Piketty and Krugman Admit the Laffer Curve Is Real

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Liberal and conservative economists disagree sharply over the extent to which a lower marginal tax rate motivates talented workers to take the risks and suffer the consequences necessary to earn more money. The strongly held belief that higher tax rates do not create significant disincentive for risk-taking is central to the liberal argument. Imagine the shock, then, when two pillars of liberal economics-Paul Krugman and Paris School of Economics professor Thomas Piketty-conceded that a lower U.S. marginal tax rates had a profound effect on the economy precisely through its motivational effects on the most productive workers.

In his review of Piketty's new book, Capital in the 21st Century, Krugman admits that he is "more or less persuaded by Piketty's explanation of the surge in wage inequality," which Krugman summarizes as the following:

"Piketty argues high-level executives set their own pay, constrained by social norms. He attributes skyrocketing pay at the top to an erosion of these norms. Falling tax rates for the rich have in effect emboldened the earnings elite. When a top manager could expect to keep only a small fraction of the income...he might have decided that the opprobrium wasn't worth it. Cut his marginal tax rate drastically, and he may behave differently."

Piketty (as described by Krugman) advances the premise that a lower marginal tax rate motivates talented workers to risk their reputations and stature to earn more money. They seem to suggest that we need high tax rates to rein in workers who would otherwise be "emboldened" to earn more.

The only difference between their hypothesis and the conservative hypothesis is the restriction Krugman and Piketty place on the risks people are motivated to take. Conservatives see money motivating highly talented workers to take the entrepreneurial risks necessary to earn more money. Krugman and Piketty only see it motivating undesirable behavior-public-company CEOs, for example, damaging their standing in the community to make more money by manipulating cronies on their corporate board of directors to pay them at the expense of shareholders.

The facts make their restriction all the more dubious. The vast majority of people in the top one percent or even the 0.1 percent are not public-company CEOs with an opportunity to steal from their shareholders. They are entrepreneurs and service providers who earned more by convincing customers to pay them more despite competitive alternatives. And they competed with those alternatives for the same pool of talented employees. They did not "set their [own] pay"; they competed to earn it. Nevertheless, the earnings of this group of people rose, at precisely the same time public-company CEO earnings rose. In fact, the pay of the 0.1 percent has risen faster than the pay of public-company CEOs since the late 1990s. Nor has the pay for public-company CEOs risen relative to the pay for CEOs at private companies, where owners, and not alleged cronies, control compensation.

Were rising "crony capitalism" a significant driver of the outsized success of the one percent, growth would have slowed relative to economies with more equally distributed incomes. Misallocating resources, after all, slows growth. Yet, U.S. innovation, employment, and economic growth accelerated relative to the high-wage economies of Europe and Japan with more equally distributed incomes-the exact opposite of what the Piketty/Krugman hypothesis would predict. Without the skewed benefit of U.S. innovation, Europe and Japan's growth would have been even slower. The facts strongly indicate that the rising opportunity costs, rather than cronyism, have driven up the compensation of the most talented and properly trained workers.

No surprise, even Krugman concedes, Piketty's "diagnosis...clearly lacks...rigor."

In truth, Krugman and Piketty ascribe motivational effects to marginal tax rates that go far beyond the level most serious conservative economists ascribe to them. In the Piketty/Krugman view, the motivational effects from a lower marginal tax rate alone accounted for the large increases in the pretax earnings of the one percent.

Most mainstream economists see other powerful factors at work. They recognize that information technology and globalization created entrepreneurial opportunities that exceeded the supply of properly trained talent needed to capitalize on these opportunities. As a result, pay for those workers rose independent of the marginal tax rate.

The rapid growth of companies and communities, like Google, Microsoft, and Silicon Valley, provided valuable on-the-job training and networks of expertise that greatly increased America's chances to innovate successfully relative to Europe and Japan.

Minimal needs for startup capital gave individuals and not just large corporations access to IT-related entrepreneurial opportunities.

Like any game of chance, higher payoffs for success motivated increased risk-taking, especially among talented workers. With higher payoffs, Americans produced more innovation than their counterparts in Europe and Japan. A lower marginal tax rate only increased payoffs further.

America's success drove up the opportunity cost and pay of highly talented workers throughout the economy. The lack of competition from Europe and Japan's talented elite drove up top American pay even further.

In an increasingly innovation-driven economy, the difficulty investors face with regard to established companies is motivating CEOs to take the risks necessary to innovate. Over and over again, we see companies like Kodak, Dell, Yahoo, and Microsoft reluctant to take the risks needed to innovate and grow until seriously threatened by competitors. CEOs often avoid confronting strategic risks where the possibility of failure jeopardizes their career. They prefer the status quo, even if it is detrimental in the long run, because they generally care far more about preserving their stature than they do about earning more money. Motivating CEOs to take risks that jeopardize their careers is expensive. In Piketty and Krugman's version of the economy, the most talented workers eagerly sell their stature for money. Were that the case, CEOs would earn a lot less!

Edward Conard, the author of Unintended Consequences: Why Everything You've Been Told About The Economy Is Wrong, is a visiting scholar at the American Enterprise Institute and a former Bain Capital partner. 

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