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Be careful when taxing the rich: someone else may pay

Paul-AndrÈ Belle-Isle/iStockphoto

Let's suppose that the government decides to increase personal income tax rates on high earners. What happens next?

In my back-of-the-envelope calculations for how much this sort of measure would generate in the way of revenues, I made the standard assumption that in the face of higher tax rates, high earners would simply 'swallow hard and write bigger cheques to the Receiver-General'. But of course this won't be the case: one doesn't become a high earner by passively accepting one's fate in the job market.

The first reaction to a higher income tax rate is to demand a higher wage to compensate. But if workers must take the going market wage as given, then they are only left with the choice of how much labour to supply in return for the lower after-tax wage.

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But high earners are different. There aren't many of them, and they have market power that most workers do not. If their tax rates go up, they will try to leverage that bargaining power and obtain a salary increase that at least partially offsets the higher tax burden.

An extreme example of this sort of effect occurred when the UK government imposed a 50 per cent bonus 'supertax' on banks last year: banks simply doubled the size of the bonus pool so that after-tax bonuses would stay the same.

High-earner market power changes the analysis dramatically. For one thing, the whole Laffer curve debate loses much of its relevance. If high earners keep working, and if they pay higher tax rates on increased incomes, it's hard to see how higher tax rates will result in lower tax revenues.

What becomes more problematic is just who will bear the burden of those taxes – or, in the language of public finance, what is the incidence of increased income taxes on high earners? The ostensible targets of the UK bonus supertax were high-earning bank employees, and since they bore the statutory incidence of the supertax, they did indeed pay more taxes. But since they were able to obtain increases that left their after-tax incomes untouched, they weren't left out of pocket by the measure: the economic incidence was passed on to shareholders, other employees and bank customers – in short, everyone except the original target. If the goal of the bonus supertax was to reduce the gap between high earners and the rest of the income distribution, it's hard to see how it could be considered a success.

More policy energy needs to be spent on understanding how and why high earners came to obtain their market power in the first place. In some cases, no policy action is necessary: it's hard to see why the state should intervene in order to weaken Jarome Iginla's bargaining position.

Corporate governance issues certainly deserve closer scrutiny. Again, if properly-informed shareholders are satisfied with executive pay, then it`s not obvious that there's a policy problem to solve. But if corporate structures are sufficiently opaque as to separate ownership from control, then there may be little to stop insiders from exploiting their position for personal gain.

The continued concentration of incomes at the top end of the distribution is a serious policy issue, and increased tax rates on high earners may well be part of the solution. But an effective policy response must be based on a proper understanding of the problem; the history of economic policy is littered with well-intentioned measures that had unintended, counterproductive consequences.

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The redistributional effects of increasing tax rates on top incomes will be unclear so long as high earners have enough bargaining power to at least partially deflect tax increases further down the income distribution. There's not much point in imposing a tax on high earners if they're not going to be the ones who pay it.

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