I was thinking about which possible parts of economy are effectively destroyed in our society by having an income tax (as an analogy to Paul Graham’s article saying that wealth tax would effectively destroy startups; previous shortform). And I think I have an answer; but I would like an economist to verify it.
Where I live, the marginal income tax is about 50%. Well, only a part of it is literally called “tax”, the other parts are called health insurance and social insurance… which in my opinion is misleading, because it’s not like the extra coin of income increases your health or unemployment risk proportionally; it should be called health tax and social tax instead… anyway, 50% is the “fraction of your extra coin the state will automatically take away from you” which is what matters for your economical decisions about making that extra coin.
In theory, by the law of comparative advantage, whenever you are better at something than your neighbor, you should be able to arrange a trade profitable for both sides. (Ignoring the transaction costs.) But if your marginal income is taxed at 50%, such trade would be profitable only if you are more than 2× better than your neighbor. And that still ignores the fixed costs (you need to study the law, do some things to comply with it, study the tax consequences, fill the tax report or pay someone to do it for you, etc.), which are significant if you trade in small amounts, so in practice you sometimes need to be even 3× or 4× better than your neighbor to make a profit.
This means that the missing part of economy are all those people who are better at something than their neigbors, but not 2×, 3×, or 4× better; at least not reliably. In an alternative tax system without income tax, they could engage in profitable trade with their neighbors; in our system, they don’t. And “being slightly better, but not an order of magnitude better at something” probably describes a majority of population, which suggests there is a huge amount of possible value that is not being created, because of the income tax.
Even worse, this “either you are an order of magnitude better, or go away” system creates barriers to entry in many places in the society. Unqualified vs qualified workers. Employees vs entrepreneurs. Whenever there is a jump required (large upfront investment for uncertain gain), fewer people cross the line than if they could walk across it incrementally: learn a bit, gain an extra coin, learn another bit, gain two extra coins… gradually approaching the limit of your abilities, and getting an extra income along the way to cover the costs of learning. The current system is demotivating for people who are not confident they could make the jump successfully. And it contributes to social unfairness, because some people can easily afford to risk a large upfront investment for uncertain gain, some would be ruined by a possible failure, and some don’t even have the resources necessary to try.
To reverse this picture, I imagine that in a society without income tax, many people would have multiple sources of income: they could have a job (full-time or part-time) and make some extra money helping their neighbors. The transition from an employer to an entrepreneur would be gradual, many would try it even if they don’t feel confident about going the entire way, because going halfway would already be worth it. And because more people would try, more would succeed; also, some of them would not have the skills to go the entire way at the beginning, but would slowly develop them along the way. Being an entrepreneur would not be stressful the same way it is now, and this society would have a lot of small entrepreneurs.
...and this kind of “bottom-up” economy feels healthier to me than the “top-down” economy, where your best shot at success is creating a startup for the purpose of selling it to a bigger fish. I suppose the big fish, such as Paul Graham, would disagree, but that’s the entire point: in a world without barriers to entry, you wouldn’t need to write motivational speeches for people to try their luck, they could advance naturally, following their incentives.
I think this is insightful, but my guess is that a society without income tax would not in fact be nearly as much better at providing opportunities for people who are kinda-OK-ish at things as you conjecture, and I further guess that more people than you think are at least 2x better at something than someone they can trade with, and furthermore (though it doesn’t make much difference to the argument here) I think something’s fundamentally iffy about this whole model of when people are able to find work.
Second point first. For there to be opportunities for you to make money by working, in a world with 50% marginal income tax, what you need is to be able to find someone you’re 2x better than at something, and then offer to do that thing for them.
… Actually, wait, isn’t the actual situation nicer than that? Roll back the income tax for a moment. You can trade profitably with someone else provided your abilities are not exactly proportional to one another, and that’s the whole point of “comparative advantage”. If you’re 2x worse at doing X than I am and 3x worse at doing Y, then there are profitable trades where you do some X for me and I do some Y for you. (Say it takes me one day to make either a widget or a wadget, and it takes you two days to make a widget and three days to make a wadget, and both of us need both widgets and wadgets. If we each do our own thing, then maybe I alternate between making widgets and wadgets, and get one of each every 2 days, and you do likewise and get one of each every 5 days. Now suppose that you only make widgets, making one every 2 days, and you give 3⁄5 of them to me so that on average you get one of your own widgets every 5 days, same as before. I am now getting 0.6 widgets from you every 2 days without having to do any work for them. Now every 2 days I spend 0.4 days making widgets, so I now have a total of one widget per 2 days, same as before. I spend another 1 day making one wadget for myself, so I now have a total of one wadget per 2 days, same as before; and another 0.2 days making one wadget for you, so you have one wadget per 5 days, same as before. At this point we are exactly where we were before, except that I have 10% of my time free, which I can use to make some widgets and/or wadgets for us both, leaving us both better off.
I haven’t thought it through but I guess the actual condition under which you can work profitably if there’s 50% income tax might be “there’s someone else, and two things you can both do, such that [(your skill at A) / (your skill at B)] / [(their skill at A) / (their skill at B)] is at least 2”, whereas without the tax the only requirement is that the ratio be bigger than 1.
Anyway, that’s a digression and I don’t think it matters that much for present purposes. (If what you want is not merely to “earn a nonzero amount” but to “earn enough to be useful”, then probably you do need something more like absolute advantage rather than merely comparative advantage.) The point is that what you need is a certain kind of skill disparity between you and someone else, and the income tax means that the disparity needs to be bigger for there to be an employment opportunity.
But if you’re any good at anything, and if not everyone else is really good at everything—or, considering comparative advantage again, if you’re any good at anything relative to your other abilities, and not everyone else is too, then there’s an opportunity. And it seems to me that if you have learned any skill at all, and I haven’t specifically learned that same skill, then almost certainly you’ve got at least a 2x comparative advantage there. (If you haven’t learned any skills at all and are equally terrible at everything, and I have learned some skills, then you have a comparative advantage doing something I haven’t learned. But, again, that’s probably not going to be enough to earn you enough to be any use.)
OK, so that was my second point: surely 2x advantages are commonplace even for not-very-skilled workers. Only a literally unskilled worker is likely to be unable to find anything they can do 2x better than someone.
Moving on to my (related) first point, let’s suppose that there are some people who have only tiny advantages over anyone else. In principle, they’re screwed in a world with income tax, and doing fine in a world without, because in the latter they can find someone they’re a bit better at and work for them. But in practice I’m pretty sure that almost everyone who is doing work that isn’t literally unskilled is (perhaps only by virtue of on-the-job training) doing it well more than 2x better than someone completely untrained, and I suspect that actually finding and exploiting “1.5x” opportunities would be pretty difficult. If someone’s barely better than completely-unskilled, it’s probably hard to tell that they’re not completely unskilled, so how do they ever get the job, even in a world without income tax.
Finally, the third point. A few times above I’ve referred to “literally unskilled” workers. In point of fact, I think there are literally unskilled workers. That ought to be impossible even in a world without income tax. What’s going on? Answer: work isn’t only about comparative or absolute advantage in skills. Suppose I am rich and I need two things done; one is fun and one is boring. I happen to be very good at both tasks. But I don’t wanna do the boring one. So instead I pay you (alas, you are poor) to do the boring task. Not because of any relevant difference in skill, but just because we value money differently because I’m rich and you’re poor, and you’re willing to do the boring job for a modest amount of money and I’m not. Everybody wins. Or suppose there’s no difference in wealth or skill between us, and we both need to do two things 100x each. Either of us will do better if we pick one thing and stick with it so we don’t incur switching costs and get maximal gains from practice. So you do Thing One for me and I do Thing Two for you. I think income taxes still produce the same sort of friction, and require the advantages (how much more willing you are to do boring work than me on account of being poor, how much we gain from getting more practice and avoiding switching costs) to be larger roughly in inverse proportion to how much of your income isn’t taxed, so this point is merely a quibble that doesn’t make much difference to your argument.
I was thinking about which possible parts of economy are effectively destroyed in our society by having an income tax (as an analogy to Paul Graham’s article saying that wealth tax would effectively destroy startups; previous shortform). And I think I have an answer; but I would like an economist to verify it.
Where I live, the marginal income tax is about 50%. Well, only a part of it is literally called “tax”, the other parts are called health insurance and social insurance… which in my opinion is misleading, because it’s not like the extra coin of income increases your health or unemployment risk proportionally; it should be called health tax and social tax instead… anyway, 50% is the “fraction of your extra coin the state will automatically take away from you” which is what matters for your economical decisions about making that extra coin.
In theory, by the law of comparative advantage, whenever you are better at something than your neighbor, you should be able to arrange a trade profitable for both sides. (Ignoring the transaction costs.) But if your marginal income is taxed at 50%, such trade would be profitable only if you are more than 2× better than your neighbor. And that still ignores the fixed costs (you need to study the law, do some things to comply with it, study the tax consequences, fill the tax report or pay someone to do it for you, etc.), which are significant if you trade in small amounts, so in practice you sometimes need to be even 3× or 4× better than your neighbor to make a profit.
This means that the missing part of economy are all those people who are better at something than their neigbors, but not 2×, 3×, or 4× better; at least not reliably. In an alternative tax system without income tax, they could engage in profitable trade with their neighbors; in our system, they don’t. And “being slightly better, but not an order of magnitude better at something” probably describes a majority of population, which suggests there is a huge amount of possible value that is not being created, because of the income tax.
Even worse, this “either you are an order of magnitude better, or go away” system creates barriers to entry in many places in the society. Unqualified vs qualified workers. Employees vs entrepreneurs. Whenever there is a jump required (large upfront investment for uncertain gain), fewer people cross the line than if they could walk across it incrementally: learn a bit, gain an extra coin, learn another bit, gain two extra coins… gradually approaching the limit of your abilities, and getting an extra income along the way to cover the costs of learning. The current system is demotivating for people who are not confident they could make the jump successfully. And it contributes to social unfairness, because some people can easily afford to risk a large upfront investment for uncertain gain, some would be ruined by a possible failure, and some don’t even have the resources necessary to try.
To reverse this picture, I imagine that in a society without income tax, many people would have multiple sources of income: they could have a job (full-time or part-time) and make some extra money helping their neighbors. The transition from an employer to an entrepreneur would be gradual, many would try it even if they don’t feel confident about going the entire way, because going halfway would already be worth it. And because more people would try, more would succeed; also, some of them would not have the skills to go the entire way at the beginning, but would slowly develop them along the way. Being an entrepreneur would not be stressful the same way it is now, and this society would have a lot of small entrepreneurs.
...and this kind of “bottom-up” economy feels healthier to me than the “top-down” economy, where your best shot at success is creating a startup for the purpose of selling it to a bigger fish. I suppose the big fish, such as Paul Graham, would disagree, but that’s the entire point: in a world without barriers to entry, you wouldn’t need to write motivational speeches for people to try their luck, they could advance naturally, following their incentives.
I think this is insightful, but my guess is that a society without income tax would not in fact be nearly as much better at providing opportunities for people who are kinda-OK-ish at things as you conjecture, and I further guess that more people than you think are at least 2x better at something than someone they can trade with, and furthermore (though it doesn’t make much difference to the argument here) I think something’s fundamentally iffy about this whole model of when people are able to find work.
Second point first. For there to be opportunities for you to make money by working, in a world with 50% marginal income tax, what you need is to be able to find someone you’re 2x better than at something, and then offer to do that thing for them.
… Actually, wait, isn’t the actual situation nicer than that? Roll back the income tax for a moment. You can trade profitably with someone else provided your abilities are not exactly proportional to one another, and that’s the whole point of “comparative advantage”. If you’re 2x worse at doing X than I am and 3x worse at doing Y, then there are profitable trades where you do some X for me and I do some Y for you. (Say it takes me one day to make either a widget or a wadget, and it takes you two days to make a widget and three days to make a wadget, and both of us need both widgets and wadgets. If we each do our own thing, then maybe I alternate between making widgets and wadgets, and get one of each every 2 days, and you do likewise and get one of each every 5 days. Now suppose that you only make widgets, making one every 2 days, and you give 3⁄5 of them to me so that on average you get one of your own widgets every 5 days, same as before. I am now getting 0.6 widgets from you every 2 days without having to do any work for them. Now every 2 days I spend 0.4 days making widgets, so I now have a total of one widget per 2 days, same as before. I spend another 1 day making one wadget for myself, so I now have a total of one wadget per 2 days, same as before; and another 0.2 days making one wadget for you, so you have one wadget per 5 days, same as before. At this point we are exactly where we were before, except that I have 10% of my time free, which I can use to make some widgets and/or wadgets for us both, leaving us both better off.
I haven’t thought it through but I guess the actual condition under which you can work profitably if there’s 50% income tax might be “there’s someone else, and two things you can both do, such that [(your skill at A) / (your skill at B)] / [(their skill at A) / (their skill at B)] is at least 2”, whereas without the tax the only requirement is that the ratio be bigger than 1.
Anyway, that’s a digression and I don’t think it matters that much for present purposes. (If what you want is not merely to “earn a nonzero amount” but to “earn enough to be useful”, then probably you do need something more like absolute advantage rather than merely comparative advantage.) The point is that what you need is a certain kind of skill disparity between you and someone else, and the income tax means that the disparity needs to be bigger for there to be an employment opportunity.
But if you’re any good at anything, and if not everyone else is really good at everything—or, considering comparative advantage again, if you’re any good at anything relative to your other abilities, and not everyone else is too, then there’s an opportunity. And it seems to me that if you have learned any skill at all, and I haven’t specifically learned that same skill, then almost certainly you’ve got at least a 2x comparative advantage there. (If you haven’t learned any skills at all and are equally terrible at everything, and I have learned some skills, then you have a comparative advantage doing something I haven’t learned. But, again, that’s probably not going to be enough to earn you enough to be any use.)
OK, so that was my second point: surely 2x advantages are commonplace even for not-very-skilled workers. Only a literally unskilled worker is likely to be unable to find anything they can do 2x better than someone.
Moving on to my (related) first point, let’s suppose that there are some people who have only tiny advantages over anyone else. In principle, they’re screwed in a world with income tax, and doing fine in a world without, because in the latter they can find someone they’re a bit better at and work for them. But in practice I’m pretty sure that almost everyone who is doing work that isn’t literally unskilled is (perhaps only by virtue of on-the-job training) doing it well more than 2x better than someone completely untrained, and I suspect that actually finding and exploiting “1.5x” opportunities would be pretty difficult. If someone’s barely better than completely-unskilled, it’s probably hard to tell that they’re not completely unskilled, so how do they ever get the job, even in a world without income tax.
Finally, the third point. A few times above I’ve referred to “literally unskilled” workers. In point of fact, I think there are literally unskilled workers. That ought to be impossible even in a world without income tax. What’s going on? Answer: work isn’t only about comparative or absolute advantage in skills. Suppose I am rich and I need two things done; one is fun and one is boring. I happen to be very good at both tasks. But I don’t wanna do the boring one. So instead I pay you (alas, you are poor) to do the boring task. Not because of any relevant difference in skill, but just because we value money differently because I’m rich and you’re poor, and you’re willing to do the boring job for a modest amount of money and I’m not. Everybody wins. Or suppose there’s no difference in wealth or skill between us, and we both need to do two things 100x each. Either of us will do better if we pick one thing and stick with it so we don’t incur switching costs and get maximal gains from practice. So you do Thing One for me and I do Thing Two for you. I think income taxes still produce the same sort of friction, and require the advantages (how much more willing you are to do boring work than me on account of being poor, how much we gain from getting more practice and avoiding switching costs) to be larger roughly in inverse proportion to how much of your income isn’t taxed, so this point is merely a quibble that doesn’t make much difference to your argument.