Professor Tony Bernardo

EMAIL EXCHANGE WITH PROFESSOR TONY BERNARDO, INCLUDING REFERENCE TO FORWARDED COMMENTS BY PROFESSOR RICHARD ROLL.

Professor Tony Bernardo’s comments are in black and green.  Mr. Hagopian’s comments are in blue and red.  Professor Richard Roll’s comments are in a forwarded email and are in black.

Professor Antonio Bernardo (PhD, Economics, Stanford University), is a Professor of Finance at UCLA Anderson School of Management.

Professor Richard Roll (PhD, Economics, Universityof Chicago), is the Japan Alumni Chaired Professor of Finance and Economics at UCLA Anderson; Director of the FinkCenterfor Finance and Investment; and President of the American Finance Association. (Professor Roll comments are on the first draft of the essay.)

______________________________________________________________________

—–Original Message—–
From: Antonio Bernardo
Sent: Tuesday, May 03, 2011 2:03 PM
To: Kip Hagopian
Subject: RE: Class Wars

Hi Kip, I have now read your exchanges with Chait and Frum. I should have read them earlier since you directly rebut many of the arguments I brought up in my last email. I have some responses to your comments below.

Tony

From: Kip Hagopian
Sent: Monday, May 02, 2011 6:42 PM
To: Antonio Bernardo
Subject: RE: Class Wars

Hi Tony,

Thanks for taking the time to read and thanks also for the nice words. 

Lastly, thanks for all of your thoughtful comments. 

This is the kind of dialectic I was hoping for when I wrote the paper. I have interspersed my replies within your comments below. I look forward to your thoughts.

Best,

Kip

—–Original Message—–
From: Antonio Bernardo
Sent: Sunday, May 01, 2011 2:29 PM
To: Kip Hagopian
Subject: RE: Class Wars

Hi Kip, I read the unabridged version of your paper and I think it is excellent. Here are some comments:

–          My hunch is that the divide between proponents and opponents of progressive taxation comes down to differences in beliefs about the relative importance of luck (broadly defined, including the luck associated with being endowed with good genes and upbringing), aptitude (here I’m separating the investments in human capital from endowments), and effort in the determination of income. A telling example is the title of Chait’s article: “The Rich are Different: They’re Luckier.” 

Since you read the unabridged version, you read page 5, which deals with pecuniary luck (as I say in the essay, the real luck comes from being born with a high-value aptitude and caring parents). I really don’t think anyone can make a convincing case that pecuniary luck makes more than a minor impact on aggregate income (a few percent). Nor can a persuasive case be made that a significant number of people benefit from the luck of being born to wealth and privilege (maybe 1-2%). Most importantly, the contribution of any kind of luck in determining income does not change my thesis at all. Progression is still inequitable regardless of how your income is determined. If you haven’t already read it, please take look at the email debate I had with Chait on this topic. It is posted on my website just below the essay. I think it covers all of the points you have in mind and I believe I successfully refuted Chait’s arguments. Please let me know what you think.

I agree with you that pecuniary luck is a minor determinant of income, but it appears Chait is using a broader definition of luck (including natural aptitude and upbringing) which applies to a much larger group than children of privilege.  

If he is using the broader definition of luck then he is agreeing with my statement on page 5 where I say the, “…the greatest luck of all…is being born with a highly valued aptitude and competent, caring parents”. But based on his column (“The Rich are Different: They’re Luckier”), he does not appear to be using the broader definition. If you read his critique of my essay (which appears in the four paragraphs following the section of my paper that he quotes), it is almost all about the luck of being born rich (albeit there is a brief anecdote claiming that Bill Gates got rich primarily because of the timing of his birth).  When he talks about aptitude and work effort, he basically dismisses them as contributors to income. For example he says: “…it is demonstrably not the case that income levels simply reflect aptitude and work effort.” To be sure, his arguments get more nuanced when he engages me in debate, but for the most part he sticks to his guns; namely that income is derived primarily by the luck of being born rich. 

This is a complex issue. For example, investments in human capital (e.g., education) are a big determinant of income but the value of these investments are complementary to individual endowments (e.g., education is most valuable for those with the highest natural aptitude). So, it is hard to separate the impact of “luck” (in the sense of natural aptitude) from human capital investment in the determination of income.   

First, I am at best agnostic as to whether education is “most valuable for those with the highest natural aptitude.” It seems to me that work effort of all kinds (including that which is applied to education) is of greater relative benefit to people who are unlucky enough to be born with a more lowly valued aptitude. Second, I agree it is hard to separate “natural aptitude” from “human capital investment” in terms of their relative impact on income production. (BTW, as I say in the essay, human capital investment is probably the most important form of work effort there is.)  But I don’t think it is necessary to find the dividing line between income derived from aptitude and income derived from work effort; it is only necessary to know that this dividing line exists and that both factors contribute to total income. I posit that wherever there are two people with roughly the same aptitude in the same occupation, the one that worked longer and harder in school, ended up making the most money (all other things being equal) in their lifetimes. And if both persons worked equally hard in school, the one that puts in the greatest work effort every day (either in number of hours or intensity) will make the most.

Nonetheless, for any given level of natural aptitude, the tax system should not discourage investments in human capital which is precisely what a progressive tax system does. I know you want to focus your arguments on fairness rather than efficiency, but I think the efficiency case against progressive taxation is very strong. 

I agree. But I am not an economist; perhaps you and Richard will take up the efficiency issue.

By the way, the tax system should also not reduce one’s average, after-tax hourly income because he or she worked harder.

An economic argument in favor of progressive income taxation, for those who attach great importance to luck as a determinant of income, is that it is a form of insurance: if you are lucky enough to earn high income you pay higher taxes but if you are unlucky enough to earn low income you pay lower taxes (or, receive transfer payments). 

I agree with that in principle but for a different reason. Under my “fairness doctrine” I use what I call the greater-value theory to justify higher taxes on higher income people, stipulating that higher-income people should pay more because they derive greater value from their government services (regardless of whether it is derived from aptitude or luck). But how much more should they pay? Under a proportionate tax, someone who is lucky enough to make 100X as much will pay 100X as much in tax. What is the principle that would support a higher payout than that?  It certainly isn’t the benefits principle. I think I have shown conclusively that government benefits do NOT rise more rapidly than income. I also believe I have completely discredited sacrifice theory as a basis for a fair tax system. 

Let me rephrase my argument as a Rawlsian “veil of ignorance” thought experiment. Suppose you think income is determined completely by luck and you are asked to choose a tax system not knowing whether you will be lucky or unlucky.  Since individuals are risk averse they will prefer a tax system that equalizes outcomes (i.e., they will “pay” for insurance against bad luck). Such a tax system will be progressive because to get equal outcomes you have to tax income at increasingly high rates. In Rawls’ view, this constitutes a “fair” system because it would be chosen by individuals when they don’t know their circumstances. Of course, this argument relies heavily on the premise that luck is the major determinant of income determination. If work effort or human capital investment play a large role in income determination then individuals will not choose a system that equalizes outcomes.   

I think you did a great job of building a straw man and then tearing it down. In at least one respect, your thought experiment is interesting because, if you exclude the impact of work effort in determining income, you can argue that luck is the only factor that determines income (within each occupation), since aptitude (as defined) is largely, if not solely, a result of luck (due to circumstances of birth). However, one thing you omitted from your comments on Rawls, is his view that economic efficiency is a necessary part of maximizing economic equality; thus he deemed it perfectly acceptable for some in a society to have more economic goods—a larger slice of the pie—as long as their success resulted in a large enough expansion of the pie to enhance the economic position of the least advantaged (see page 26 of the essay). So a tax system that would shrink the pie would not be acceptable under his theory. Contrary to the opinions of some casual readers of Rawls’s work, Rawls was not advocating for equal outcomes, he was advocating for a system that elevated the standard of living of the least advantaged in the society without unduly reducing aggregate incomes. Moreover, under his theory, this objective had to be met without infringing upon any individual’s basic liberties. Meeting that latter test is a tall order under a progressive system which, by its nature, is a coercive transfer of wealth. In any event, it is inconceivable to me from my reading of Rawls’s views that he would condone a policy that infringed upon a person’s right to better her or himself through increased work effort. And I certainly do not believe Rawls would support a system that reduced a person’s average, after-tax hourly income because he or she worked harder (my Rawls “consultant” basically agrees with that, although he might tax income progressively at very high income levels). So your last sentence is apt, because work effort clearly does play a large role determining income.

To go further, if you believe that all income is produced by luck then risk-averse individuals would prefer (in the Rawlsian sense) highly progressive taxation so that after-tax incomes are equalized. 

My understanding of Rawls is that he favored a proportionate tax on consumption and only supported progression if the system could be shown to be unjust. But he didn’t define “unjust” for us.

If you believe that income is largely determined by investments in human capital and effort then progressive income taxation is hard to justify on efficiency or “fairness” grounds. 

As to the latter, I would say it is virtually impossible to justify on fairness grounds (I would rather leave the efficiency issue to you economists).  What conceivable rationale could there be?

–          Related to this is the argument over the estate tax. My sense is that proponents of estate taxes are also proponents of the “luck” view of wealth determination. 

You might be surprised to hear this (don’t tell Richard), but I actually support some form of estate tax. But that issue is beyond the scope of the essay. 

I am surprised. Perhaps this should be the subject of your next essay. 

I have not thought through the estate tax issue very deeply and when I do, I may change my position. As of this moment, my views are as follows: We should all pay for our government services in proportion to the value we take out. If I inherit money, even though taxes have been paid on that money when it was originally earned, it is income I am getting that I (as distinguished from my benefactors) neither earned nor paid taxes on. Thus, inasmuch as I am receiving benefits from my government, I think it would be unfair to my fellow citizens if I did not pay my share of the cost of those benefits in proportion to the value I receive. But I think the old system, which exempted $1 million and imposed a marginal tax rate as high as 55%, is not based on any identifiable principle and appears arbitrary and illogical on its face. I would prefer a system that allowed the estate to be held in a trust until income was withdrawn from it by the beneficiaries, at which time the the beneficiaries would pay taxes at the same prevailing marginal rates in place at the time. Thus, if the top marginal rate was 35%, and the income withdrawn from the trust (when combined with his or her other income) placed the beneficiary in that bracket, he or she would pay that rate. There would be no exemption from the tax, and income earned within the trust (pre-distribution) would be taxed at prevailing rates as to the character of the income. This idea is subject to attack from both the right and the left for all of the obvious reasons. But as you say, it could be the subject of another essay–if there ever is one.

–          Your example of the Class brothers was very illuminating, but proponents of the “luck” view of income determination will argue that this example is not representative of the causes of income inequality in theU.S. 

I don’t know why this is relevant.  Income inequality is caused by many factors, not the least of which is aging (the older you are, the more experienced you are and the more likely you are to make higher income). I think it is clear that the primary cause of inequality is aptitude, so if you are saying that being born with a high-value aptitude is the “luck of the draw”, you are right. But there is no doubt that work effort does play a significant role and work effort provides virtually the only means of making up income differentials caused by differences in aptitude.  Thus, progression has the truly pernicious effect of increasing inequality by reducing after-tax hourly income for the harder workers. 

In your example, the brothers have similar luck (endowments) and aptitude, but their incomes vary because of work-leisure decisions. 

Aren’t you agreeing with my point? To wit: Whether there are 1,000 or 100,000 tiers of aptitude in our society, within each tier (and within each occupation), those that work the hardest (those above the median in work effort) are being treated unfairly. How would anyone refute that? And how could anyone claim that is fair?

I do agree with you, but I am playing devil’s advocate. 

–         I think most Americans agree with your view but the issue is currently confounded by the popular belief that the wealthy take advantage of the large number of deductions/exemptions/loopholes in the tax code. 

As I say in my “debate” with David Frum (it’s on the website), I have the best tax advice available but I don’t know how to reduce my taxes using “loopholes”. On the other hand, if you look at footnote 1, you’ll see that the credits and deductions from which Tom and Dick benefit are huge. 

I don’t know if such a survey has been done, but I wouldn’t be surprised if a survey showed that most Americans believe that high-income earners pay a lower proportion of their income in taxes than middle-income earners because they exaggerate the importance of these loopholes. 

They would be wrong, as I show with statistics on who pays taxes. (For example, the top 1% pay almost 40% of the taxes; the bottom 50% pay about 2.7% of the taxes; over 40% pay no taxes at all.)

I suspect that a flat tax rate on a broad-based definition of income with few exemptions would be very popular in theU.S. 

It would be popular with everyone whose tax bill goes down; not so popular for those whose bill goes up. 

I disagree. Tax-the-rich policies are often more popular among wealthy people living on the coasts while the Republican’s low-tax message is popular among many low- and middle-income voters who benefit from progressive taxation but believe it is unfair and aspire to higher incomes and fair treatment in the future. 

I hope you are right, because the current system appears to hurt lower income people much more than higher income people.   

–        By the way, I’ve always been troubled by the terminology “progressive” and “regressive” because it refers to rates of taxation rather than total tax payments. For example, why do we call the payroll tax “regressive” when someone earning $100K pays twice as much payroll tax as someone earning $50K? Worse still, the high-earners expected retirement benefits are not twice as high. Language matters! Even though the payroll tax is a flat tax, it is an excellent example to dispel the benefits principle because one can definitively show that the benefits to the high earners are lower per dollar of taxes paid. 

You are right. Please look at my footnote 7. Also look at my debate with David Frum. David is brilliant, but he is under the impression that payroll taxes are regressive. Payroll taxes are decidedly NOT regressive.  Medicare tax is clearly redistributive. We each pay proportionately for essentially the same benefits, thus someone who pays $100,000 into the system gets the same medical insurance benefits as someone who pays $25,000. And the Social Security tax is at worst, proportionate (that is, for any particular cohort, the amount paid in is proportionate to or more than the amount paid out). 

This is an example of why Richard Roll felt that you may not have gone far enough: even a flat tax can be demonstrably unfair! 

I believe Richard’s point was that, inasmuch as government’s non-income benefits (life, liberty, protection, infrastructure, etc) are essentially the same for everyone, the fairest tax would be a head tax. I disagree with Richard based on my “greater-value” theory, which is explained in the essay. Nonetheless you are right that for some, a proportionate tax is unfair. I point this out in my “Critique of the doctrine” on page 24. 

–         One minor point: I believe your third point on the protection theory (on page 10 of the unabridged version) is incorrect. It’s true that declining marginal utility of income implies that individuals put less value on protecting each subsequent dollar, but wealthy individuals have more dollars to protect so the total value of protecting their wealth (total wealth not just the marginal dollar) will be higher. The other four arguments against the protection theory are more persuasive.

I am not sure I understand your point. In this context (and in the literature), protection theory applies to income only. I am not aware of a federal tax on wealth (other than the estate tax which is taxed under a different system) but if there were one, wouldn’t the marginal utility of money principle apply to wealth just as it does to income (that is, the more wealth you have the less you value the next dollar)? In any event I don’t say that people with higher income should not pay higher taxes, I say that their taxes, should not be disproportionately higher? What am I missing? 

I’m sorry I was sloppy interchanging income and wealth. And, I misread your argument. My point was that higher income individuals should pay higher total taxes under the protection theory, but you are exactly right that this does not imply progressive taxation, i.e., disproportionately higher taxation.  

We agree that higher income people should pay more, but I base my belief on my own interpretation of the benefits principle rather than on protection theory. Under one very respectable interpretation of the benefits principle, you can argue (as Richard Roll does) quite logically that a head tax is the most fair. This is because the non-income benefits of government (national defense, police and fire protection of property, infrastructure, etc.) seem clearly to redound to the benefit of each citizen equally. But I argue, under the “greater value” theory, that if you distilled all government services down to a single, ultimate benefit it would be “well-being”. I also argue that income is a quite reasonable proxy for well-being; thus, we should all pay taxes in proportion to the income we take out of the system. This insight was not very well refined or explained in the earlier draft that Richard read, so he correctly raised the question: If taxes are to be paid for government services, why shouldn’t we price those services as we would any other good. When we buy a car, we don’t set the price of the car as a percentage our income, we use market value; so why would we set tax rates in that way. My argument (as refined) is that the ultimate “good” we receive from our government is well-being. And since income is a reasonable proxy for well-being, the fairest price to pay for that good is an amount in proportion to income, which is, in effect, market value. In support of this position, I argue in the essay (see page 12), that the logic of it can be inferred by imagining that aptitudes (or any other type of luck) could be purchased on the open market. If such a thing were possible, it is certain that the more highly valued aptitudes (or luck quotients)—those that would produce higher incomes—would be bid up to amounts in excess of the per-capita cost of government (the head tax).  Based on my reading, this principle is novel and stands out as the most persuasive case for rejecting a head tax.

Best regards,

Tony

From: Kip Hagopian  
Sent: Tuesday, April 26, 2011 10:17 AM
To: Antonio Bernardo
Subject: FW: Class Wars

Dear Tony,

It was a pleasure speaking to you this morning. I have a call into Charlie Wolf to see if we can change the time of the May 10 event he is planning.

Here are Richard’s comments on the paper we discussed. What Richard read was a very early draft. I believe it is much better now, in large part because of comments from Richard and several other scholars who vetted it (you can read the names in the acknowledgments section of the website). As I told you, the essay was published in abridged form in the April-May edition of Policy Review, a publication of the Hoover Institution. You can find both the article and the unabridged version of the essay on a website I created for this purpose and for the purpose of hosting a debate on the issue.  Here is the link: www.kiphagopian.com. If you decide to read the essay, I really hope you will take the time to read the unabridged version. It is somewhat longer but it includes some important subjects that got left out of the journal article.

Thanks,

Kip

PS:  I have inserted in red, some replies to Richard’s comments.

—–Original Message—–
From: Richard Roll

Sent: Saturday, February 27, 2010 10:10 AM
To: Kip Hagopian
Subject: Re: Class Wars

Hi Kip,

Thanks for sending the paper.  It is excellent, in my opinion.  Congratulations.  I have only a couple of observations but I’m not sure they are worth incorporating in a future draft.

First, I think you give in too easily on a flat tax being equitable. True, it’s a lot better than a progressive income tax in terms of  equity, but it’s also completely unfair. The flat tax implies that the price of government provided goods and services is higher for more affluent citizens. There is NO good or service produced by the private sector whose price depends on the income of the purchaser. Only government goods have this feature. Why is that fair? This explains, I think, why support for the provision of more government declines with income.

Tony:  I think Richard is wrong about this, but he makes a great point (which was also made in the literature in the 19th century). It is interesting that most of the scholars who have historically argued in favor of a proportionate tax did not have a very good rationale for their argument. In addition to proving that progression is inequitable, I believe I have done the best job of showing that a head tax is also inequitable. This is based on my own interpretation of the benefits principle which I call the “greater-value” theory. That part of the paper wasn’t very clearly written in the draft Richard read, so I expanded on it to take Richard’s comments into account. I now feel comfortable with my position on this issue.

Second, even though everyone in the country might agree that both the progressive and flat taxes are inequitable, the voting majority will still support them because they benefit. They don’t CARE that these taxes are inequitable because they get government goods at below costs while the affluent minority pays for them. When self-interest is traded off against equity, self interest wins every time. People will take property away from others whenever they can do so legally or without punishment. As Mark Twain said, “He’s a man isn’t he. You can’t say anything worse.”

Of course Richard is right about this. But I am not trying to write something that is politically feasible; I am trying to write something that is true. If politicians are going to impose a progressive tax, they should at least know that what they are imposing is inequitable.

Third, minor point: You admit too easily that progressivity can reduce inequality. I’ll send you a paper on Monday that delves into this issue in great detail, but here let me just point out the basic idea. Let’s consider income (not wealth) after all taxes and transfer payments via the government. Inequality might be based on this after-tax and transfers income. My claim is that greater progressivity can actually INCREASE after-tax and transfers inequality. It can increase inequality rather than reduce it (contrary to your admission on page 19, infra.). The reason is that pre-tax incomes respond to tax progressivity so that more skilled persons have their pre-tax incomes increase when taxes go up. This can happen to such an extent that  after-tax inequality ends up being higher even though the more affluent pay a higher share of total taxes.

This is very interesting and I have to admit, I did not have time (or space) to introduce it in the essay. I do say that redistribution “undoubtedly has some affect on income inequality”; I should probably soften that.

You certainly should send this draft around. I mentioned a few persons that would be good, but here’s a partial list:

Harvard: Robert Barro; Greg Mankiw; Andrei Shleifer

Wash U (St. Louis): David Levine

Chicago: John Cochrane; Robert Lucas; Gene Fama; Gary Becker

Princeton; Paul Krugman; Orley Ashenfelter

MIT; Steve Ross

If you don’t mind, I’ll send it to a few others who you probably don’t  know, including a couple of philosophers (who are interested in  justice) and some investment bankers friends.
Congratulations on a great paper.

Best Regards, RR

quotingKip Hagopian:

Dear Dick,
 
Here, for better or worse, is a DRAFT of the paper we discussed. I remind you, this is a work in progress, so I will look forward to your comments.
 
Have a great weekend.
 
Kip
 
Class Wars-Rev Expanded Version-27-E.doc

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