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Paul Krugman’s Conversion to a 70-Percent Income Tax – William L. Anderson (01/16/2019)

Paul Krugman was the featured speaker at a special session of the 2004 Southern Economic Association meetings, held the weekend before Thanksgiving, and a number of economists listened intently as the most famous man at the conference spoke religiously about the glories of Keynesian economics. Professor Joseph Salerno and I were in the audience sitting next to each other, and we kept our disagreements with Krugman’s points to ourselves.

When the Q&A began, I raised my hand immediately and was able to ask the first question, and so I asked Krugman the following: “You have been very critical of the Bush tax cuts. Do you favor going back to the 70 percent rates that existed before 1981?”

Krugman answered emphatically, “Oh, no! Those rates were insane.”

To be honest, I felt some relief. Krugman had not gone off the deep end, I thought. Despite his politically-partisan rhetoric and his semi-weekly tirades against the tax policy of the Bush II administration, Krugman seemed to understand that taxes really were an economic drag and that jacking up the marginal rates would create havoc on the economy.

That was then. In the intervening years Krugman has received a Nobel Memorial Prize in economics (something I “celebrated” with this snarky piece on the Forbes website), and left his prestigious post at Princeton University for a professorship at the less-prestigious Graduate Center if the City University of New York. While he was decidedly on the left when I saw him in 2004, his journey to being a hard leftist has accelerated, and he has become a “woke,” born-again “Democratic Socialist” since then.

Lest anyone still believes that any vestige of a real economist remains in Krugman, think again. In his recent New York Times column, Krugman not only offers effusive praise for Rep. Alexandria Occasio-Cortez’s “Green New Deal” in which she calls for a return to the 70-percent marginal tax rates (thus endorsing what he once labeled as “insane”), but he also gives readers a lesson in faulty utility theory that should have earned him an “F” in any legitimate doctoral program in economics.

Krugman’s column is loaded with economic fallacies, the first employing the informal fallacy of argumentum ad verecundiam, or the “appeal from authority” to qualify his point. Krugman writes:

The controversy of the moment involves AOC’s advocacy of a tax rate of 70-80 percent on very high incomes, which is obviously crazy, right? I mean, who thinks that makes sense? Only ignorant people like … um, Peter Diamond, Nobel laureate in economics and arguably the world’s leading expert on public finance. (Although Republicans blocked him from an appointment to the Federal Reserve Board with claims that he was unqualified. Really.)

Of course, there are other famous economists such as Emmanuel Saez, and Christina Romer, Barack Obama’s chief economic adviser that Krugman points out that favor top rates from 73 to 80 percent, with Krugman’s implication being that since Krugman has declared them to be experts, they have to be correct. End of argument.

Krugman doesn’t stop with the argumentum ad verecundiam fallacy, however, as he presses on in turning economic analysis into a socialist caricature. Pushing Saez’s arguments, Krugman turns utility theory upside down:

Underlying the Diamond-Saez analysis are two propositions: Diminishing marginal utility and competitive markets.

Diminishing marginal utility is the common-sense notion that an extra dollar is worth a lot less in satisfaction to people with very high incomes than to those with low incomes. Give a family with an annual income of $20,000 an extra $1,000 and it will make a big difference to their lives. Give a guy who makes $1 million an extra thousand and he’ll barely notice it.

What this implies for economic policy is that we shouldn’t care what a policy does to the incomes of the very rich. A policy that makes the rich a bit poorer will affect only a handful of people, and will barely affect their life satisfaction, since they will still be able to buy whatever they want.

While Krugman’s analysis might seem to be “common sense,” it actually employs what economists call “interpersonal utility comparisons,” which any first-term graduate student knows not to use in economic analysis. Marginal utility is ordinal, not cardinal in scope – and there is a very good reason for making that point.

I use the following example: Assume I wish to exchange the ring I am wearing for your watch. In order for the voluntary exchange to take place, I have to value your watch more than I value my ring, and, at the same time, you must value my ring more than you value your watch. Note that we are not in a state of affairs in which I value your watch more than you do, and you value my right more than do I. While cardinal measurements of utility might seem to be “common sense,” they actually are nonsensical, and economists do not use them.

To put it another way, we have no way of knowing if an extra $1,000 obtained by a wealthy person provides less “utility” than an extra $1,000 obtained by someone who makes $20,000 a year. The only thing we can know is that $1,000 as a percentage of income is less for the billionaire than it is for the person with the lesser income, but we have no way of measuring the personal satisfaction that each person receives from the additional income, much less compare them.

This is not a trivial point (although I suspect Krugman would claim otherwise). First, and most important, the whole point of raising tax rates as one’s income increases is based upon cardinal utility measurements. So the theory goes, as one’s income goes up, one’s purchases continually bring less satisfaction than did purchases made at a lesser income. Thus, since satisfaction levels are declining as income increases, the so-called punitive effects of income confiscation become less harmful.

Krugman justifies confiscatory levels of taxation by claiming that the policy would create overall net positive levels of utility for society, a positive social welfare function. His logical chain goes as follows: (1) there are only a small number of people with very high incomes and taxing their upper levels of income at high rates results in a small loss of social utility; (2) the income confiscated from wealthy people then is distributed to lower-income people, and the utility that they gain from the extra income is greater than the social utility lost by the highly-taxed rich; (3) therefore, society overall gains by such a tax policy.

However, if one (correctly) rejects measures of cardinal utility, the only other choice would be employing Pareto Criteria in which a move that makes anyone worse off is not welfare-enhancing. (Not surprisingly, Murray Rothbard strongly stood behind Pareto Optimality.)

Krugman does not stop at using faulty utility theory; he also mangles production theory with his very crabbed and mechanistic view of competition and monopoly. He writes:

But here’s where competitive markets come in. In a perfectly competitive economy, with no monopoly power or other distortions — which is the kind of economy conservatives want us to believe we have — everyone gets paid his or her marginal product. That is, if you get paid $1000 an hour, it’s because each extra hour you work adds $1000 worth to the economy’s output.

He goes on to explain that high marginal tax rates on the wealthy in a perfectly-competitive economy would be extra welfare-enhancing:

In that case, however, why do we care how hard the rich work? If a rich man works an extra hour, adding $1000 to the economy, but gets paid $1000 for his efforts, the combined income of everyone else doesn’t change, does it? Ah, but it does — because he pays taxes on that extra $1000. So the social benefit from getting high-income individuals to work a bit harder is the tax revenue generated by that extra effort — and conversely the cost of their working less is the reduction in the taxes they pay.

Or to put it a bit more succinctly, when taxing the rich, all we should care about is how much revenue we raise. The optimal tax rate on people with very high incomes is the rate that raises the maximum possible revenue.

In other words, if all workers are making their marginal revenue product (or, more accurately, their discounted marginal revenue product), then if a wealthy person earns $1,000, that is a $1,000 addition of created wealth, which increases social welfare. Taking $700 of that money in taxes and giving it to lower income earners thus enhances the welfare of that group but, simultaneously, does not result in an actual $700 loss to the wealthy person, since diminishing marginal utility limits the actual damage to, say, $400, creating net benefits of $300 to the state and, thus, to society. Thus, the overall gain in a perfectly-competitive economy of having a wealthy person earn $1,000 and levying a 70 percent tax enhances society by $1,300.

Alas, Krugman sadly notes, the U.S. economy is not competitive and is full of monopolies. He writes:

What if we take into account the reality that markets aren’t perfectly competitive, that there’s a lot of monopoly power out there? The answer is that this almost surely makes the case for even higher tax rates, since high-income people presumably get a lot of those monopoly rents.

Time for some Krugman math. Krugman argues that since the American economy really is not competitive, or, to be more direct, because (1) all firms are price takers in which demand for their products always is perfectly elastic; (2) not all products in various markets are exactly like one another (homogeneous products); (3) not everyone in the market operates with perfect information that is obtained with no opportunity cost; and (4) the markets do not have costless entry and exit, then rates really should be above 70 percent so that the government can confiscate the monopoly rents that so-called free markets regularly provide to producers. Confiscatory tax levels, he argues, somehow would magically transform the economy from one dominated by rapacious monopolies to one that would closely resemble the imaginary ideal of perfect competition.

(Murray Rothbard demolishes the dichotomy between monopoly and competition in a free market in Chapter 10 of Man, Economy, and State, arguing that so-called perfect competition neither is perfect nor competitive nor is not the “ideal” state of affairs.)

Krugman’s reasoning goes as such: Because almost all private enterprise enjoys vast monopoly rents (since private enterprise is uncompetitive), and since monopolies are economically harmful, confiscating money from wealthy monopolists is welfare maximizing because after society gets the benefit of the new wealth created by the monopoly (yes, monopolies do create at least some wealth), there is the net benefit of the added tax dollars and the confiscation of the monopoly rent which government will spend more wisely than would have been the case had the individual been permitted to hold onto it.

To put it mildly, there are major problems in Krugman’s line of reasoning. I have alluded to his insistence on employing cardinal utility measures and his belief that confiscatory levels of taxation will result in an imaginary “maximization” of an imaginary “social utility function.” While Rothbard was very critical of such welfare schemes in economic analysis, he hardly is the only one. Kenneth Arrow, also a Nobel winner (to use Krugman’s own fallacies against him), laid out his impossibility theorem in which he points out that any voter-based social welfare scheme is going to require a form of dictatorship, which violates the terms of Pareto Optimality.

Economist David Henderson notes that utility only can be ordinal, not cardinal, and he also quotes Robert Murphy (familiar to readers of this page), who emphasizes the same point. There are no cardinal measures of “utils” that one gains from consumption or in improving one’s place in the world. Likewise, as Henderson notes here, one cannot

measure difference s in the marginal utility of money across people. Why? …Utility is ordinal, not cardinal. So there’s no such thing as a “difference” to measure.

Henderson and Rothbard are not making capricious statements. Legitimate cardinal measurements of utility would require that there be standard measurements of satisfaction (utility) that are not arbitrarily constructed to fit the personal preferences of certain people who have coercive power over others and, thus, wish to force others to act in a certain manner contrary to their own desires, or even to have contrary thoughts to those who are the so-called standard setters of utility. Krugman may say that such cardinal measurements are based upon “common sense,” but it is impossible to impose such measures without coercing others against their will.

The second issue with Krugman’s ex cathedra declarations is that he assumes the state always will find better uses for the money confiscated from wealthy people than those individuals would use themselves. He bases his beliefs on two points: the first is the application of cardinal utility, which is not legitimate in economic analysis. The second is that entrepreneurship and capital development at best are irrelevant in the economy, or even that state-sponsored “development” is superior to whatever private individuals would do.

Discussion of that second point will take more space than can be allotted to this particular article. However, suffice it to say that Krugman consistently employs the same methodology as before: he and like-minded people should have the power to decide what is good for everyone else.

There are many reasons why to oppose 70+ percent marginal tax rates, and if one believes that the growth of private enterprise is a good thing for people, then Krugman’s original statement that confiscatory taxes are “insane” makes sense. In repudiating his own earlier-held beliefs, however, Krugman not only embraces viewpoints that he once rejected, but he also employs what only can be called intellectually-illegitimate means to accomplish this dubious feat.

William L. Anderson is a professor of economics at Frostburg State University in Frostburg, Maryland.