FEATURED: The 70% Solution: December 1, 2011: Project Syndicate

Via a circuitous Internet chain – Paul Krugman of Princeton University quoting Mark Thoma of the University of Oregon reading the Journal of Economic Perspectives – I got a copy of an article written by Emmanuel Saez, whose office is 50 feet from mine, on the same corridor, and the Nobel laureate economist Peter Diamond. Saez and Diamond argue that the right marginal tax rate for North Atlantic societies to impose on their richest citizens is 70%.

It is an arresting assertion, given the tax-cut mania that has prevailed in these societies for the past 30 years, but Diamond and Saez’s logic is clear. The superrich command and control so many resources that they are effectively satiated: increasing or decreasing how much wealth they have has no effect on their happiness. So, no matter how large a weight we place on their happiness relative to the happiness of others – whether we regard them as praiseworthy captains of industry who merit their high positions, or as parasitic thieves – we simply cannot do anything to affect it by raising or lowering their tax rates.

The unavoidable implication of this argument is that when we calculate what the tax rate for the superrich will be, we should not consider the effect of changing their tax rate on their happiness, for we know that it is zero. Rather, the key question must be the effect of changing their tax rate on the well-being of the rest of us.

From this simple chain of logic follows the conclusion that we have a moral obligation to tax our superrich at the peak of the Laffer Curve: to tax them so heavily that we raise the most possible money from them – to the point beyond which their diversion of energy and enterprise into tax avoidance and sheltering would mean that any extra taxes would not raise but reduce revenue.

The utilitarian economic logic is clear. Yet more than half of us are likely to reject the conclusion reached by Diamond and Saez. We feel that there is something wrong with taxing our superrich until the pips squeak so much that further taxation reduces the number of pips. And we feel this for two reasons, both of them set out more than two centuries ago by Adam Smith – not in his most famous work, The Wealth of Nations, but in his far less discussed book The Theory of Moral Sentiments.

The first reason applies to the idle rich. According to Smith:

“A stranger to human nature, who saw the indifference of men about the misery of their inferiors, and the regret and indignation which they feel for the misfortunes and sufferings of those above them, would be apt to imagine, that pain must be more agonizing, and the convulsions of death more terrible to persons of higher rank, than to those of meaner stations…”

We feel this, Smith believes, because we naturally sympathize with others (if he were writing today, he would surely invoke “mirror neurons”). And the more pleasant our thoughts about individuals or groups are, the more we tend to sympathize with them. The fact that the lifestyles of the rich and famous “seem almost the abstract idea of a perfect and happy state” leads us to “pity…that anything should spoil and corrupt so agreeable a situation! We could even wish them immortal…”

The second reason applies to the hard-working rich, the type of person who:

“devotes himself forever to the pursuit of wealth and greatness….With the most unrelenting industry he labors night and day….serves those whom he hates, and is obsequious to those whom he despises….[I]n the last dregs of life, his body wasted with toil and diseases, his mind galled and ruffled by the memory of a thousand injuries and disappointments….he begins at last to find that wealth and greatness are mere trinkets of frivolous utility…. Power and riches….keep off the summer shower, not the winter storm, but leave him always as much, and sometimes more exposed than before, to anxiety, to fear, and to sorrow; to diseases, to danger, and to death…”

In short, on the one hand, we don’t wish to disrupt the perfect felicity of the lifestyles of the rich and famous; on the other hand, we don’t wish to add to the burdens of those who have spent their most precious possession – their time and energy – pursuing baubles. These two arguments are not consistent, but that does not matter. They both have a purchase on our thinking.

Unlike today’s public-finance economists, Smith understood that we are not rational utilitarian calculators. Indeed, that is why we have collectively done a very bad job so far in dealing with the enormous rise in inequality between the industrial middle class and the plutocratic superrich that we have witnessed in the last generation.