zz:Taxing like Europe by Ohanian

Lee Ohanian (UCLA) gave a very good summary to a paper by Fatih Guvenen (Minnesota), Burhanettin Kuruscu (Toronto), and Serdar Ozkan (UPenn). This piece is actually a little bit old (published in Forbes 6 months ago), but I was fond of reading it today while seeing several European governments struggle to control their run-away deficits.

Taxing Like Europe
Lee E. Ohanian,

A key economic principle is that society faces a trade-off between efficiency, which is often described as the size of the economic pie, and inequality, which is the difference in the size of the slices of the pie allocated to individuals within society. From this perspective, the best economic policies aimed at reducing inequality are those that reduce the economic pie relatively little.

Some have argued that European economic polices have been effective along these lines, as wage inequality, measured as the differences in wages between the highest income earners and lower income earners, has risen substantially in the U.S. in recent years, but not in Europe. But some recent research is showing that lower inequality in Europe is the consequence of tax policies that are more damaging to economic growth than previously considered.

Economists Fatih Guvenen, Burhanettin Kuruscu and Serdar Ozkan have recently studied differences in wage inequality between the U.S. and continental Europe. They have found that lower inequality in Europe is partially the consequence of differences in the progressiveness of income tax rates that reduce the incentives to accumulate human capital. That is, inequality is lower in Europe partially because tax rates on the most productive workers are significantly higher than in the U.S.

To assess differences in “progressivity,” these economists compared high-income workers with average-income workers in both Germany and the U.S. They found that the tax rate for the high-wage German earner relative to the average German worker is 50% higher than for the high-income American earner relative to the average American workers. This more progressive European tax schedule reduces the incentives for workers to increase their productivity by reducing the return to human capital investment. Moreover, this prediction of economic theory is born out by data, as the authors also find that high-ability European workers accumulate less human capital than high-ability American workers.

These economists also considered a hypothetical experiment in which they estimated how much European workers would be willing to pay in order to face the U.S. tax schedule rather than face the tax schedule in their own countries. For those individuals in the 90th percentile of learning ability–those who become society’s most productive workers through training and education–Guvenen et al found that European workers would be willing to pay between 8% (United Kingdom) up to 25% (Denmark) of their lifetime income in order to pay U.S. taxes rather than pay their home country tax schedules.

And it is not just those with the highest learning abilities who would benefit from the U.S. tax system. The authors find that European workers of all learning abilities would prefer U.S. tax rates to those in their home country, with the only exception being U.K. workers who are in the lower 35% of the ability distribution. This means that most European workers accumulate less human capital than their comparable U.S. peers resulting from higher taxes, which means less economic growth and lower living standards than in the United States. This implies that the U.S. has benefited from a more efficient tax system by attracting some of Europe’s most productive workers.

However, Guvenen, Kuruscu and Serdar Ozkan based their analysis on income tax schedules from 2003. U.S. tax rates, particularly on the highest-income earners, are rising significantly as a consequence of the expiration of the Bush tax cuts, as well as projected tax increases in the future that reflect current and recent deficits. And higher future taxes not only suggest that future Americans–particularly high-ability Americans–will accumulate less human capital, but they also mean that the U.S. will become a less attractive work destination for the best and brightest from Europe. This is good news for Europe, which may be able to slow down brain drain to the United States as the consequence of U.S. tax policies that are becoming increasingly like those of Europe. And this is bad news for the U.S.

Lee E. Ohanian (www.leeohanian.com) is professor of economics and director, Ettinger Family Program in Macroeconomic Research, UCLA.

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