Why would we assume that high earners are price takers in the labour market?

Greg Mankiw's column in the New York Times makes the point that available evidence - in the US as well as Canada - suggests that high earners have higher labour supply elasticities than do workers lower down in the income distribution. As a result, increasing income tax rates on high earners would have disproportionately stronger effects on labour supply and total income. But there's one thing I don't understand in his analysis, and it's a point that never seems to be raised when the issue of taxing high earners is discussed: why would Greg Mankiw act as if the demand for his services were perfectly elastic?

In most contexts, it may be a good idea to make policy decisions under the hypothesis that labour demand is fairly elastic when compared to labour supply. For example, these assumptions would lead one to conclude that the incidence of payroll taxes falls mainly on workers, and this prediction seems to be consistent with what we observe ([1], [2], [3]).

But it's far from obvious to me that this sort of result can be extended to high earners. For example, if you find yourself in the market for Greg Mankiw's services, you quickly realise that there are very, very few good substitutes for Greg Mankiw. If he were to decide to increase his reservation wage in the face of a higher marginal tax rate rate, then many would-be employers would revise their offers accordingly. More generally, high earners operate in labour markets that are - almost by definition - fairly thin: with great salaries comes great market power. (See, for example, this anecdote.)

If high earners are able to offset higher taxes with higher gross incomes, then the force of some arguments is attenuated:

• As Alan Blinder notes here, inelastic demand elasticities shift the peak of the Laffer curve well to the right. Increased tax rates on high earners will almost certainly increase revenues.
• To the extent that market power partially offsets the increase in the effective marginal income tax rate, the efficiency losses predicted by optimal tax theory will be reduced.
• If high earners can deflect a significant portion of the incidence of the increased tax burden, then a tax on high incomes may not have the redistributional effects its proponents may have wished for (see also this post).

I'm unaware of any econometric evidence on the labour demand elasticities faced by high earners. Does anyone know of a study that could clarify matters?

Comments

[Adam P]

I'm not aware of any study to help you but the point is a very, very good one. And something you'd think Mankiw'd think of, assuming he didn't have an agenda when he wrote that!

[Rick]

Whether high income earners are price takers or not is not a conclusion that should be drawn from an academic study, and its certainly not an economic matter in any sense that could be derived from economic fundamentals of free markets. High income earners are in short supply because they enjoy the protection of a regulatory system that allows them to nestle in to positions where they are brokers of services; either high fee of high volume, and free from any meaningful competition.

Free market arguments do not apply to high income earners, period, since demand for their service isn't decided in a free market, instead it is decided a prior i by policy. Change the policy, change the incentives, use the tax reform to expedite, and or fund the process.

Its a myth that well paid individuals have some sort of intellectual superiority that makes their services indispensable or rare and as a result make it impossible to do without them. We live in a vocational world (for the most part) and high income earners are just another part of it; running a bank is far less complicated than sending a satellite into space, but somehow the banker gets paid 100x more than an aerospace engineer, what they have in common though is that both positions are funded in one way or another by the government, just less resources are directed through Houston/St. Hubert than through Manhattan/Toronto.

[Patrick]

Seems to me that, under current conditions in the US, it wouldn't be a bad thing if wealthy people in the US decided to opt for leisure over supplying more labour if it means they end up spending money they otherwise would have saved.

[tyronen]

The ratio of executive to average-worker pay took a sharp rise after the 1981 tax cuts in the US. This suggests that the 70+ percent marginal rates of the 1970s had acted as a cap on executive compensation. Lowering the top marginal rate increased the incentives for executives to pay themselves more. The result is that changes to the tax rate had the unexpected result of increasing *pre*-tax incomes for the top decile, and with it, overall inequality.

(Yes I know, this is only a hypothesis, not proven fact...but I'd love to know if anyone has seriously examined this.)

[anon]

I think Stephen Gordon is right. We often forget that assuming perfect competition can be very problematic.

Another issue (hinted at by Rick) is that, more generally, high-earning positions tend to extract uncompensated rents from the economic environment. To the extent that this occurs, a tax on high-earners is less inefficient than naive analysis would suggest.

[Frances Woolley]

Stephen,

Three points:

1. I suspect a fruitful way of looking at this might be by occupation.

Doctors, dentists etc might (I don't know so much about the US, this is true here) have relatively limited abilities to change the price they charge for a given procedure, but they may have more freedom to vary their hours - so higher earnings reflect longer hours of paid work. Actually given the amount of over-treatment in the US, giving doctors an incentive to work less might be a really good thing - as others have suggested earlier.

For senior executives or top athletes, pay isn't related to hours worked and/or there is less control over hours worked (I don't think - and though athletes might get paid less if they sit out a game, they can't say 'I'll play 92 games this season instead of 82'). So higher earnings would tend to be associated with greater bargaining power/having a good agent.

So what I'd like to know is: who are these higher earners?

2. Although neither Mankiw nor the site that he links to mention this, I would be willing to bet that the sample considered in those studies were all male. Women typically have higher labour supply elasticities than men, and earn less. If you looked at the entire economy, men and women, you might find a different earnings/elasticities relationship.

3. I heard another economist (Hal Varian???) reach a very different conclusion in a talk he gave at the AEA meetings one year. He said his brother, a businessman, had told him "never turn down a job." If you're busy, name a higher price - a price that would make it worth your while to do the job. If they say no, fine, if they say yes, well - that was worth while.

Varian's approach makes more sense to me than Mankiw's - and is basically the point you're making, Stephen - why take the price offered as fixed?

[Stephen Gordon]

Actually dentists - at least, dentists in Quebec - set their own fees. There's a guideline, but it's not binding, and there's significant variation. As for doctors, you have to figure that when their fees are set, the fact that they have to face new tax rates would be taken into account during the negotiations.

But yes, that last point is what I'm thinking of. It's not as if high earners go down to the Rich Folks' Job Centre, where they are given take-it-or-leave-it offers.

[happyjuggler0]

Unless I am misreading you guys, are you seriously suggesting that if you raise tax rates on high income earners, that they will charge more for their services and still work the same amount?

If so, then what is stopping them from raising the price for their services that high under the lower tax rate that prevailed before the tax increase? Surely "charge what the market will bear" would always be the prevailing ethos except for charitable reasons, such as a doctor lowering his fee for poorer patients.

[Stephen Gordon]

No, that's not it. Unless demand is perfectly inelastic - in which case, people would indeed be demanding and receiving infinite amounts of money in salary - then they would still be working less. But they'd be working more than what they would have if wages hadn't changed.

[Frances Woolley]

happyjuggler - if you read Mankiw's original blog, he talks about being asked to, say, do a speaking engagement for $1000, but turning it down because the offer wasn't good enough. His point was if tax rates go up, he'll turn down more offers.

Stephen's point was Mankiw's strategy violates the 'never turn down a job' principle - if you don't want to do a speaking engagement for $1000, the smart strategy is to name the price that you *would* be willing to work for.

If taxes go up, then perhaps you'll be asking for a higher price more often. Sometimes people will say yes and increase their financial offer, sometimes they'll say no, we can't afford to pay more.

[Leigh Caldwell]

happyjuggler: Mankiw's current rates might be limited by competition from his perfect substitutes: other textbook-writing, former CEA-staffing economists. If taxes go up, presumably the competition's rates will go up as well as his, and therefore Stephen's hypothesis can be true without implying that Mankiw could still raise today's rate.

[happyjuggler0]

Leigh, thanks for the insight. I'll buy your notion of everyone's (everyone relevant anyway) reservation rates going up. Thinking dynamically can be tricky; I am not sold that the outcome is all that good, but I am not 100% it isn't either. I'm going to have to stew over this one. Anyway, the issue under discussion is why would one think that labor prices of high income individuals would plausibly go higher, and you have provided me with a good answer.

Stephen and Frances, neither of you has persuaded me, albeit for different reasons.

Stephen said:

But they'd be working more than what they would have if wages hadn't changed.

You didn't explain why he "could" raise his wage rates higher than under a lower tax regime, where he presumably was charging what the market would bear. But at least you conceded he would likely (or at least plausibly) be working less than otherwise, which is more than the others I have argued with on other sites will grant me.

Frances said:

If taxes go up, then perhaps you'll be asking for a higher price more often.

My point was why wouldn't you already be asking that higher amount under the lower tax regime? What is so magical about higher tax rates that people are suddenly supposed to start thinking more rationally?

You could be right though, we aren't perfect, and they say that necessity is the mother of invention, so perhaps for some people it would cause them to realize that they should have been charging more all along.

But to Mankiw's point in his last two paragraphs, we surely wouldn't want for example for surgeons to be raising their rates, and as such we need to be sure that the tradeoff from higher taxes on those surgeons is worth it.

[Frances Woolley]

happyjuggerD: "My point was why wouldn't you already be asking that higher amount under the lower tax regime?" If you knew the other party's willingnes to pay, you might do so.

But if you don't, then naming a price greater than your reservation wage means that you risk losing a gig worth doing.

[Rick]

Let's assume Doctors, Athletes and Executives are the top earners. The tax goes up.

1. Doctors work less and refuse services unless they collectively get a pay raise. Ok, who cares. They may get away with this temporarily because the college of physicians (or whatever its called) has allowed them to collectively bargain (ahem lobby) for their exclusive positions. But just expedite nurse practitioners into the market and open up more spots medical spots in universities and loosen restrictions on immigrant doctors to increase competition (the government is doing it to teachers as we speak), it'll probable save money and improve delivery of services anyway.

2. Athletes demand raises, or they won't play (in favor of doing what? but lets leave that alone) look at the NFL or NHL for an answer. There is a hard cap on salaries, which raises only if the leagues revenue grows it would be hard to justify a strike at the expense of the owners when the structure of the existing contracts remains unchanged.

3. Executives work less (do they really work anyway?), or try to extract equity from the company to make up the difference as in the anecdotal story of the UK bank. Well this is an easy fix. Executives are valuable because of political connections and ability to manipulate legislation to benefit their firms/companies and they don't really answer to shareholders because the majority of shareholders are other large institutions run by folks of similar ilk. If you eliminate network by reforming the financial service sector (maybe include a hard cap on salaries across the board) at the same time taxes are raised, you might kill 2 birds with 1 stone and people might have to be qualified to take on executive positions in the sense that they know something about the company and be able to increase productivity and growth the old fashioned way; long term.

I don't see any problems if this is done properly.

[Just visiting from Macleans]

When Canadian born supermodel Linda Evangelista was in great demand, she famously stated: "I won't get out of bed for less than $10,000 a day."
She didn't say: "Marginal tax rates being what they are, my marginal benefit of remaining supine exceeds $5,230". I think I saw her last night, maybe 15-20 yrs later doing a wrinkle cream commercial, or something related. I bet she gets out of bed for a lot less these days.

If one was to take Mankiw's argument to the logical extreme, he should therefore cut back all consulting activity once he meets the $250,000 threshold - a marginal buck at 250k attracts the same tax as one at 300k.

However, if his personal goal was to maintain the same level of net income then he should work more. Perhaps as a tenured Harvard prof his long term security is not nearly as a risk as others. Being "sated" seems to be the key, irrespective of income level.

[Frances Woolley]

Just visiting - you raise a good point. The income effect of increased taxes would tend to increase labour supply if leisure is a normal good - if people are working to pay the mortgage, then higher taxes mean that one should work more to pay the mortgage.

Estimates of labour supply elasticity often estimate how much the quantity of labour supplied changes when the after-tax wage rate changes *holding real income constant*. (They do this because the efficiency costs of taxation depend upon substitution effects not income effects). If the studies that Mankiw cites follow this common practice, they may be an imperfect guide to predicting actual changes in behaviour.

[Mercure]

Greg Mankiw compares the current tax system to a hypothetical zero tax system.
To make it a fair comparison, one should wonder what would be the working opportunities for M. Mankiw in a state of total anarchy without any public infrastructure, police, public education, public health agency,...
My best guest is that M. Mankiw would be a peasant giving a part of is crop to the local warlord for protection...

[Mercure]

guest = guess. sorry.

[Matt]

Stephen, to the extent that high income earners will have their pretax hourly income increased due to the interplay between their labor supply's elasticity and the elasticity of the demand for their labor, the cost of the taxes imposed on them will be passed on to the consumers of their labor (people who are mostly not high income earners).

I believe that was the point of the article; to demonstrate that either the quantity of their labor supplied or the unit price of their labor would have to dramatically shift.

[Just visiting from Macleans]

The Mankiw article was covered in last night's Colbert Report - at 3:05 of this clip (2nd of 4):

http://watch.thecomedynetwork.ca/the-colbert-report/full-episodes/#clip359777