Bargaining power and the incidence of taxes on high earners in Canada

Today I'm presenting a paper at the meetings of the Canadian Economics Association: "Bargaining power and the incidence of taxes on high earners in Canada." The bottom line is that once you take into account the fact that high earners have bargaining power - that's why they are high earners in the first place! - then it's by no means clear that increasing the top marginal personal income tax rate will result in a progressive redistribution of after-tax income.

This is a theme I've been pursuing for years. From a post I wrote in November of 2009:

We can be pretty sure that if there's one group of people who won't be paying the tax, it is the high-income earners themselves - the reason for the increase in wages is to compensate them for the higher tax bill. And if we're talking about a small open economy whose capital markets are highly integrated with the rest of the world - and in the case of Canada, we are - then we also know that the tax will not be borne by owners of capital.

If neither high-income earners nor investors are paying those increased taxes, then they must be being taken from workers further down the income distribution. And as we move down the income distribution, workers' bargaining power diminishes: demand for labour becomes more elastic, and supply becomes less elastic. We could even have the perverse result of a tax on high incomes having regressive effects.

(Note also that imposing a wage cap just puts us back to being on the wrong side of the Laffer curve.)

So here are the possible outcomes:

1. If wages don't adjust after the tax change, then we are very likely already on the wrong side of the Laffer curve for high-income earners: increasing the tax rates on high-income earners will reduce total revenues.
2. If wages do adjust, the gross incomes of high-income will rise so that their after-tax incomes are the same. Extra revenues will be generated, but the burden of the tax increase will be borne by those below the top end of the income distribution.

The reality is likely to be more nuanced,  but we can pretty much rule out the naive scenario in which there are no behavioural responses. And the existing literature suggests that those responses will generate effects that are almost exactly the opposite of the what we want to see happen.

See also this. At the time, and for several years after that, this was only a theoretical conjecture. But the recent deterioration of incomes and of top income shares at the very top of the Canadian income distribution provides an opportunity to identify high earner bargaining power, and that's what this paper tries to do.

Here's the abstract:

This study explores the 'brain drain' explanation for the concentration of incomes in Canada during the past thirty years, namely, that high-skilled Canadians have made use of the high salaries on offer in the United States to extract higher salaries at home. If this is the case, then for a given level of US salaries, the threat to accept outside offers should be more credible when the Canadian dollar is depreciating against the US dollar, and weaker when the Canadian dollar is appreciating. The data are broadly consistent with this claim: income concentration worsened during the depreciations of the 1980s and 1990s, and eased when the Canadian dollar began to appreciate in value.

The paper develops a simple two-parameter model based on the propositions that high earners in Canada can use US salaries to bargain for higher salaries, and that Canadian high earners can shelter part of their income from personal income taxes. It also offers some preliminary evidence about the parameter values consistent with available data. The results suggest that higher top marginal personal income tax rates may actually accentuate top-end after-tax income inequality. If high earners are able to use their bargaining power to extract pay increases to offset higher tax rates, the the burden of increased taxes will be pushed down to those lower down in the income distribution, leaving the after-tax income distribution more unequal than it was before.

Here is a draft version of the paper, and here are my slides. And this is my conclusion:

This is still at the preliminary-draft please-do-not-cite stage;  a more definitive version will be circulated in a few weeks. Comments are welcome.

Comments

[Vladimir]

I don't know if this would help provide you evidence , anyway, in some of the soccer leagues in continental Europe, wages are negotiated on a net basis. When the French considered raising their top marginal rate to about 70% , the sports pages carried stories about how the Parisian club PSG would see their wage bill rise dramatically .

[Avon Barksdale]

I have a question about the bargaining power. The bargaining strength is a form of monopoly power that the talented employee has. Why doesn't the employee exploit all of her monopoly power at the first instance? For example, if my marginal product is $1,000 per hour, but because of my monopoly power, I can negotiate a higher wage, why would I not do that immediately? So, if the government introduces new taxes, I have no more bargaining power to increase my wage – I already used it all before the new taxes were implemented.

If bargaining power was hidden and the employee has to learn the strength of her position through a costly process, I could see how a search-match arrangement might cause the employee to start re-exploring her position in the face of new taxes. But in the limit of perfect information why wouldn't the employee exploit all of her bargaining power regardless of the tax situation?

[Stephen Gordon]

Vladimir: Yes, I think I used that example in an earlier post. I think I'll add that and the FT story of the bankers' bonus tax to the introduction as anecdotes to illustrate the point.

Avon Barksdale: The bargaining power is based on a 'wage arbitrage' story, not monopoly power.

[Hugo André]

A very interesting point of view. Must be tough to make policy in a country like Canada - seems like you can't do anything without considering the conditions of your larger neighbor.

One thing that seems to make the conclusion less convincing is the lack of time-periods where there the risk of a spurious correlation is minor. As you've written in the paper, the last decade (2006-2013) is the only example of such a period. I'm sure the paper would benefit if you could show a few more examples of this. Perhaps you could use Mexican data to make your point more forcefully?

I also have a question. With the idea of a strong wage bargaining effect, shouldn't pre-tax wages for top-earners decline when top marginal rate taxes are reduced? A cursory look at data from where I live (Sweden) does not seem to reveal any such effect.

[Avon Barksdale]

Sorry, I missed the link to your paper. Thanks for the clarification. Really great food for thought!

[Avon Barksdale]

I would be interested in your thoughts on how bargaining with wage arbitrage between economies might be a good thing. If your idea holds in the data, and if the government then recognizes that the burden of high marginal tax rates gets down shifted on to other works, the mechanism might provide a check against the growth of government. In particular, the most egregious sources of rent often come from the government itself. On rent seeking David Andolfatto wrote:

“Perhaps there is a way in which reforms may emerge ‘spontaneously.’ Suppose, for example, that there are two economies, one without rent seeking and one with a rent-seeking sector. Then the latter economy will grow less quickly and over time, a large gap will emerge between the level of per capita income (at least, to the extent that knowledge does not flow across borders). At some point, those in power may come to fear the economic might of their neighbors and realize that it is ultimately in their interest to promote growth (by undertaking reforms that dismantle the rent-seeking sector).”

In the quest for the right balance of equality, it seems to me that we've lost track of pro-growth policies. Perhaps having competing jurisdictions with wage arbitrage is a good thing.

[Stephen Gordon]

Hugo André: The story is really only one for Canada, and maybe some other English-speaking countries, where the threat to emigrate to the US is most credible.

[Gene Callahan]

Excellent post: Mises made this same point: i is always the market that determines who actually pays a tax.

[Patrick]

Interesting.

Dumb layman's question: What constitutes a high income earner? Are we talking $250K, $10 million, or $1 billion?

Just trying to figure out how this plays out in practice. I know some people in the $250K range, and it doesn't seem to me they could do much to avoid a higher marginal rate as their earnings are almost exclusively wages, and you really can't hide from your T4. And moving is easier said than done. I don't think any of them would leave friends, families, community for a few percentage points on their income tax.

I have no idea what the super-wealthy can/would do. From my perspective, I have to wonder why they'd get into a snit and leave over a few marginal percentage points when they already have more than they could ever spend. But considering the example of Mossack Forseca where they apparently will risk jail, who knows. I have to wonder if it's their hired managers and the incentives they face?

Maybe the behavioural people have some insight.

[Jacques René Giguère]

Even if you are not a wage earner as such, business person or surgeon, moving implies finding a new client base and getting a new life. Is it worth a few tax points? Only the really wealthy, a good lot of them not being wealth creator tied down to a place, go the MF way.

[Stephen Gordon]

The entire analysis in the paper is at the margin. People may decide that those costs are enough to accept a certain gap between Canadian and US salaries, but there will be some behavioural response if the gap widens. If nothing else, salaries would have to increase to attract people who are just starting out and who haven't yet made those sunk costs.

[Bob Smith]

I can think of examples of wage earners whose income is in the low/mid 6-figure range for whom this account would be credible - law professors. Just looking at UofT, there were a number of high profile profs who upped and left to US school (at least before the bottom fell out of the US law school racket) and others who used the credible threat of doing so to negotiate better packages. Moreover, the faculties at other Ontario law schools have long claimed that higher tuition fees (or, in some cases, larger class sizes) were necessary for them to attract and retain top flight professors. Granted, that claim is self-serving and, in most cases, I have real doubts about the credibility of their exit threat, but the mechanism clearly exists.

[Bob Smith]

You certainly observed this phenomenon in Canadian law schools in the early 2000's, with law professors using offers as US law schools as leverage to get pay increases. Enough of them took the US schools up on the offer to make the threat credible. This was, in part the rationale for the tuition increases/increased enrolment at Ontario law schools, namely to attract and retain top talent. Certainly, when I was at UofT a number of prominent scholars decamped for the US. It's certainly a plausible story. Similarly, I've seen non-residents working here temporarily get their incomes topped up to cover the higher taxes, so, that's consistent with the story.

[Nick Rowe]

Bob Smith has two comments stuck in spam.

[Patrick]

Yeah, I can see that. At the risk of sounding like I'm taking a cheap shot at lawyer, I'm guessing a law professor doesn't typically have school age kids? And based on my anecdotal observations of the few lawyers I know, I doubt the ex-spouse(s) are any hinderance to moving.

Do law professors cost more in taxes (in the form of subsidize paid to Universities) than they pay themselves in taxes? Leaving for the US might be a net gain.

[Stephen Gordon]

We also saw the same thing in Canadian economics departments. Probably other disciplines as well. There were just enough actual cases of people accepting a US job that the threat to leave was usually taken seriously.

[Nathanael]

Increasing the top marginal personal income tax rate DOES, in actual fact, result in a progressive redistribution of after-tax income. Proven empirically from historical evidence.

You may have to increase it to 92%, as it was under Eisenhower in the US.

Even the most thieving CEOs often do not have the bargaining power to increase their salaries by factors of more than 10. With the Eisenhower-era tax rates, the payback from increased salaries becomes so small that they do not bother to ask for more money. They ask for nonmonetary benefits of perks and prestige instead, according to the historical evidence. (This is much better for society.)

There is a possible threat that all the greediest CEOs will move to the US, of course; the answer to that is (a) "good riddance" and (b) a tax on removing their wealth from the country. Many countries have implemented that.