Monday, October 27, 2008

What McCain's and Obama's tax plans will do for your incentive to work

Harvard economist Greg Mankiw using the Walls Street Journal's analysis of the the tax plans of Republican John McCain and Democrat Barack Obama to explain what each plan will do for your incentive to work:
Let me try to put each tax plan into a single number. Let's suppose Greg Mankiw takes on an incremental job today and earns a dollar. How much, as a result, will he leave his kids in T years?

The answer depends on four tax rates. First, I pay the combined income and payroll tax on the dollar earned. Second, I pay the corporate tax rate while the money is invested in a firm. Third, I pay the dividend and capital gains rate as I receive that return. And fourth, I pay the estate tax when I leave what has accumulated to my kids.

Let t1 be the combined income and payroll tax rate, t2 be the corporate tax rate, t3 be the dividend and capital gains tax rate, and t4 be the estate tax rate. And let r be the before-tax rate of return on corporate capital. Then one dollar I earn today will yield my kids:

(1-t1){[1+r(1-t2)(1-t3)]^T}(1-t4).

For my illustrative calculations, let me take r to be 10 percent and my remaining life expectancy T to be 35 years.

If there were no taxes, so t1=t2=t3=t4=0, then $1 earned today would yield my kids $28. That is simply the miracle of compounding.

Under the McCain plan, t1=.35, t2=.25, t3=.15, and t4=.15. In this case, a dollar earned today yields my kids $4.81. That is, even under the low-tax McCain plan, my incentive to work is cut by 83 percent compared to the situation without taxes.

Under the Obama plan, t1=.43, t2=.35, t3=.2, and t4=.45. In this case, a dollar earned today yields my kids $1.85. That is, Obama's proposed tax hikes reduce my incentive to work by 62 percent compared to the McCain plan and by 93 percent compared to the no-tax scenario. In a sense, putting the various pieces of the tax system together, I would be facing a marginal tax rate of 93 percent.

The bottom line: If you are one of those people out there trying to induce me to do some work for you, there is a good chance I will turn you down. And the likelihood will go up after President Obama puts his tax plan in place. I expect to spend more time playing with my kids. They will be poorer when they grow up, but perhaps they will have a few more happy memories.

5 comments:

Anonymous said...

Anybody still reading this far down? I was hoping for a response from an email to the author but no luck yet. This has got to be one of Mr Cothran's goofiest posts yet.

jah

Martin Cothran said...

Jah,

You e-mailed me? Don't see it. And what do you think is goofy about this post?

Anonymous said...

I had indeed originally thought that Mr Cothran had written the quoted material. But I sent an email to Prof. Mankiw. I'll explain the goofiness by this weekend.


jah

Anonymous said...

The article by Mankiw is written on the highly dubious assumption that any extra income a person could earn over what they earn now is invested in shares and then left to their children.

Clearly for the vast majority of people this is not the case.
When most people get a pay rise or extra money somehow they generally adjust their lifestyle to spend the extra money (thus avoiding all taxes but income tax and payroll tax) or maybe pay more off their mortgage(again avoiding all but income and payroll tax)

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