Monday, October 11, 2010

On the effort of high-earners

Greg Mankiw is the latest to claim that an increase in the high-income tax rate will induce high-earners to withhold their labor from the market, because it’s not “worth it” to work so hard. I don’t buy it.

My impression is that to be a member of the $250,000+ taxable income crowd, you have to work a lot. Period. You’ve given up most of your leisure. You work long hours during the week, and probably on the weekend. You don’t see your family as much as you’d like (and, like Mankiw, you probably justify it by claiming you’re earning the money for them). The people I see earning north of a quarter mil are driven people, workaholics. It’s their nature.

Once you’re in that rarified zone, the actual level of income is driven less by “level of effort” and more by innate talent, choice of industry and/or employer, negotiating skills, networking connections, and luck. You work hard, all the time, and see how much you can get in return for it.

The idea that earners are rational actors, who precisely calibrate their effort to their income is also laughable. To at least some degree, income is not just a way to buy things, but a way of keeping score. Relative income matters as much as absolute income. You want to earn more than the guy in the office next to you. You want to earn more this year than you did last year. You want to earn $1 more than the next highest-paid guy on the team. Since rank-ordering of income is generally preserved regardless of tax rates, the decrease in effort is surely going to be much less than a utilitarian prediction would suggest.

Finally, what if the highest earners do withhold their labor? Suppose a firm wants to hire a certain high earner, but she has withheld her labor from the market because it’s no longer worth working. The firm has to go with its second choice, who earns a little less. We’re told by economists that this is a bad thing—the second choice will perform worse than the first choice, to a degree greater than the savings in salary. This belief presupposes that salaries paid to employees are rational, accurately reflecting their value to the firm. Isn’t it just as likely that the highest-earning workers are not the best value, but are instead examples of “bubbles” in the labor market? A high P/E for a stock implies high prospects for growth, assuming a rational market—but markets experience bubbles, and a high P/E is more likely a sign of an overbid asset. Why shouldn’t the same be true in labor markets? If the highest earners withdraw from the labor market, maybe that will compel firms to hire labor that’s more appropriately valued.

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