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Tuesday, December 14, 2010

Taxes and Marginal Utility

Over at ProfsBlawg, Matt Bodie (following up on a post by Stephen Bainbridge) comments on a WSJ editorial entitled "Billionaires on the Warpath?" and concludes, among several other things, that a progressive tax code is simply a matter of economics:

One of the basic principles of economics is diminishing marginal utility. Marginal utility represents the change in utility from the increase in consumption of a particular good or service. As you get more and more of a good, your marginal utility with each increment generally decreases. Eventually, you can have so much that an additional increment adds nothing to your overall utility. Money is not a good or service, but it represents the ability to obtain goods and services. And thus one would expect money to have diminishing marginal utility as well. The more money you have, the less utility you get from each addition dollar.

So if you're constructing a tax code, it makes sense to keep this in mind. The lower the income, the higher the utility each dollar represents to that individual. Since the government is indifferent as to which dollar it takes, it makes sense to take more money that has a lower utility to the taxpayer. Doesn't $100 mean something different to someone who makes $30,000, as opposed to someone who make $30,000,000?

But this argument seems a bit of a non sequitur to me.

For the sake of argument, let's assume diminishing marginal utility applies. That still doesn't mean everyone has the same utility curve.  $100 might easily mean more to someone who makes $251,000 than it does to someone who makes $30,000.   Maybe you think it shouldn't, but that's not an economic argument. So you can't really justify a progressive tax code on the theory that it is just a way to maximize utility in society. Can you?

(By the way, even if you could figure out how to do it, I suspect most people would object rather strongly to a system that taxed people based on who had the lowest marginal utility to the next dollar raised).



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Yes but on average lower income individuals will likely have greater utility for a dollar at the margin. Therefore this is a valid economic argument since most economic analyses (at least macro) incorporate statitical data as economic modeling would probably be too cumbersome and complex otherwise.

Posted by: Gustav | Dec 27, 2010 9:22:37 AM

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