that because it sends a signal to him about how he is viewed in society and that really matters to him.
I see this in lobbying all the time. Because, I am a soulless technician who will faithfully advise anyone and everyone who asks I see the back rooms of opposing lobbyists all the time.
Here at the state level I can safely say that virtually no one has any idea what they are doing. That is, for the most part the lobbyist do not know and indeed are not particularly interested in what is in the best interest of their clients.
Further, this seems to stem from the fact that the clients are not particularly interested in what is in their best interests.
What they are very interested in is whether legislation is pro them or anti them. However, if you begin to talk about the economy as a complex system full of unintended consequences where anti legislation could be in their best interests their eyes glaze over.
Read the whole thing, it's worth it: http://modeledbehavior.com/2011/12/21/why-not-plutocracy-apathy-runs-deep-edition/

So if the issue is really status, then at a certain level, it is no longer really about money. It is about being shown respect, it is about people knowing that you have power, and money is a means to that end.

But when the tax rate was 90 percent, people who ran things still had status and power. Their status may have been reflected in the executive washroom and the executive jet, because giving them more money would only send most of it to the government.

This sort of status depended on perks supplied by the company, rather than the perks you could purchase with your salary. The result was the loyal company man. Head-hunters could hardly outbid your company for your services, given that most of any additional money wouldn't go to you.  A golden parachute did you little good, because again, most of it went to the government.

This has some interesting effects on the incentives for managers. A prime problem with hiring managers, which any public company must do, is that they are likely to act on their own behalf instead of that of the owners (it's called the agency problem.) For example, when I started banking with Washington Mutual Savings in high school, it was a sort of chain version of the Jimmy Stewart savings and loan, risk averse and steady, serving middle class families.

At some point, it began to grow rapidly, taking substantial risks to get there. Why would the managers risk what eventually turned out to be the ruin of the company to make it bigger?

It turns out bankers tend to be paid based on the size of the company, regardless of performance, according to this study. Therefore, growing the bank, even if it means the quality of the loan portfolio declines, is the way for managers to manage the company in their own interest. Washington Mutual went bankrupt, but the managers are still rich. (Though they did have to give back some of the money.)

If their taxes were 90 percent on the top part of their income, the managers would get their status and perks from the company, making its continued health the path to their own continued status.

I can see where it might be difficult to write a paper that gets published in an economics journal pushing this idea, because how do you turn it into math? Yet there's plenty of evidence that people care about status more than they care about their absolute wealth, once their basic needs are taken care of. Why do those who earn just above the minimum wage often oppose raising the minimum wage? Because it would put them on the same status level as people earning the minimum wage.

The problem is, how do we convince billionaires that it is not an insult to their status if they pay at a higher rate? Years of running two foreign wars while cutting taxes and adding Medicare Part D left the country in debt, and a long, grinding recession has made that much, much worse. Something must be done, and as workers have become more productive over the last couple decades, most of the wealth created has gone to the top-level earners. We could, of course, raise taxes on the poor, but they are, you know, poor. You've got to follow the money.

And besides, taking food out of the mouths of the poor seems like less of a problem than taking some status from the rich.

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