Luck and Taxation

Liberals and conservatives tend to disagree about the role of luck in financial success, the former thinking it plays a very big role, the latter thinking it plays a small role: that instead financial success is largely attributable to talent and hard work. Taken to its extreme, the second position is the one that was espoused by the radical libertarian Ayn Rand.

The economic significance of the disagreement has mainly to do with taxation. Taxing success that is attributable to pure luck does not have disincentive effects, and so is a cheap away of financing government. Taxing success that is attributable to hard work may induce a substitution toward leisure, reducing money incomes, and taxing financial success attributable to talent may induce some talented people to substitute activities that generate substantial nonpecuniary income (apart from leisure), which may not be socially as productive as business. Beyond the economic concern, however, is an ethical one that is particularly acute in a society, such as ours has become, in which there is great inequality of income and wealth.

I don't find any merit to the celebration of the tycoon by Ayn Rand and her followers. I think that ultimately everything is attributable to luck, good or bad. Not just the obvious things, like IQ, genes that predipose to health or sickliness, the historical era and the country in which one is born, the wealth of one's parents, whom one happens to meet at critical stages of one's life and career, one's height and looks and temperament, to the extent genetic, and one's innate propensity to risk or caution (that is an exceptionally important factor); but also the characteristics that cause a person to make critical decisions that may turn out well or badly, characteristics that really are derivative from some of the previously noted "luck" characteristics. The decision-determining characteristics include intelligence, imagination, attitude toward risk, and personality characteristics such as aggressiveness, maladjustment, indolence, and having a low or high personal discount rate (how future-regarding one is or is not). Talent is luck but so is the propensity for working hard (often the consequence of a compulsive personality) or not working hard.

In short, I do not believe in free will. I think that everything that a person does is caused by something. It is true, and is the basis of belief in free will, that often we are conscious of considering pros and cons in deciding on a course of action; "we" are deciding, rather than having the decision made by something outside "us." But calculation and decisionmaking are different. Deciding may just mean calculating the balance of utility and disutility; the result of the balance determines the decision. No doubt when a cat pounces on a mouse, it has decided to do so; but the decision was compelled by circumstances—the feline diet, the presence of the mouse, etc. A complete description of the incident would not require positing free will.

If this is right, a brilliant wealthy person like Bill Gates is not "entitled" to his wealth in some moral, Ayn Randian sense. But it would be ridiculous to infer from this that the government should take his wealth away from him and scatter it among the poor, on the theory that the only difference between Gates and a poor person is that one is lucky and the other is not. But the reason that it would be ridiculous is that it would have terrible incentive effects, not that it would violate some deep sense of human freedom.

The effects of heavy taxation of wealth may depend in part on the kind of luck that generated the wealth that is now to be taken away and given to someone else. There may be different effects from taxing wealth that results primarily from personal qualities, such as IQ and ambition, and taxing wealth that is unrelated to such qualities—inherited wealth, for example, or wealth obtained by winning a lottery, or, a subtler and more important example, wealth resulting from financial risk taking unguided by real insight (or, it hardly needs noting, from antisocial activities such as crime). Heavy taxation of earned wealth is likely to induce many able and energetic people to increase their leisure activities relative to productive work—but to induce other such people to increase their work effort relative to leisure in order to preserve or augment their wealth in the face of the heavy taxation. Heavy taxation of unearned wealth is more likely to have the second than the first effect, because, lacking talent, such people will have to work hard (to work, period—maybe they were living off their inherited or otherwise bestowed wealth and not working at all) in order to maintain a decent standard of living, lacking as they do the talent of the wealthy people who earned their wealth rather than having it fall into their laps.

I mentioned financial risk taking. Because of the uncertainty (in the Knight-Keynes sense—that is, a probability that cannot be quantified) of speculation, speculative profits, as by trading stocks and bonds, are mainly the result of dumb luck rather than of skill or hard work. In fact many speculators work hard, but the number who are consistently successful seems little if any greater than one would expect as a result of mere luck. Speculative profits tend to soar in rapidly rising markets and collapse when markets sour. Market turns are hard to spot and fluctuations in the prices of particular stocks are difficult to predict because, as Keynes famously pointed out, when you are speculating on stock prices you are speculating not merely about the fortunes of the company that issued the stock but about how other speculators assess those fortunes and indeed how they assess your assessments. Although speculation tends to generate information about underlying values and to that extent is socially productive, the benefits of that information bear no relation to the profits and losses that speculation generates. Those are gamblers' profits and losses and taxing the profits heavily would probably have only a small negative effect on the generation of socially valuable information.

So there is in my view nothing "unfair" about heavy taxation of wealth, but there are practical objections. One is that the wealthy have sufficient political influence to pepper any new tax law with loopholes that will enable wealthy persons to minimize their tax liability. Another is that the additional tax money raised will be squandered on unproductive governmental activities, including handouts that reduce recipients' work incentives. This objection would disappear, however, if the proceeds of additional taxes on the wealthy were earmarked for reducing the federal deficit.

There are complaints that already, though the maximum federal income rate is low (the top marginal rate is 35 percent, and for capital gains, dividends, and interest is only 15 percent), the very wealthy pay a very high proportion of total federal income tax, and almost half the adult population pays no federal income tax at all, though it pays federal payroll taxes and state taxes. I can't see why anyone should care that the wealthy pay a "disproportionate" share of federal income tax, unless there is evidence (of which I'm unaware) that taxing the wealthy at even lower rates than they are being taxed would elicit greater productive effort. Indeed, I don't even know what "disproportionate" should mean in this context. Would it be "disproportionate" to require the highest-earning 1 percent of the population to pay 1.5 percent of total federal income tax?

Federal tax law is riddled with deductions and exemptions that are loopholes in the sense that they have no social product. An example is the mortgage-interest deduction, which incentivizes people to own rather than rent their homes—and why encourage home ownership? Another example is the exemption of employer-paid employee health benefits from federal income tax, which encourages excessive expenditures on health care. Some taxes, such as the corporate income tax, cause distortions, as does treating dividends and interest differently by allowing interest but not dividends to be deductible by corporations. Reform of the tax code would be preferable to raising taxes on anyone, but the major loopholes and deductions and exemptions are sacred cows, leaving changes in tax rates and spending levels as the only feasible methods of achieving fiscal discipline.