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November 23, 2014

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Posted: 23 Nov 2014 12:06 AM PST

'High Marginal Tax Rates on the Top 1%'

Posted: 22 Nov 2014 12:37 PM PST

Fabian Kindermann and Dirk Krueger:

High marginal tax rates on the top 1%: Optimal tax rates for the rich are a perennial source of controversy. This column argues that high marginal tax rates on the top 1% of earners can make society as a whole better off. Not knowing whether they would ever make it into the top 1%, but understanding it is very unlikely, households especially at younger ages would happily accept a life that is somewhat better most of the time and significantly worse in the rare event they rise to the top 1%.
Recently, public and scientific attention has been drawn to the increasing share of labour earnings, income, and wealth accruing to the so-called 'top 1%'. Robert B. Reich in his 2009 book Aftershock opines that: "Concentration of income and wealth at the top continues to be the crux of America's economic predicament". The book Capital in the Twenty-First Century by Thomas Piketty (2014) has renewed the scientific debate about the sources and consequences of the high and increasing concentration of wealth in the US and around the world.
But what is a proper public policy reaction to such a situation? Should the government address this inequality with its policy instruments at all, and if so, what are the consequences for the macroeconomy? The formidable literature on optimal taxation has provided important answers to the first question.1 Based on a static optimal tax analysis of labour income, Peter Diamond and Emmanuel Saez (2011) argue in favour of high marginal tax rates on the top 1% earners, aimed at maximising tax revenue from this group. Piketty (2014) advocates a wealth tax to reduce economy-wide wealth inequality....
Conclusions and limitations Overall we find that increasing tax rates at the very top of the income distribution and thereby reducing tax burdens for the rest of the population is a suitable measure to increase social welfare. As a side effect, it reduces both income and wealth inequality within the US population.
Admittedly, our results apply with certain qualifications. First, taxing the top 1% more heavily will most certainly not work if these people can engage in heavy tax avoidance, make use of extensive tax loopholes, or just leave the country in response to a tax increase at the top. Second, and probably as importantly, our results rely on a certain notion of how the top 1% became such high earners. In our model, earnings 'superstars' are made from luck coupled with labour effort. However, if high income tax rates at the top would lead individuals not to pursue high-earning careers at all, then our results might change.7 Last but not least, our analysis focuses solely on the taxation of large labour earnings rather than capital income at the top 1%.
Despite these limitations, which might affect the exact number for the optimal marginal tax rate on the top 1%, many sensitivity analyses in our research suggest one very robust result – current top marginal tax rates in the US are lower than would be optimal, and pursuing a policy aimed at increasing them is likely to be beneficial for society as a whole.

'The Risks to the Inflation Outlook'

Posted: 22 Nov 2014 12:02 PM PST

Remember all those predictions from those with other agendas about runaway inflation (e.g. see Paul Krugman today on The Wisdom of Peter Schiff)?:

The Risks to the Inflation Outlook, by Vasco C├║rdia, FRBSF Economic Letter: The Federal Reserve responded to the recent financial crisis and the Great Recession by aggressively cutting the target for its benchmark short-term interest rate, known as the federal funds rate, to near zero. The Fed also began providing information about the probable future path of the short-term interest rate. Known as forward guidance, this policy is intended to lead to lower long-term yields and therefore stimulate economic activity. Additionally, the Fed has purchased long-term Treasury securities and mortgage-backed securities, leading to a balance sheet that is substantially larger than before the financial crisis. Taylor (2014), among others, argues that these policies are likely to lead to substantially higher inflation. Nevertheless, the inflation rate remains below 2%, the target set by the Federal Open Market Committee (FOMC).
This Economic Letter describes results from a model that explicitly accounts for the different dimensions of monetary policy to quantify the risks to the inflation forecast. This analysis suggests that inflation is expected to remain low through the end of 2016, and the uncertainty around the forecast is tilted to the downside, that is, the risk of lower inflation. In particular, the probability of low inflation by the end of 2016 is twice as high as the probability of high inflation—the opposite of historical projections. The analysis also suggests that the risk of high inflation collapsed in 2008 and has remained well below normal since. Importantly, according to the model, there is little evidence that monetary policy constitutes a major source of inflation risk. ...

Of course, the lack of inflation can't be explained with modern macroeconomic models:

Inflation Dynamics During the Financial Crisis, by Simon Gilchrist, Raphael Schoenle, W. Sim, and Egon Zakrajsek,  September 18, 2013,  Preliminary & Incomplete: Abstract Using confidential product-level price data underlying the U.S. Producer Price Index (PPI), this paper analyzes the effect of changes in firms' financial conditions on their price-setting behavior during the "Great Recession." The evidence indicates that during the height of the crisis in late 2008, firms with "weak" balance sheets increased prices significantly, whereas firms with "strong" balance sheets lowered prices, a response consistent with an adverse demand shock. These stark differences in price-setting behavior are consistent with the notion that financial frictions may significantly influence the response of aggregate inflation to macroeconomic shocks. We explore the implications of these empirical findings within the New Keynesian general equilibrium framework that allows for customer markets and departures from the frictionless financial markets. In the model, firms have an incentive to set a low price to invest in market share, though when financial distortions are severe, firms forgo these investment opportunities and maintain high prices in an effort to preserve their balance-sheet capacity. Consistent with our empirical findings, the model with financial distortions—relative to the baseline model without such distortions—implies a substantial attenuation of price dynamics in response to contractionary demand shocks.

I know, some of you hate old Keynesian models (which can also explain this), and you don't believe in New Keynesian models (ad hoc price stickiness -- reject! -- even if, for some, it is only a cover to reject the notion of government involvement in the economy...). But your model predicted inflation that never came. Or some other such nonsense.

One final note. When I objected to this in 2010, I was called "Grumpy Thoma":

... I think it is quite possible that we will look back on QE2 as a severe error. In spite of the talk from some quarters about the intervention being too small, this is a very large-scale asset purchase for the Fed, on top of a previous very large purchase of mortgage-backed securities and agency securities. One possibility is that economic growth picks up, of its own accord, reserves become less attractive for the banks, and inflation builds up a head of steam. The Fed may find this difficult to control, or may be unwilling to do so. Even worse is the case where growth remains sluggish, but inflation well in excess of 2% starts to rear its ugly head anyway. Bernanke is telling us that he "has the tools to unwind these policies," but if the inflation rate is at 6% and the unemployment rate is still close to 10%, he will not have the stomach to fight the inflation. My concern here is that, given the specifics of the QE2 policy that was announced, the FOMC will be reluctant to cut back or stop the asset purchases, even if things start looking bad on the inflation front. Once inflation gets going, we know it is painful to stop it, and we don't need another problem to deal with.

More than four years later...we now have the same group using neo-Fisherism to explain why the Fed is causing low inflation with low nominal interest rates. With QE2 (and QE of any sort), it was the Fed's fault that we faced so much inflation risk, now it's the Fed's fault that we don't.

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