You kids know me, when Steve Landsburg has a new post up with which I find myself in 99% agreement, I have to focus on what I don’t like. (It’s not a grudge or anything. I’m actually testing the Coase Theorem’s prediction that Steve will efficiently offer me $10,000 to leave him alone.)
Anyway, both Landsburg and Scott Sumner (with whom I agree only about 15% of the time, but that’s because he spends 85% of his posts talking about one topic) have lately been hitting their familiar theme of the evils of income taxation. (1, 2, 3) Of course, I totally agree that the government shouldn’t be taxing people’s income, and I also agree that the income tax screws up the intertemporal allocation of present vs. future consumption, and thus inefficiently penalizes saving.
Nonetheless, the way Landsburg and Sumner go about making their case, disturbs me. To give a 30,000 foot view, they often come across as saying: Investment income is really just deferred consumption out of prior wages, and so it’s not fair to tax people more heavily just because they are quirky and happen to enjoy a lifetime consumption stream that’s biased to the right. I don’t have the time to go hunting and make an airtight prosecution. My only pieces of evidence are: [UPDATE: Upon re-reading, I understand what the commenter was saying and why Steve agreed.]
(A) a commenter at Landsburg’s site says something that is arguably wrong, depending on how it is interpreted (as my example below demonstrates), and Steve merely says, “Point extremely well taken.” (B) Sumner actually wrote a post saying the very concept of income was “meaningless, misleading, and pernicious.”
Before jumping into my example, here’s my basic message: As the title of my post indicates, consumption and income are different terms, and that’s OK. They are both important. Just because consumption is a more useful concept than income for certain questions, doesn’t mean we should therefore jettison the latter. (So Sumner is wrong.) Furthermore–and this point is less obvious–the standard way that a lot of free-market guys critique the income tax, obscures exactly what the concept of income does for civilization. In short, accountants aren’t fools; there’s a reason they construct Income Statements. (Have you ever heard of a Consumption Statement?)
Without further ado, here’s another Excel chart. (Don’t worry, there are no apples in this example.)
So here’s what’s going on in the table above:
There are two brothers, Paul and Freddy. They each work at a job and earn a single paycheck of $100,000, in the beginning of period 1. Paul blows the whole paycheck on consumption that period. Freddy, in contrast, only consumes half of that paycheck. He saves the rest in a bank account, where it earns
5% 10% interest every period.
The middle column tracks Freddy’s consumption through five periods. The accounting in this example is discrete (not continuous), so I have Freddy earn his interest income at the beginning of period 2 from the $50,000 in wealth that he held at the “end of period” (eop) 1. (Just to reiterate, Paul and Freddy only get labor income of $100,000 at the start. Then neither of them labors another second.) You can see the vagaries of Freddy’s wealth, as he changes his consumption from period to period. During period 5, Freddy consumes his remaining wealth, and so ends with nothing, just as Paul had done by the end of period 1.
Now here is what Steve Landsburg and Scott Sumner want us to take away from this demonstration: Both Paul and Freddy put in the same labor effort in period 1. They each earned $100,000 in salary or wages. Paul is prodigal, and consumed it all immediately. Freddy, in contrast, deferred his enjoyments, and spread the consumption out over 5 periods. However, if you calculate the present discounted value of Freddy’s consumption from the perspective of period 1 then you find over his lifetime, Freddy will consume exactly $100,000 worth of goods and services, just like Paul.
So Landsburg and Sumner argue that because of this phenomenon, clearly it would be unjust to have an income tax, or at least to have a tax on capital income (as opposed to labor income). In the table above, if there had been an x% income tax every period (that didn’t distinguish between labor and capital income), then Freddy would clearly pay more in taxes during his life. In period 1, he would pay the same in taxes as Paul, but then in periods 2 – 5 he would get dinged on his interest income too. Even in present value terms calculated in period 1, Freddy would pay more in taxes during his lifetime, and not because he was “richer” than Paul–so Landsburg and Sumner would argue–but merely because he decided to spread out his consumption.
Another way of seeing this important point is to imagine that there are extensive derivative markets to deliver future goods. (The casual reader probably wants me to call these “futures markets,” but that’s actually not right. Really what we’re talking about here is Freddy using all of his income in period 1 to buy call options with a strike price of $0, on the consumption items dated periods 2 – 5 that he desires.) So in period 1, Paul buys a steak dinner for $100, but Freddy buys an airtight claim to a steak-dinner-delivered-in-period-3 for
$90.70 $82.64. (This assumes the spot price of a steak dinner will still be $100 in period 3.)
If this is how Freddy arranged his affairs in period 1, in order to set up his desired lifetime consumption stream using that paycheck from period 1, then gosh it really does look like Paul and Freddy are both spending all of their paychecks in period 1–it’s just that they have different tastes. Paul likes burgers-with-pickles, while Freddy likes burgers-with-onions. Fine; the government shouldn’t be taxing the latter but not the former, because that wouldn’t be fair. Yet by the same token, if Paul likes to eat “steak-in-period-1″ while Freddy likes to eat “steak-in-period-3″ then why the heck should Freddy suffer a higher tax burden?
Now we can finally see why Scott Sumner hates the very concept of income. As the table above shows, even though Paul and Freddy have the same lifetime consumption (measured in market value in period 1), Freddy nonetheless has a higher lifetime income–even if we measure everything in PDV terms in period 1. (This has to be true, since Paul and Freddy both have $100,000 in labor income in period 1. So the further interest income that Freddy earns during periods 2 – 5, no matter how highly discounted, will still in period 1 push Freddy over the top in terms of lifetime income.)
For the purists, another way of seeing the injustice that so irks Landsburg and Sumner is that even doing the derivatives trick would still ding Freddy, so long as the IRS properly measured people’s accounting income. Specifically, if Freddy buys that claim ticket to a steak in period 3 that we discussed, it had a market value of
$90.70 $82.64 in period 1. As time passes, that asset appreciates in market value. Maybe the government won’t ding him on the capital gain until it is realized, but when he exercises the claim in period 3, presumably the IRS will say, “Ah! You just exercised that option, which currently has a market value of $100. So you owe us tax on that capital gain from the asset you purchased at a lower price in period 1.” My point is, Freddy can’t help but earn income, even if he avoids banks and the stock market, if we do the accounting right. Because of the positive interest rate, in period 1 he can lock in consumption goods in the future, for a lower price than what their spot values will ultimately be at the time of consumption. That’s the source of the growth in Freddy’s wealth over time (offset by his consumption) and his income.
We now come to my main point: Thus far I’ve just been saying how smart Landsburg and Sumner are. So what the heck is my deal? Well, you might get the idea from those two guys that income is, I don’t know, a meaningless or useless concept. But that can’t possibly be right; of course we need income.
Specifically, Freddy can use the notion of income to guide his decisions through time. In any period, Freddy’s income tells him, “This is how much you can consume this period, without reducing your wealth below last period’s level.” Put differently, if interest rates are expected to remain constant, then your (net) income in a period tells you how much you could consume, if you wanted to maintain that level of consumption forever.
To see how that works, look again at Freddy’s numbers. In period 2, he consumed exactly his income of $5,000. That’s why his wealth at the end of period 2 was the same as it was at the end of period 1. If Freddy continued to consume $5,000 per period, his wealth would remain constant at $50,000 and he could tread water like that perpetually.
But Freddy got impatient. In period 3 he consumed twice his income. So he consumed $5,000 of his wealth or capital; he dissaved $5,000. That’s why he ended up with only $45,000 in wealth at the end of period 3.
So what? Who cares if wealth goes down? Well, that means (with constant interest rates) that in period 4, his income is now only $4,500. That means, just to tread water, Freddy now has to settle for only $4,500 in consumption. Put differently, his one-time splurge of living above his means in period 3, would forever condemn Freddy to $500 less consumption per period, if he just wanted to maintain his wealth at its new, lower level.
Then, just to round out the discussion, I have Freddy consuming all of his wealth in period 5.
In simple little thought experiments like this, Freddy might not care about such questions as, “Did I live beyond my means last period?” or “How much can I consume this period without reducing my opportunities in the future?” But in the real world–especially when things change all the time, from period to period, and we learn new information–we have to continually update our plans. In such a world, the concept of income is crucial.
Sumner is mad at the concept of income because it makes Freddy seem richer than Paul, and hence gets hit with a bigger tax burden. But that’s because Sumner is using a hammer to tighten a screw. The relevant concept is wealth, and yes, given our assumptions in this scenario, Paul and Freddy both have the same wealth in the beginning of period 1, as a result of that paycheck.
Now Sumner might complain, “OK, but in period 2 Paul has no wealth, and Freddy still has a bunch. So this is misleading.” No, it’s not. Who the heck said we should forever be condemned to calculating things from the perspective of period 1? In period 2, looking at Paul and Freddy, it really is the case that Freddy is richer in material terms, and can enjoy a higher standard of living.
We can go ahead and acknowledge these obvious facts without thereby endorsing an income tax (let alone a wealth tax). Look, I can use Sumner’s own logic against him: Take two identical twins, Lazy Larry and Workaholic Will. Larry cuts lawns once a week, and spends all $100 on consumption. Will cuts lawns every day, and spends all $700 on consumption. Under Sumner’s call for a progressive consumption tax, Will not only pays more in absolute terms, he actually pays a higher percentage of his potential consumption to the taxman. And why? Simply because Will has quirky tastes and prefers to exchange more of his leisure for other goods and services. How arbitrary is that, Sumner? What do you have against work? I think we can all see that “consumption” is a meaningless, misleading, and pernicious concept, since it gives ammunition to silly calls for a consumption tax, which is really just a penalty on work.
Last point: As the government debt debate made very clear, an important fact of life is that many people work and invest not to consume, but to pass on an estate to their heirs. That’s yet another reason that people in the real world ask their accountants to keep track of their assets and income.