Incentives and Time

In Howard's recent post "In Love with a Fantasy", he wrote:

If you spend some time perusing political and economic blogs you might read posts or comments by people who are enamoured with the Swedish economic/social model. Unfortunately their perceptions are detached from reality...

However, what's interesting is that for many years, decades even, those perceptions were not detached from reality. Sweden was one of the richest countries on earth while having very high tax rates and a high degree of socialism. It took a very long time for Sweden's adoption of socialism to catch up with them.

It's pretty straight forward to understand why there was such a large delay between the Sweden becoming a socialist country and the relative slippage of its economic growth by considering a fairly simple thought experiment. Let's consider a world where there are two career paths:

Career Path A: After graduating from high school at 18 you average $50,000 per year salary. Think of this career path as blue collar workers.

Career Path B: After an additional 10 years of school costing $250,000 (plus 10 years lost opportunity cost of $500,000) you average $200,000 per year salary. Think of this path as doctors and other professionals.

Let's also consider two possible tax structures:

Flat Tax Structure: 20% of all income.

Progressive Tax Structure: Income is tax free up to $50,000. Over $50,000, 80% is taxed.

Let's say that the tax structure starts out as the Flat Tax Structure. In this case, Path B takes 6.25 years after graduation to catch up with Path A (by paying off school costs and overcoming lost opportunity) which occurs at 34.25 years of age. That's quite a long payback time when you consider that most businesses won't consider an investment with a payback time that's much more than five years (unless it's a very low risk investment). Nonetheless, it's not a bad deal, because if you survive till 34.25, after that you are a lot better off.

Now let's say the tax structure is changed to the Progressive Tax Structure. This is somewhat similar to the tax structure in a country like Sweden.

Those who are in the middle of their careers and have already made their career path choice are stuck. Even though their after tax income has dropped from $160,000 to $80,000, those who chose Path B have little choice but to stick with their careers. It doesn't do them any good to drop their after tax incomes further to $50,000 by switching back to Path A. Perhaps they'll retire a little earlier, but perhaps some have debts and other obligations that force them to work harder and longer.

So at first, there is little negative impact on the economy in this hypothetical world and there are a couple of benefits. The poor Path A people are now better off. Their after tax income has increased from $42,000 to $50,000. In addition, the government can now provide free services like health care to everybody using the windfall in revenues from taxing the rich Path B folk at a much higher rate. So the Path A folk are even better off. These benefits can continue for quite some time, as long as the composition of the work force remains more or less the same.

However, now the career path investment choice looks much different. It now takes 25 years after graduation for Path B to overcome costs of school plus lost opportunity which pushes the break even point to age 53. Thirty-five years is a very, very long time to break even. What's clear is that, at the margin, fewer people are going to invest in themselves and follow Path B. Even if the school costs are subsidized, the lost opportunity costs still make Path B quite onerous.

So, over time, fewer and fewer people will choose Path B and instead will go with Path A. Tax revenues will drop accordingly. Benefits to the poor Path A people will strain the system. Overall, the economy is worse off with fewer high skilled workers and more lower skilled jobs. Sounds a bit like Sweden, no?

But isn't it still true that the poor Path A people pay no taxes and the wealthier Path B professionals bear more of the burden? Not necessarily. Since there will eventually be many fewer Path B people, they will be in much higher demand relative to supply and can therefore charge far more for the goods and services they provide. Perhaps they now make $500,000 instead of $200,000. The delta of $300,000 is essentially a tax on everybody to incentivize enough people to choose Path B to meet demand. The Path A people pay this indirect tax just like everybody else. If they paid $10,000 for Path B services under the Flat Tax Structure, they now pay $25,000 and 80% of that ends up being paid in taxes by the Path B workers. Essentially, the indirect tax on Path A people under the Progressive Tax Structure exceeds the direct tax under the Flat Tax Structure so everybody pays more taxes, the economy is smaller, and everybody is worse off.

There's little doubt in my mind that progressive tax structures provide disincentives to people trying to become progressively wealthier by investing in things like education and training and that limits overall wealth creation. Furthermore, the working poor still bear a similar share of the burden of government expenditures via increased costs of higher salaried people.

The government can't help the working poor via taxing the rich - the government can only hurt them in the long run. Just like Sweden.