When they won the 2011 Nobel Prize in economics for their research on the causes and effects of government policy on the macroeconomy, Thomas Sargent and Christopher Sims were given a unique opportunity to connect their academic work to actual government action. They had spent their professional lives studying macroeconomic policy, and here we were in the middle of a macroeconomic crisis with the entire policymaking world anxious to hear what they had to say. How do tax cuts affect GDP? How should the government respond to sluggish growth and a terrible labor market? Might we experience serious inflation? Is fiscal stimulus effective? Everyone was listening — now was Sargent and Sims’s chance to let the world know their policy prescriptions.
The first questions the press asked the new laureates went right to the heart of the matter: Had
the U.S. government responded appropriately to the Great Recession and what should it do to create jobs and support the economy? Sims’s answer was fascinating:
I think part of the point of this prize in the area that we work in is that answers to questions like that require careful thinking, a lot of data analysis, and that the answers are not likely to be simple. So that asking Tom [Sargent] and me for answers off the top of our heads to these questions — you shouldn’t expect much from us. My own view is that what we ought to do is the kind of thing that Chairman Ben Bernanke has urged the U.S. government to do: make good long-run plans for resolving our budget difficulties without imposing severe fiscal stringency in the short-run and that accommodative monetary policy is a good idea. But these are not very original ideas. I think eighty percent of the economics profession would agree with this. The problem is to figure out how in the real world to get these things done.1 His answer echoed his response in another interview, quoted in The New York Times: ‘‘‘The methods that I’ve used and that Tom [Sargent] has developed are central for finding our way out of this mess,’ [Sims] said. But asked for specific policy conclusions of his research, he responded, ‘If I had a simple answer, I would have been spreading it around the world.’Those answers are a model of how academic economists should behave when facing questions about specific policy. It is extremely difficult to take the results in an academic journal article and apply them to real-world policy questions because the method used in much of economics research is to start with assumptions and to derive conclusions...
...4. Determining the optimal rate. Diamond and Saez use those two effects to find the socially optimal top marginal income tax rate. In their model, raising taxes on the rich makes them worse off. And if the behavioral effect outweighs the mechanical effect — if raising taxes results in less tax revenue — then middle- and low-income individuals also are worse off because the tax increase results in less money (consumption) being redistributed to them. However, provided that the mechanical effect offsets the behavioral effect, raising taxes on those with high incomes makes the non-rich better off. In that case, how should we weigh the gain to the non-rich against the losses to the rich?
Recall that the goal is to set the top rate so that society as a whole is as well-off as possible. How do Diamond and Saez determine what is socially optimal, given that some individuals are worse off and others are better off?
Diamond and Saez argue that because of diminishing marginal utility, the decrease in utility experienced by the rich under the new tax regime will be much less than the increase in utility experienced by the non-rich when the government redistributes the new tax revenue to them. In fact, Diamond and Saez argue that the loss to the rich is so small relative to the gain to the non-rich that we might as well assume it is zero.
Because the social loss from taking money from the rich is assumed to be zero and the social gain from giving money to the non-rich is greater than zero, society’s goal is clear: The government should take as much money as possible from the rich and redistribute it to the non-rich. In other words, the government should raise taxes on the rich until the behavioral effect just barely offsets the mechanical effect—that is, until the government maximizes the revenue collected from the rich....MUCH MORE (11page PDF)HT: TaxProfBlog