A recent blog post by Paul Krugman makes an economic argument that I find puzzling. Though the analysis is pretty elementary and therefore presumably easy for him, I think he’s dead wrong under his own explicit assumptions; so I thought I’d explain why and see if anyone can debunk my critique.
Krugman’s topic is the proposition that, from a utilitarian perspective (one that rejects the notions that high earners have a moral “right” to keep their own income or that they “need” it as much as the less wealthy do), the ideal income tax rate on the highest earning Americans is the rate that maximizes revenue from those taxpayers. This is the apex of the so-called Laffer curve, the point at which, were the rate raised any higher, the average taxpayer subject to that rate would decrease the amount of work he does such that his income would decrease so much that the amount of taxes he pays would be less than at the lower rate; when the tax rate is higher than (to the right of) the apex rate, the government can increase revenues from taxpayers only by decreasing the tax rate they pay. The apex, according to the proposal he discusses, is around 70%—double the current federal rate on the top earners.
Krugman’s contribution to this proposal is an ostensible rebuttal of a conservative counterargument* he summarizes thus: “You’ll kill job creation!” The “job creation” argument, as best I can tell, says that high earners benefit society overall by creating jobs for others without being fully compensated for doing so—if they are fully compensated, then a utilitarian shouldn’t care if they do less when taxes go up, since in that case the top earners are eating up all the benefits of their actions without leaving any consumer surplus; and increased benefits for the top earners are of scant import to a utilitarian when weighed against aiding the poor with tax transfers from the top earners. But if the conservatives are correct that the top earners are not fully compensated, then a higher tax rate that causes high earners to work less would have negative effects on the economy beyond the decreased tax revenues caused by their lower incomes. And that would mean that, from a purely utilitarian standpoint, the ideal tax rate is somewhere to the left of the apex of the Laffer curve—lower than 70% (assuming, again, that the apex is at 70%; I wouldn’t know).
To rebut this counterargument, Krugman points to the proposition of “textbook economics” that
in a competitive economy, the contribution any individual…makes to the economy at the margin is what that individual earns—period. What a worker contributes to GDP with an additional hour of work is that worker’s hourly wage, whether that hourly wage is $6 or $60,000 an hour. This in turn means that the effect on everyone else’s income if a worker chooses to work one hour less is precisely zero. If a hedge fund manager gets $60,000 an hour, and he works one hour less, he reduces GDP by $60,000—but he also reduces his pay by $60,000, so the net effect on other peoples’ [sic] incomes is zip.
From this he concludes that “this claim [that high earners are 'job creators']—and the lionization of high earners as people who make a vast contribution to society—is not, in fact, something that comes out of the free-market economic principles these people claim to believe in.”
I’m happy to accept this account of “textbook economics,” leaving aside how accurate it is in a real-world economy (see here for a good empirical response), but I don’t see why Krugman thinks his conclusions—that raising rates on top earners to the point that maximizes revenue from them is ideal from a utilitarian standpoint and that high earners don’t “make a vast contribution to society” (which I take to mean a nontrivial net contribution; who knows what “vast” means to Paul Krugman)—even plausibly follow from his premises.
The second conclusion, that the “job creation” crowd is wrong to think that high earners contribute more to society than what they earn themselves, is based on a simple confusion between marginal effects and average or aggregate effects: the fact that the seller of a good or a factor of production (in this case, a worker who sells his labor) gets the marginal value of his contribution in wages does not imply that workers in the aggregate are paid the total value of their contributions; rather, in the “textbook economics” competitive market Krugman posits, the average value of, say, an hour of labor (the aggregate value divided by the number of man hours worked) will be higher than the marginal value, and thus a consumer surplus—the amount by which the aggregate value is greater than the wages—will be created. [EDIT: I initially wrote "social surplus" throughout this post where I meant to refer only to the "consumer surplus," a component of social surplus; Mike has made me aware of this error in his comment, and while I admit my error I've fixed my references to prevent confusion for future readers.] The consumer surplus is the amount by which the worker helps society over and above the amount he’s compensated for—it’s the portion of his production that the competitive economy prevents him from keeping. Were there no consumer surplus from economic activity, there would be no reason to trade, no reason to have an economy. What this means is that every class of worker in Krugman’s textbook economy—including the top earners—fails to internalize the full amount by which it increases GDP and thus makes an uncompensated contribution to society.
An example: If I own a Chipotle and need ten employees of equal skill and experience to do work for which the employees are interchangeable, then under Krugman’s assumptions I will pay each one the value of the marginal hour of the marginal worker, which is to say the amount that the tenth worker I hired would produce in the final hour that I pay him to work, assuming that I’d already assigned the first nine to the nine most important jobs. Suppose that amount is $10; then I’ll pay each employee $10; and if one employee decides to work an hour less, the loss to me (and to the GDP) will be $10, but the worker will lose that amount, too, so he’ll internalize the entire shortfall and neither the GDP nor I will care one way or the other. It’s just as Krugman says.
But the fact (if it is a fact) that the wage equals the marginal value of a worker does not tell us anything about the average value of a worker (except that it must be no lower than the marginal value). So the total value of the work done by my workers is at least $100 per hour, but presumably it is rather more than that. In fact, it would be very surprising if it were only $100 per hour because we usually have diminishing returns to scale in such a context. And after all, if the staff taken as a whole were not generating any surplus for me as the owner, then it wouldn’t make sense for me to go through the bother of employing them in the first place: I’d be getting $100 worth of value and then turning around and paying back $100, the economic equivalent of running in place.
Much the same error underlies Krugman’s second conclusion, that raising taxes on top earners to the apex of the Laffer curve would not have a negative effect on the economy (one such effect could be a lower rate of job creation, and there would be others, such as higher prices on consumer goods; the conservatives’ focus on “job creation” is merely a consequence of the fact that unemployment is viewed as a much bigger problem at present than high prices). As one moves up the Laffer curve toward its apex (Krugman’s assumption goes), taxpayers decrease the amount of work they do (and at a 100% tax rate—well to the right of the apex—no one would work and government tax revenues would be down to zero, just as they’d be at a 0% rate). This does not just mean that the “marginal” worker somewhere decides not to work that “marginal” hour, in which case Krugman would be correct that the worker would internalize the whole decrease in GDP and the economy would be unharmed. Instead, it means that increasing numbers of workers throughout the economy will decide to not work increasing numbers of hours (at least in the long run). Add them all up, and we’re not at the margin anymore. The last (marginal) hour of labor from my tenth (marginal) worker at Chipotle may be worth only $10, but if three of my workers quit, or if all ten of them decide to work an hour fewer each day, then I’ll lose a sizable chunk of the surplus they were producing (a surplus which, by the way, the textbook competitive economy Krugman posits would force me to pass on to the burrito-eating public in the form of lower prices, keeping for myself only a “reasonable return on investment”).
* Krugman purports to list the possible counterarguments, yet he ignores what would surely be the primary serious objection to his version of the utilitarian argument: A dollar paid in taxes by a rich person does not turn into a dollar, or a dollar’s worth of stuff (food, education, medicine, whatever), received by a poor person; much of that dollar is eaten up by government programs among which are many that most informed observers, Krugman among them, recognize as wasteful regardless of their politics (agricultural subsidies, for instance). (And liberals might object, along the same lines, that a very substantial proportion of every dollar an American pays in taxes go not feed the poor but to military spending.)
Hat tip: Tyler Cowen at Marginal Revolution. Cowen’s post makes an empirical critique of Krugman, which does not overlap with my theoretical argument.