If you advocate the complete abolition of all personal income taxes, corporate income taxes, and inheritance taxes, the left will think you are beyond the pale.  If you then suggest that 80% MTRs on the consumption of the ultra-rich might be appropriate, the right won’t be happy.  Let me just offer a few observations:

1.  Some on the left argue that consumption taxes will favor the ultra-rich because they consume a very small share of their income.  But if that’s so, then no tax regime will put much of a tax burden on the ultra-rich.  Just as you can’t squeeze blood from a stone, you can’t put a tax burden on misers.  As Steven Landsburg pointed out in one of my all time favorite posts, society views misers like Scrooge as being selfish individuals, when actually it’s people who consume a lot who are selfish. Misers leave more for others to consume.

2.  Some conservatives questioned my assumption of very low marginal utility of consumption at very high levels of consumption.  I find it completely implausible that ultra-rich get significant marginal utility from extra consumption, apart from the satisfaction of doing better than other billionaires.  But note that this sort of “nah-nah, I have a bigger boat than you do” utility would not be at all affected by a tax regime that applied to all billionaires.

Here’s an example.  A billionaire might get a great deal of satisfaction from a 400-foot yacht if his rival billionaire has a 300-foot yacht.  There is data that shows happiness increases all the way up the income scale.  So I do buy that argument.  But I would insist that roughly the same enjoyment would be gained from a 300-foot yacht if his rival had a 200-foot yacht.  If an 80% consumption tax reduces each billionaire’s consumption proportionately, then could it really impact their happiness? Perhaps I’m missing something, but that claim seems preposterous.  That doesn’t mean you necessarily want to go to the very top of the Laffer curve, as there are deadweight losses associated with high MTRs.  But unless I see good empirical evidence that those losses are important in the very, very, very tiny labor market for the ultra-rich, I’ll continue to assume that standard public finance theory plus utilitarian values implies that the MTRs on the consumption of the ultra-rich ought to be fairly high.

Tax burdens occur when people consume less.  That means approximately 100% of all the articles you have ever read in your life on tax progressivity are utter nonsense.   They look at the legal incidence as a share of income, whereas they should look at the economic incidence as a share of consumption.  That’s not one but two huge errors.  I’d encourage people to block out all the noise, and focus on how much the consumption of people will change under different tax regimes.  That’s tax incidence.

3.  The left seems very unhappy with proposals to eliminate all capital taxation, including inheritance taxes.  They seem to view the heirs of the wealthy as being “undeserving.”  I agree about that, but I also think yachts are undeserving, and thus I believe the billionaire who spends a fortune on yachts should be taxed just as highly as a billionaire who gives his fortune to his children.  But that’s just me.

In any case, I sometimes wonder whether the left has a hidden agenda here.  As an analogy, suppose I were crusading for the legalization of pot in Massachusetts.  And suppose that day after day I got hammered by drug warriors, who insisted that pot was a threat to western civilization. Would they be sincere?  Perhaps.  But now suppose that while this was going on all of the countries in Europe did not just allow the smoking of marijuana, they mandated it!!  Residents were forced at gunpoint to smoke pot.  And now let’s suppose that the drug warriors who strongly objected to my “pro-choice” views were completely silent about that outrageous European policy.  Then I might suspect something else is going on.

What does this have to do with taxes, inheritance, and meritocracy?  Consider this article from the Economist:

TO UNDERSTAND one of the gulfs separating the Anglo-Saxon world from continental Europe, consider Warren Buffett’s children. Omaha’s sage investor long ago said he would leave most of his fortune to charity, with more modest sums to his offspring. For Mr Buffett, leaving vast wealth to his children would be “anti-social” in a society that “aspires to be a meritocracy.”

In 26 out of 27 European Union countries, Mr Buffett’s plans would not just be shocking, but illegal. The exception is Britain, or rather England and Wales (Scotland has its own, centuries-old legal system, with a strong continental flavour). In continental Europe a big part of an estate (often around half) is reserved for the surviving children of the deceased and must be equally divided between them. This “forced heirship” makes it impossible to disinherit feckless children (though several countries exclude bequests to “unworthy” children, who have for example murdered a parent or two). Such rules also make it hard to reward the deserving by, say, leaving more to a daughter who gave up a career to care for her ailing parents. Finally, “clawback” laws in many countries stop parents from dodging forced heirship by giving assets away while they are still alive. This applies to gifts made in the last years of life (two years in Austria, ten in Germany), or much longer: in some countries, no time limit applies.

So it’s illegal for a European billionaire to give 70% of his fortune to starving kids in low income countries, because his children “deserve” the money.  And these policies exist in the most “progressive” welfare states on the planet. Now ask yourself how often you’ve heard complaints about these laws from progressives who are terrified by the prospect of wealthy dynasties.  I can hear crickets chirping.

I would love to see an old German billionaire give his entire fortune to the Gates Foundation, and then see the German government have to go to court to try to claw back the money to redirect it to some spoiled kids who spend all their time partying in Ibiza.

What is the real agenda here, if not preventing dynasties?  I’m not sure.  Perhaps the European welfare states fear that altruism to the poorest of the world’s poor would leave less money to tax; less revenue for the world’s most lavish welfare states.  What do you think?  What is the hidden agenda?  Whatever it is, it must be morally repulsive.

PS.  I’d like to congratulate Mark Sadowski on his NGDP forecast of only 0.5% (and minus 1.4% for RGDP).  Yes, the actual number for NGDP was 1.4%, and 0.1% for RGDP.  But the consensus was well over 3%, and around 1.5% for RGDP.   You should have taken a long position in bonds right before the report, as this was the market reaction:

• Treasuries are seeing a sharp reversal following the soft Q1 GDP (0.1% actual v. 1.0% expected) print.

Mark was too low, but the consensus was too high.  And we didn’t know that Mark nailed the 2013:4 numbers until the revisions came in.  My comment section consistently offers good investment tips.  If Goldman Sachs hired this guy they could recoup his entire salary trading on a single GDP number.

In the blogosphere, Mark is the undisputed King of Data.

If you dare to stray from the liberal orthodoxy on inequality, you are often assumed to be the sort of right-winger who also opposes gay marriage, carbon taxes and fiscal stimulus.  So perhaps I should mention the areas where I agree with the left on inequality.

1.  High MTRs on the rich.  Recall that in recent posts I argued that the baseline assumption should be equal taxes on current and future consumption (i.e. no taxes on investment income) and you only deviate from that when there are important second order issues such as risk/insurance and tax evasion problems.  In my view the strong presumption of sharply decreasing marginal utility at high levels of consumption means that the baseline tax policy is highly progressive, and to deviate from that assumption conservatives need to make arguments based on second order effects. Ironically some of the very same second order effects apply, such as risk and tax evasion.  I don’t really have any idea what the top rate should be, but for extremely high levels of consumption it’s certainly plausible that an 80% rate might be appropriate. I’d support that rate in a deal for a pure consumption tax and abolition of income taxes.  A $40 million dollar yacht will motivate a financier just as well as a $200 million yacht, in a world where financiers mostly care about how they are doing relative to other rich guys.  And they’d still be able to put expensive paintings on their walls—prices would fall and who else would buy them?  But fewer artists will be able to live in Brooklyn or Chelsea.

Of course I still think the top income tax rate should be zero, but high MTRs on ultra-high level consumption are fine.

2.  The system is rigged, so the rich don’t deserve their money.  We could have set up the system differently.  We could have put Donald Trump in jail for 20 years when he first went bankrupt, or let other people copy Microsoft Windows, just as we allow others to freely copy Coke’s soft drink recipe.  Yes, the decisions we made were often justified.  I’m glad we didn’t put Trump in jail for 20 . . . er . . . , well you get the point.  

Think of it as a big Monopoly game.  If the developers of Monopoly had required the owner of Boardwalk to share 40% of their profits from Boardwalk with the other players, that would have been just one more rule.  Even if the current rules are justified on efficiency grounds (and they are not all justified), that doesn’t make the beneficiaries of the rules “deserving” of their good fortune. Trump could have just as easily been born as a one-armed beggar on the streets of Dhaka. Progressive taxes are just one more arbitrary rule in the game of life, like 20 year patent protection for some inventions but not others, or get-out-of-jail free cards for people that can’t pay back millions in debt.

The downside for the left is that this means that poor Americans also don’t deserve any more than that beggar in Dhaka. Recall that we must import millions of foreigners to do jobs like picking peaches in the hot Georgia sun because even poor Americans have high enough living standards that the job isn’t attractive. And I don’t blame them.  I favor low wage subsidies for utilitarian reasons—to reduce suffering—not because anyone deserves anything.

3.  Weaken intellectual property rights, but don’t eliminate them.  When you compare market caps for companies like GM and What’s Up Whatsapp, it hard to avoid the conclusion that lots of the recent surge in inequality comes from the fact that wealth is being amassed by creating clever ideas that can be replicated at almost zero cost.  The Silicon Valley entrepreneurs and the financial sector people who fund them are getting very rich.  I don’t have an ax to grind here; I’m a pragmatist on this and all other issues.  Whatever Alex Tabarrok thinks about IP is my view as well.

4.  Weaken zoning laws that limit dense development.  As with IP, you find support for this from both the left and the right (as well as opposition from both sides.)

5.  Subsidies for low wage workers.  The left seems to be losing some enthusiasm for this idea, but it’s still a good one.

6.  Open borders.  My views on this are kind of hard to explain.  I am convinced by Bryan Caplan’s arguments on utilitarian grounds.  And yet I view this issue as being different from all other policy issues in one key respect.  This is the only good policy reform that I can think of that might well make Americans significantly worse off.  In other cases what’s good for the world is generally good for America, or perhaps roughly neutral.  So is it too much to ask for Americans to agree to open borders?  Not if everyone was like Jesus.  But although I’d personally vote in favor in a referendum, if I were a typical middle class American with the same level of selfishness that I currently have, I might vote against.  That’s why I prefer to work for more modest gains, such as a rate of immigration of say 1% per year (i.e. 3 million people.)  I believe that would greatly reduce illegal immigration.  I’d prefer a balance of low and high skilled workers.  I realize that this would reduce the amount that we could plausibly do with low wage subsidies, but it’s still the right thing to do.  (Bryan will say that in 1850 I would have favored “gradually” reducing slavery.)

If you are confused by my wishy-washy views on immigration, here’s an analogy. On purely utilitarian grounds I’d have to say that transferring my entire pension to the poor of Dhaka is probably a good idea.  If you hooked me up to a lie detector I’d have to say it’s the “right policy.” But I don’t do it because of the thought of still grading papers at age 83, and because I’m a selfish bastard.  Fortunately, that dilemma doesn’t occur on any of the public policy issues I discuss in my blog.  I always say what I believe (rightly or wrongly) is the right policy.  I just don’t talk about the sort of proposals that Peter Singer might contemplate.

So I’m actually in favor of lots of policies that would address inequality.  And no one can argue these are trivial policies, I’ve singled out most of the biggest policy issues that relate to inequality. So why do I always feel like I’m on the right wing side of the debate?  I think it’s partly because I write about things I find intellectually interesting.  To me it’s a no brainer that we should have a progressive consumption tax.  I’ve made this argument on and off for 5 years, but don’t dwell on it. I find the confusion between income taxes and consumption taxes to be more interesting.  Or the way in which the left misinterprets income inequality data.  Or the minimum wage debate.

Those who read my blog know that I’ve been making the argument for years that the top 20% is functionally middle class, not upper class, and that the “poor” include lots of young people (including me at age 25) and lots of retired people who aren’t really poor because they have assets.   And that there’s lots of churn, as lots of people are in the top 1% for a single year because they sell a property. And now the NYT catches up to what I’m been preaching for 5 years.  Everyone is SHOCKED to find out that 12% of people are in the top 1%, or that 73% are in the top 20%.  A Boston cop married to a nurse makes $200,000.  Why is anyone who pays attention surprised to find out that the top 5% aren’t who we thought they were?  As the left has figured this out, they focused first on the top 1%, and then on the top 0.1%.  That’s progress.

I think the biggest area where I disagree with the left is that I’m way less nationalistic than most liberals, or Pat Buchanan.  If anything I care more about the overseas poor, because they are much poorer.  I actually find some of the things I read on the progressive side (and on the right as well) to be almost grotesquely insensitive.  In recent decades living standards in places like China, India and even Africa have grown considerably faster than in the developed world. And yet we are constantly told that inequality is getting worse and that it is the defining issue of our time.  If we dissent we are scolded for being “insensitive.”

Remember the famous joke about the Lincoln assassination? It would have been insensitive to say to Mrs. Lincoln; “Yes, your husband was shot, but the play was pretty good.”  In 1945 it would have been insensitive to say to a European; “Yes, there was WWII and the Holocaust, but overall Europe’s done well in the past 5 years because the economies of Sweden, Switzerland, and Spain have boomed.” And it is insensitive to say; “Yes, billions have been raised out of abject misery but inequality is getting worse because the gap between average Americans and the top 1% is widening.”

Yes, let’s have progressive taxes, but do it sensibly and don’t exaggerate the problem.  That’s all.

PS.  My daughter just got back from a field trip to a high school in central China.  It was the number one rated high school in mostly rural Chongren country, Jiangzi (an inland province.)  Her group had raised money for financial aid for 22 students to attend high school that otherwise could not afford to do so (tuition is $80 a semester.)  The classrooms each have 60 students (vs. 20 at her school.)  They visited some of the students’ homes, where the entire family would live in just a single room with few furnishings and a bare concrete floor.  (Pity that they are building all that housing that China “doesn’t need.”)  One of the brightest of the 22 students was crippled with a progressive degenerative disease.  His mom literally carried him on her back between classrooms, as schools in China are not handicapped accessible. My daughter said the classes seemed very academically rigorous, especially math.

If you ever convince me that I’m wrong about “deserve,” I won’t conclude that Donald Trump or Donald Sterling deserve their money.  Rather I’d tax it and give it to that more deserving mom. Indeed I’d take most of the money we spend on welfare and move it overseas.

Does that question seem incomplete?  Then try this one (from a commenter):

If the Fed raised interest rates how would that affect inflation?

Still maddeningly incomplete?  Then how about this one:

If the Fed adopted a more expansionary monetary policy, how would that affect inflation?

Finally we have a real question!  People often seem to forget that changes in interest rates are an effect of “the thing the Fed does” whereas monetary policy is “the thing itself.”

The first question should have been:

If the Fed adopts an expansionary monetary policy how will that affect interest rates?

Because of the liquidity and Fisher effect, there is no unambiguous relationship between interest rates and inflation.  But there is an unambiguous relationship between monetary policy and inflation.  Easy money leads to higher inflation (ceteris paribus) and vice versa.  But exactly what is easy money?  And why can’t we talk about changes in the fed funds rate as being “the thing itself?”

First of all, the fed funds rate is not always equal to the fed funds rate target, so obviously there are forces beyond Fed policy that influence that rate.  It is affected by Fed policy, but it isn’t the thing itself.  Here’s what I mean by easier money:

A policy that increases the supply of base money or reduces the demand for base money is expansionary.  Here are ways to increase the supply of base money:

1.  Open market purchases

2.  Discount rate cuts

Here are ways to reduce the demand for base money:

1.  Lower reserve requirements.

2.  Lower interest on reserves.

None of these policy changes will have much effect if temporary.

And here is a very reliable way to signal an intention to adopt an easier monetary policy (usually an intention to boost the base through open market purchases):

1.  Lower the fed funds target, relative to expectations.

That signaling device has been so reliable over the years that central banks have been able to see a clear connection between their policy signaling and asset prices linked to inflation expectations (such as stock and commodity prices, or TIPS spreads.)

It is that reliable response of asset prices to unexpected fed funds changes, i.e. unexpected changes in the expected future path of the base, that causes central banks to be absolutely confident the neo-Fisherites are wrong.  They see evidence of their policies “working.”  But here are two facts that lead to confusion:

1. The vast majority of the time interest rates and inflation are positively correlated—the Fisher effect dominates the liquidity effect.

2.  Central banks and their supporters in the academic community often talk as if interest rates are “the thing itself.”  That’s incorrect, and it leads them to often confuse easy and tight money, because of point 1.

Combine those two facts, and it’s easy to understand how intelligent, freethinking economists might reject the conventional wisdom, and end up as neo-Fisherites.

The solution is not to throw out mainstream Keynesian monetary theory and embrace neo-Fisherism, the solution is to throw out mainstream Keynesian monetary theory and embrace market monetarism.

Like Coke, it’s the real thing the thing itself.

PS.  Off topic, but I only hate Noah on days where he insults me or my friends on Twitter, otherwise I like his blog a lot.  Love the sinner, hate the sin.

And a person Miles and Izabella like can’t be all bad.  🙂

Here’s Noah Smith:

First, the basic idea. The Fisher Relation says that nominal interest rates are the sum of real interest rates and inflation:

R = r + i

That’s not an assumption, that’s just a definition (actually it’s an approximation, but close enough). What I call the “Neo-Fisherite” assumption is that in the long term, r (the real interest rate) goes back to some equilibrium value, regardless of what the Fed does. So if the Fed holds R (the nominal interest rate) low for long enough, eventually inflation has to fall. This is exactly the opposite of the “monetarist” conclusion that if the Fed holds R very low for long enough, inflation will trend upward.

Noah Smith is making a very subtle error here, but before getting into the details let’s blow the neo-Fisherite model right out of the water.  We can do so with a couple points made in the comment section.  First Nick Rowe:

Here is one very big bit of empirical evidence against the “Neo-Fisherite” theory:

For the last 20 years the Bank of Canada has been targeting 2% inflation. And the average inflation rate over that same 20 years has been almost exactly 2%.

The Bank of Canada has said it has been doing the exact opposite to what Neo-Fisherites would recommend: whenever the BoC fears that inflation will rise above 2% it raises the nominal interest rate, and whenever it fears that inflation will fall below 2% it cuts the nominal interest rate.

If the BoC had been turning the steering wheel the wrong way this last 20 years, there is no way it could have kept the car anywhere near the centre of the road. Unless it was incredibly lucky. Or was lying to us all along.

No, they aren’t lying.  And if you don’t believe me, do you think financial and commodity market participants are also “lying,” and hence intentionally losing lots of money.  Here’s Kevin Donoghue, responding to Noah:

If the Neo-Fisherites are right, then not only is the Fed massively confused about what it’s doing, but much of the private sector may be reacting in the wrong way to monetary policy shifts.

The NFs are committed to RatEx, so if the private sector is reacting in the wrong way their theory has a serious problem.

So how come all these brilliant neo-Fisherite economists are making an elementary mistake?  It’s partly because the mainstream never really internalized Milton Friedman’s insight:

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.

.   .   .

After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

At first glance that looks almost neo-Fisherite.  But of course Friedman had quite conventional views on the liquidity and Fisher effects.  Still it makes sense that if Friedman’s insights were mostly ignored, later economists who discovered the strong correlation between low rates and low inflation might easily draw the wrong conclusion.  Friedman believed that a tight money policy would initially raise rates, but over time would lower both interest rates and inflation.  So over the vast majority of time you’d see inflation move in roughly the same direction as the short term interest rate directly controlled by the central bank.  That’s the Fisher effect—conventional macroeconomics.  But because it was not internalized (remember how crazy everyone viewed me in 2009 when I said money was tight?), it pushed the door wide open for the neo-Fisherites and MMTers, and lots of other odd critters to walk into the house.

And now we can see the subtle error that Noah Smith made in the passage quoted at the beginning of the post:

This is exactly the opposite of the “monetarist” conclusion that if the Fed holds R very low for long enough, inflation will trend upward.

Reasoning from a price change!!!  If I had a crystal ball, and peered into that ball, and saw that Yellen was going to hold short term rates at zero for the next 10 years, I’d absolutely predict ultra-low inflation, condition on that interest rate forecast.  So no, the monetarist prediction is not that inflation will trend upward.  As Milton Friedman said, the monetarist prediction is that inflation would trend downward.

Noah Smith is thinking like a Keynesian.  He’s trying to translate monetarist ideas about monetary policy into a Keynesian (interest rate) language.  He knows that we think easy money is associated with higher inflation, so he assumes we must also think that an extended period of low interest rates is associated with higher inflation.  Not so.  We don’t think low rates imply easy money.

Noah Smith and the neo-Fisherites are confusing the situation described by Friedman, with a subtly different case. Suppose a madman is put in change of the Fed who is committed to zero rates over the next 10 years, come hell or high water.  Then I might forecast an upward drift in inflation; indeed I think hyperinflation would be quite possible.  It depends on what else the madman did. But if you simply told me that rates would be low over the next 10 years under Janet Yellen, I’d assume that inflation would be low, and that low inflation is precisely the reason why Yellen held rates down.

There are no paradoxes to be explained, and that’s why we need to keep the “market” in market monetarism.  Markets tell us that all theories of monetary policy ineffectiveness at the zero bound, and also all reverse causation theories, are wrong. (I.e. RBC, MMT, Neo-Fisherite, old Keynesian, etc., are all wrong.)  It doesn’t matter if your model predicts that a change on monetary policy should have X effect on the price level.  If commodity markets respond in the “wrong way” then you’ve lost.  Game over. Case closed.

PS.  Edward Lambert comments:

Noah,
You sense the same thing that I do. I commented on Williamson’s post pretty much your thoughts. I am in agreement with the Fisher effect.
I simply want to thank you for having sufficient wisdom and constitution to write this post.

Yikes, if Noah has a friend in Edward Lambert then he doesn’t need any more enemies.

HT.  Tom Brown, TravisV.

Tax theory is full of cognitive illusions.  Things are never as they seem.  Here are some examples:

1.  In the long run it doesn’t matter how the payroll tax is split between workers and companies. Right now the split is 50-50 in the US, but this has no bearing on the actual incidence of the tax.  If the tax were set up where 100% was paid by workers, it would not “favor” business in the long run (although it would in the short run, due to sticky wages.)

2.  AFAIK, most countries levy VAT on imports, but not on exports.  US politicians and pundits will sometimes demagogue this issue, claiming that this tax regime “favors” exports.  It doesn’t.  As far as I know all public finance experts agree on this point.  It’s trade neutral.  (In all of these cases there are obviously possible real world complications with second order effects—my point is the demagogues prey on the public’s tendency to use a common sense approach to taxes, which is almost invariably wrong.)

3.  The VAT applies to consumer goods but not capital goods.  Again, this is to avoid double-taxing the part of consumer goods that represents the cost of capital.  In no sense does this mean the VAT system “favors” capital goods over consumer goods.

4.  A flat 10% VAT and a flat 10% wage tax are essentially identical in the long run (ignoring enforcement problems.)  At first glance the payroll tax seems to tax “labor” while the VAT seems to tax “consumption.”  But that’s an illusion.  They are both wage taxes and they are both consumption taxes.  They are essentially identical.

Here’s what annoyed me so much about the Solow quotation in the previous post. Yes, there are a number of articles that provide some (weak) justification for a tax on capital income.  These involve everything from risk/insurance, to enforcement/evasion problems.  So I’m not claiming there are no arguments at all for some sort of capital income tax.  But the baseline you start from is a zero tax, not a capital income tax equal to the wage tax.  When Solow talked about our tax system “favoring” capital income he was clearly pandering to the public’s ignorance of tax theory.  If Warren Buffett says he pays a lower tax rate than his secretary, that’s going to look unfair to almost everyone, even to GOP voters.

I think I have a better way of explaining all this, which might convince some commenters who were confused by the previous post.  Many people are aware of the 401k pension plan in America.  You contribute money you have earned, and do not pay tax on that money until it is withdrawn at retirement.  If you allowed unlimited 401k contributions, and then taxed the amount only when it was withdrawn for consumption purposes (by your or your heirs) then you would have essentially converted the income tax into a pure consumption tax.  AFAIK, this claim is completely uncontroversial among tax experts.

Now let’s think about a world of unlimited 401ks, with no taxes on capital income, just a 50% wage tax.  You earn $100,000, and save $20,000 in the current year. That means you pay $40,000 in tax today, and consume $40,000 today.  The other $20,000 goes into a 401k, where it grows to $60,000 over the next two decades. Then you take the money out and spend it.  How much tax do you pay at that point?  The answer is $30,000, as the wage tax also applies to funds removed from the 401k.  You can think of that tax as having two parts:

$10,000 of the tax is a deferred tax on the $20,000 that you failed to pay tax on when you put the money into the 401k.

$20,000 is the tax paid on the capital gain of $40,000 that you earned on your invested money.

Thus to the average person it looks like the 401k account is not “tax free” but rather “tax deferred.” A politician or pundit would have a difficult time demagoguing that issue.  Suppose they claimed that 401k holders were paying zero taxes on their investment earnings.  Outraged 401k holders would say; “Wait a minute, I am paying the full income tax on all my investment gains when I take the money out and spend it.  And even the wage tax I initially avoided is only deferred, I still must pay the full wage tax in the future.”

Under this 401k approach it looks like both wage earners and investors are paying the exact same 50% tax rate.  No one in their right mind could claim this tax system “favored” capital income over wage income.

And yet our current tax system taxes capital income at a higher rate (relative to wage income) than the system just described.  

You’d get the identical result if you applied the 50% wage tax to the full $100,000 (i.e. $50,000 in tax), if you assume they spent $40,000 on consumption today, and then invested the other $10,000 for 20 years, consuming $30,000 at that time, with no capital income tax.  But the 401k approach looks much “fairer,” as it “seems” to tax capital income at 50%.

Of course Solow is a brilliant economist who certainly understands basic tax theory.  Whenever I see smart liberal economists argue that our tax system favors capital income I immediately suspect them of pandering to the ignorance of the public.  Tax theory is counterintuitive.  A neutral tax system will often appear to favor capital, and European exporters, and businesses, and also appear to punish workers and consumers and domestic firms competing with European exporters. But these are cognitive illusions, and it’s about time we stopped pandering to these illusions.

If people want to make sophisticated arguments for special capital income taxes where evasion is rife (say hedge funds or entrepreneurs) then do so. But don’t use that as an excuse to double tax the money saved by ordinary working Americans.  At a minimum they should remove any contribution limits on 401ks. Recoup the revenue with higher payroll taxes on upper income Americans.

And don’t liberals claim that working people can’t afford to save very much?  Then my proposal shouldn’t cost much revenue.

PS.  Some commenters wrongly think all this is some weird idea I concocted.  Not so. I’ve seen Yglesias and DeLong discuss progressive consumption taxes. They certainly understand the points I’m making, even if they may not agree with all my policy preferences.

Prove me wrong and there’s a Nobel Prize waiting for you in Stockholm.