Rent-Seeking Effects

Pay may not be equal to the marginal economic product for top income earners. In particular, executives can be overpaid if they are entrenched and can use their power to influence compensation committees. Indeed, a large literature in corporate finance has made those points (see for instanceBebchuk and Fried (2004)for an overview).⁵⁷

There is relatively little work in optimal taxation that uses models where pay differs from marginal product.⁵⁸Here we adapt the very basic model ofPiketty et al. (2011)to illustrate the key issues created by rent seeking effects. Rothschild and Scheuer (2011) consider a more elaborate model with rent-seeking and earnings heterogeneity with two sectors where rent-seeking activities prone to congestion are limited to a single sector.⁵⁹ Let us assume that individualireceives a fractionηof her actual producty. Individual ican exert productive effort to increaseyor bargaining effort to increaseη. Both types

57In principle, executives could also be underpaid relative to their marginal product if there is social outrage about high levels of compensation. In that case, a company might find it more profitable to under-pay its executives than face the wrath of its other employees, customers, or the public in general.

58A few studies have analyzed optimal taxation in models with labor market imperfections such as search models, union models, efficiency wages models (seeSorensen, 1999for a survey). Few papers have addressed redistributive optimal tax policy in models with imperfect labor markets.Hungerbuhler, Lehmann, Parmentier Der Linden, and Bruno (2006) analyze a search model with heterogeneous productivity, andStantcheva (2011)considers contracting models where firms cannot observe perfectly the productivity of their employees.

59In their model (and in contrast to the simple model we use here), when seekers “steal” only from other rent-seekers, it is not optimal to impose high top tax rates because low top tax rates stimulate rent-seeking efforts, thereby congesting the rent-seeking sector and discouraging further entry.

426 Thomas Piketty and Emmanuel Saez

of effort are costly to the individual. Hence, individualiutility is given by uⁱ(c, η,y)=c−hi(y)−ki(η),

wherec is disposable after-tax income,hi(y)is the cost of producing output yas in the standard model, andki(η)is the cost of bargaining to get a shareηof the product. Both hi andki are increasing and convex.

Letb=(η−1)ybe bargained earnings defined as the gap between received earnings ηy and actual product y. Note that the model allows both overpay (when η > 1 and henceb >0) and underpay (whenη<1 and henceb <0). Let us denote byE

b the average bargained earnings in the economy. In the aggregate, it must be the case that aggregate product must be equal to aggregate compensation. Hence, ifE(b)>0, average overpayE

b must come at the expense of somebody. Symmetrically,ifE

b <0,average underpay−E

b must benefit somebody. For simplicity, we assume that any gain made through bargaining comes at the expense of everybody else in the economy uniformly.

Hence, individual incomes are all reduced by the same amount E

b (or increased by

−E(b)ifE(b)<0).⁶⁰

Because the government uses a nonlinear income tax schedule, it can adjust the demogrant intercept−T(0)to fully offsetE

b . Effectively, the government can always tax (or subsidize)E

b at 100% before applying its nonlinear income tax. Hence, we can assume without loss of generality that the government absorbs one-for-one any change inE(b). Therefore, we can simply define earnings asz =ηy = y+band assume that those earnings are taxed nonlinearly.

Individualichoosesyandηto maximize:

uⁱ(c, η,y)=η·y−T(η·y)−hi(y)−ki(η), which leads to the first order conditions

(1−τ)η=h_i(y) and (1−τ)y=k_i(η),

whereτ =T is the marginal tax rate. This naturally definesyi, ηiasincreasingfunctions of the net-of-tax rate 1−τ. Hencezi =ηi·yi andbi =(ηi−1)·yiare also functions of 1−τ.

Let us consider as in the previous section the optimal top tax rateτabove income level z^∗. We assume again that there is a fractionqof top bracket taxpayers. Let us denote by z(1−τ),y(1−τ),b(1−τ)average reported income, productive earnings, and bargained earnings across all taxpayers in the top bracket. We can then define the real labor supply elasticityey and the total compensation elasticityeas:

ey= 1−τ y

dy

d(1−τ) ≥0 and e= 1−τ z

dz

d(1−τ) ≥0.

60Piketty et al. (2011)show that this assumption can be relaxed without affecting the substance of the results.

We definesas the fraction of the marginal behavioral response due to bargaining and let eb=s·ebe thebargaining elasticity component:

s= db/d(1−τ)

dz/d(1−τ) = db/d(1−τ)

db/d(1−τ)+dy/d(1−τ) and eb=s·e= 1−τ z

db d(1−τ). This definition immediately implies that (y/z)eb = (1−s)·e. By construction,e =

(y/z)ey +eb. Importantly,s (and henceeb) can be either positive or negative but it is always positive if individuals are overpaid (i.e., ifη>1). If individuals are underpaid (i.e., η<1 ) thens(and henceeb) may be negative.

For simplicity, let us assume that bargaining effects are limited to individuals in the top bracket.As there is a fractionqof top brackets individuals,we hence haveE(b)=qb(1−τ).

We assume that the government wants to maximize tax revenue collected from top bracket earners, taking into account bargaining effects:

T =τ[y(1−τ)+b(1−τ)−z^∗]q−E(b)=τ[y(1−τ)+b(1−τ)−z^∗]q−qb(1−τ).

The second term−E(b)arises because we assume that average underpay−E(b)due to rent-seeking at the top is fully absorbed by the government budget as discussed above.

In this model,the top tax rate maximizing tax revenue satisfies the first order condition 0= dT

dτ = [y+b−z^∗]q−qτ dy

d(1−τ) −qτ db

d(1−τ) +q db d(1−τ).

The last term reflects the rent-seeking externality. Any decrease in top incomes due to a reduction inbcreates a positive externality on all individuals, which can be recouped by the government by adjusting the demogrant. The optimal top tax rate can then be rewritten as follows:

Optimal top tax rate with rent-seeking: τ^∗= 1+a·eb

1+a·e =1−a(y/z)ey

1+a·e, (8) τ^∗ decreases with the total e (keeping the bargaining component eb constant) and increases witheb(keepingeconstant). It also decreases with the real elasticityey(keeping eandy/zconstant) and increases with the level of overpaymentη=z/y(keepingeyand econstant). Ifey=0 thenτ^∗=1. Two scenarios are theoretically possible.

Trickle-Up. In the case where top earners are overpaid relative to their productivity (z > y), thens > 0 and henceeb >0 and the optimal top tax rate is higher than in the standard model (i.e.,τ^∗>1/(1+a·e)).This corresponds to a “trickle-up” situation where a tax cut on upper incomes shifts economic resources away from the bottom and toward the top. Those effects can have a large quantitative impact on optimal top tax rates. In the extreme case where all behavioral responses at the top are due to rent-seeking effects (eb=eandey=0) thenτ^∗=1.

Trickle-Down.In the case where top earners are underpaid relative to their productivity (z < y) it is possible to haves <0 and hence eb <0, in which case the optimal top tax

428 Thomas Piketty and Emmanuel Saez

rate is lower than in the standard model (i.e.,τ^∗ < 1/(1+a·e)). This corresponds to a “trickle-down” situation where a tax cut on upper incomes also shifts economic resources toward the bottom, as upper incomes are underpaid and hence work in part for the benefit of lower incomes.

Implementing formula (8) requires knowing not only how compensation responds to tax changes but also how real economic product responds to tax changes, which is considerably more difficult than estimating the standard taxable income elasticitye (see Piketty et al., 2011for such an attempt). The issue of whether top earners deserve their incomes or are rent-seekers certainly looms large in the debate on top income taxation.

Yet little empirical evidence can bear on the issue. This illustrates the limits of the theory of optimal taxation. Realistic departures from the standard economic model might be difficult to measure and yet can affect optimal tax rates in substantial ways.⁶¹

Finally, note that the model with rent-seeking is also related to the derivation of the optimal tax rates in the presence of externalities due to charitable giving responses (see e.g.,Saez, 2004a) or the presence of transfers across agents (Chetty, 2009b).