When economists think about the role taxes play in an individual’s decision to work, they think about two things. There’s the “substitution effect,” where higher tax rates make you work less, because you keep less of every extra dollar you earn. But there’s also the “income effect,” in which higher tax rates make you work more, because you need to earn more to be able to live how you want to live, or retire when you want to retire. The question is which dominates: The desire to keep more of the money you make or the desire to have more money in total?
But Peter Diamond, the MIT economist who won the 2010 Nobel prize, thinks we’re asking the wrong question. In his view, we don’t much care whether lawyers work a few more hours, or whether CEOs can take home absurd compensation packages. In fact, we don’t primarily care about individuals at all. We care about businesses.
In particular, we care about young businesses. Start-ups. Recent research (pdf) shows that it’s young businesses, not small businesses, that are the real engines of job creation. So we want to make it as easy as possible for these businesses to succeed. And what businesses need to succeed and expand is access to the funds necessary to help them get started and then expand when they’re successful.
Big businesses, Diamond says, have little trouble borrowing money when they find a profitable investment opportunity. The same goes for wealthy people who want to start a business. But small businesses and not-so-wealthy entrepreneurs do. A lot of their initial capital comes from equity in their homes, or the savings of friends and family. And so Diamond argues that a more progressive tax code is better for growth because it puts more money in the hands of people who are currently “capital constrained.”
”Start-ups matter a lot,” says Diamond. “The question is, what limits start-ups? To a large extent, it’s issues around access to capital. So ask yourself who has trouble getting access to capital. High earners tend to have to high wealth. The rest of the population, however, has very little access to wealth outside of their housing. So if you want to encourage dynamism in the economy its more important to get money into their hands than to get it to those who already have a lot of wealth.”
In this telling, the focus of our conversation around taxes is all wrong. Republicans ask what a given tax rate will do to the “job creators.” Democrats ask whether a given distribution of taxes is “fair.” Diamond thinks we should be asking how many people we’re putting into a position to become job creators.
In a society where money pools at the top of the income distribution, a lot of folks who have a great idea won’t have the funding to making it a business, and so that business won’t have the opportunity to create jobs. When you focus only on the people who have the money to be job creators now, in other words, you miss all the people who would become job creators if they had access to more money.