Do you really want to tax ability?

N. Gregory Mankiw , Matthew Weinzierl, 12 June 2009

a

A

In a famous interchange between candidate Barack Obama and voter “Joe the Plumber,” the soon-to-be President said he wanted to raise taxes on the wealthy to “spread the wealth around.” Obama’s position may not have persuaded Joe, but it did hearken back to a long tradition in political philosophy and economics.

More than a century ago, Francis Y. Edgeworth (1897) pointed out that a utilitarian social planner with full information will be completely egalitarian. More specifically, the planner will equalise the marginal utility of all members of society; if everyone has the same separable preferences, equalising marginal utility requires equalising after-tax incomes as well. Those endowed with greater than average productivity are fully taxed on the excess, and those endowed with lower than average productivity are subsidised to bring them up to the average.
William S. Vickrey (1945) and James A. Mirrlees (1971) emphasised a key practical difficulty with Edgeworth’s solution. The government does not observe innate productivity. Instead, it observes income, which is a function of productivity and effort. The social planner with such imperfect information has to limit her utilitarian desire for the egalitarian outcome, recognising that too much redistribution will blunt incentives to supply effort. The Vickrey-Mirrlees approach to optimal nonlinear taxation is now standard.

Vickrey and Mirrlees assumed that income was the only piece of data the government could observe about an individual. That assumption, however, is far from true. In practice, a person’s income tax liability is a function of many variables beyond income, such as mortgage interest payments, charitable contributions, health expenditures, number of children, and so on. George Akerlof (1978) called these variables “tags” and suggested that they might be used to identify individuals whom society deems worthy of special support.

In a recent paper (Mankiw and Weinzierl, 2009), we use the Vickrey-Mirrlees framework to explore the potential role of another variable – the taxpayer’s height. This inquiry is supported by two legs – one theoretical and one empirical.

The theoretical leg is that, according to the theory of optimal taxation, any exogenous variable correlated with productivity should be a useful indicator for determining an individual’s optimal tax liability. Intuitively, such a variable allows society to tax its more productive members, on average, without incurring the efficiency costs that come with taxing income.

The empirical leg is that a person’s height is strongly correlated with his or her income. For example, Anne Case and Christina Paxson (2008) write that "For both men and women...an additional inch of height [is] associated with a one to two percent increase in earnings." This fact, together with the canonical approach to optimal taxation, suggests that a person’s tax liability should be a function of his height. That is, a tall person of a given income should pay more in taxes than a short person of the same income.

The optimal height tax

Our research shows that, according to a conventional utilitarian calculus, the optimal height levy is sizeable. We calculate optimal taxes for adult white males in the US, whom we divide into three height groups – tall (above 72 inches), medium (between 70 and 72 inches), and short (below 70 inches). The optimal average tax on the tall is about 7.1% of the average tall income, while the average tax on the medium is about 3.8% of average medium income. These taxes pay for an average transfer to the short of more than 13% of average short income. Expressed in a more tangible way, the following table shows the optimal tax schedule by height group. A tall person making $50,000 should pay about $4,500 more in taxes than a short person making the same income.

Many people, however, will not quickly embrace the idea of levying higher taxes on tall taxpayers. Indeed, when first hearing the proposal, most people either recoil from it or are amused by it. And that reaction is precisely what makes the policy so intriguing. A tax on height follows inexorably from a well-established empirical regularity and the standard approach to the optimal design of tax policy. If the conclusion is rejected, the assumptions must be reconsidered.

What’s wrong with taxing height?

One possibility is that the canonical utilitarian model omits some constraints from political economy that are crucial for guiding tax policy. For example, some might fear that a height tax would potentially become a “gateway” tax for the government, making taxes based on demographic characteristics more natural and dangerously expanding the scope for government information collection and policy personalisation. Yet modern tax systems already condition on much personal information, such as number of children, marital status, and personal disabilities. A height tax is qualitatively similar, so it is hard to see why it would trigger a sudden descent down a slippery slope.

A second possibility is that the utilitarian model fails to incorporate any role for horizontal equity. As Alan J. Auerbach and Kevin A. Hassett (1999) note, "...there is virtual unanimity that horizontal equity – the extent to which equals are treated equally – is a worthy goal of any tax system." It may, for instance, be hard to explain to a tall person that he has to pay more in taxes than a short person with the same earnings capacity because, as a tall person, he had a better chance of earning more. Yet horizontal equity has no independent role in utilitarian theory. When ability is unobservable, as in the Vickrey-Mirrlees model, respecting horizontal equity means neglecting information about exogenous personal characteristics related to ability. This information can make redistribution more efficient. As Louis Kaplow (2001) emphasises, why would society sacrifice potentially large gains for its average member to preserve equal treatment of individuals within an arbitrarily defined group?

A third possibility is that the utilitarian model needs to be supplanted with another normative framework. Libertarians, for example, emphasise individual liberty and rights as the sole determinants of whether a policy is justified. From their perspective, any transfer of resources by policies that infringe upon individuals’ rights is deemed unjust. The prominent libertarian economist Milton Friedman (1962) writes, "I find it hard, as a liberal, to see any justification for graduated taxation solely to redistribute income. This seems a clear case of using coercion to take from some in order to give to others..." How to reconstitute the theory of optimal taxation from a strictly libertarian perspective is, however, far from obvious.

These results, therefore, leave each of us with a menu of conclusions. One thing is clear – if a person rejects the policy of a tax on height, he must also reject, or significantly amend, the standard utilitarian approach to optimal taxation and income redistribution. It seems likely, if faced with these options, Barack Obama and Joe the Plumber would make different choices. In fact, this Tax Day (15 April 2009) President Obama told an audience “And we need to end the tax breaks for the wealthiest 2% of Americans, so that people like me, who are extraordinarily lucky, are paying the same rates that the wealthiest 2% of Americans paid when Bill Clinton was President.” President Obama did not add that he stands a full 73 inches tall.

References

Akerlof, George, (1978). "The Economics of ‘Tagging’ as Applied to the Optimal Income Tax, Welfare Programs, and Manpower Planning," American Economic Review, 68(1), March, pp. 8-19.

Auerbach, Alan J. and Kevin A. Hassett, (2002). "A New Measure of Horizontal Equity," American Economic Review 92(4), pp. 1116-1125, September.

Case, Anne and Christina Paxson (2008). "Stature and Status: Height, Ability, and Labor Market Outcomes," Journal of Political Economy, 116(3).

Edgeworth, Francis Y., (1897). "The Pure Theory of Taxation," Economic Journal 7, pp. 46-70, 226-238, and 550-571 (in three parts).

Friedman, Milton (1962). Capitalism and Freedom. Chicago: University of Chicago Press.

Kaplow, Louis, (2001). "Horizontal Equity: New Measures, Unclear Principles," in Hassett, Kevin A. and R. Glenn Hubbard (eds.), Inequality and Tax Policy. Washington, D.C.: AEI Press

Mankiw, N. Gregory and Matthew Weinzierl, (2009). “The Optimal Taxation of Height: A Case Study of utilitarian Income Redistribution,” Forthcoming, American Economic Journals: Economic Policy.

Mirrlees, James A., (1971). "An Exploration in the Theory of Optimal Income Taxation," Review of Economic Studies 38, 175-208.

Vickrey, William S., (1945). "Measuring Marginal Utility by Reactions to Risk," Econometrica 13, 319-333.

Topics: Taxation
Tags: Height tax, income redistribution, optimal taxation, utilitarian

Comments

Too simple?

I would think that the biggest objection here is that taxing height is way too specific. Presumably, you'd also want to tax other "inborn" traits that affect potential earnings. These would probably include "beauty", "charisma", etc. In fact, I fail to see how "work ethic" is fundamentally distinct from these (especially "charisma" or "personality"). It is something that we are often "lucky" to have because we were raised in a family that favored it, had some social factors that promoted it, etc.

That being said, wouldn't a progressive taxation scheme that just looked at income bracket take all these things into account? Because maybe we aren't living up to our "height" averages, but we presumably would be in our ability aggregate?

Another complaint about the tall tax

Okay, so maybe I'm not objective on this subject, standing 6'6" tall, but I'm not convinced. Height might be correlated with ability, but there is huge variance. My dad was 6'4" but severely learning disabled. He might have made better tips than other taxi drivers by virtue of his height (a doubtful proposition), but his ability to earn income was clearly still well below average. Meanwhile, tiny people who have an inate ability to write best-selling macro textbooks would get off scott free under your scheme. I think if you generalized the utilitarian model so that there is a horizontal inequity cost (from overtaxing those with low abilities or undertaxing those with high abilities), a tax based on income could dominate if income is much more highly correlated with ability than height and inter- and intra-temporal elasticities of substitution are modest.

Taxing ability

The first paragraph of this article is rather misleading. Here’s what Mr Obama actually said to Mr Wurzelbacher:

“My attitude is that if the economy’s good for folks from the bottom up, it’s gonna be good for everybody. If you’ve got a plumbing business, you’re gonna be better off if you’ve got a whole bunch of customers who can afford to hire you, and right now everybody’s so pinched that business is bad for everybody and I think when you spread the wealth around, it’s good for everybody.”

Mr Obama’s observation seems to be about the implications of after-tax income distribution for aggregate demand, not optimal taxation.

As for the rest, what’s the justification for treating height as exogenous? Surely height depends heavily on nutrition?

Robert M. Beren Professor of Economics, Harvard University
Assistant Professor of Business Administration, Harvard Business School