Tax debate needs to be much more sophisticated

Recent exchange between Nobel Prize winner Robert Solow and Harvard professor Greg Mankiw is illustrative

Economists are notorious for their arguments but often protest that their discipline contains much that is settled – the trouble is, they correctly point out, that the debates are usually about economic policy, a small aspect of what economists do. The irony is often lost on the protagonists.

Thanks to the internet, economic debate has become more robust. The in-your-face exchanges in the blogosphere and on Twitter are spilling over into the usually more polite pages of the academic journals.

Nowhere is the debate sharper than over the significance of growing inequality. A recent exchange between Nobel Prize winner Robert Solow and Harvard professor Greg Mankiw is illustrative. Mankiw argued that inequality was nothing to worry about. Solow responded with these words: "The cheerful blandness of Mankiw's 'Defending the One Percent' may divert attention from its occasional unstated premises, dubious assumptions, and omitted facts." Strong stuff.

The arguments are long, technical and involve digressions into philosophy. What is the right level of redistribution and the optimal taxation system that supports it? For late-night chat show hosts the answer is obvious: more taxes on the rich.


Mankiw has a different perspective: the rich are essentially a group of people not unlike Steve Jobs, someone who became wealthy but in so doing created gains for society as a whole. While Jobs increased inequality, we all became better off, albeit to differing degrees. In such a world, the rewards to efforts and innovation are best not taxed too heavily as we all benefit.

Money buys power
First, said Solow, not all rich people get to be that way through effort and innovation. Sometimes they are just lucky. Second, income equates to political clout: money buys power. Third, the American dream is fading: fewer children are better off than their parents. Fourth, a pragmatic point: in theory, tall people "deserve" to be taxed more than short people because height leads to more income. We tax the income, not the height, mostly because it is easier.

Mankiw rebutted Solow’s arguments partly by appealing to the evidence: the problem is not as big as is often supposed. Both professors agreed that people should be taxed according to how lucky they are, rather than how innovative or hard- working they might be. The trouble is figuring out how much is down to chance. Taxing effort is unambiguously bad.

The International Monetary Fund recently tackled all this and came up with some recommendations. This is hard because optimal tax policy contains policy prescriptions that sometimes jar with popular assumptions and political realities. Theory points us to falling marginal rates of tax as income rises and also towards flat taxes. Capital should not be taxed at all.

Taxable capacity
More fiscal consolidation is required, not least in Ireland. How best to do this? How much "taxable capacity" we have is a tricky concept. We have very little leeway here as we are pretty much on the international average when it comes to most taxes.

The exception, unsurprisingly, is corporation tax. If we made our VAT system more efficient we could raise close to 2 per cent of GDP – a significant amount.

The negative growth consequences of higher taxation are widely acknowledged. Corporation tax hikes hit growth the most, followed by income taxes, then consumption taxes, with property taxes having the least negative consequences, hence the IMF’s repeated calls for us to implement and extend property taxation. Further increases in the years ahead are likely.

Of the 24 countries examined by the IMF, Korea has the least amount of redistribution. Ireland has the most.

In terms of how much more can be squeezed out of the rich, the IMF is clear: it depends on a combination of equity and efficiency. If we care nothing for the economic welfare of high earners, marginal rates could be increased another 15 points or so to max out the tax take, but we might be surprised at how little revenue results.

If, for example, we restored marginal rates back to levels that prevailed in the 1980s we would raise barely 0.2 per cent of GDP. In the unlikely event that we care anything for high earners, we need to cut marginal rates back towards 50 per cent.

Our tax debate needs to become much more sophisticated.