A new paper by Guvenen, Kurusku and Ozkan on income inequality and progressive taxation makes some interesting, though far from novel in the economic literature, claims about the effects of progressive taxation on human capital investment decisions. The theory is that progressive taxation distorts people’s incentives to invest in human capital, whether that be on the job training or returning to school for further education. The authors claim that this underinvestment in human capital is what lies beneath the slower wage inequality growth in the Continental European countries than in the United States. And, while their model is a sound one, I have vigorous objections to this particular conclusion.
Leaving aside a more general indictment of rationality in economics, I would like to make an argument about salience and then circle back to the issue of rationality, where I will claim that factors completely removed from taxation underlie much individual decision making with regards to human capital investments.
It’s no real surprise, or it ought not be, that tax salience will affect people’s response to a particular tax. The more visible the tax is, the more impact it will have on individual’s decisions to spend or invest. In this important paper, Chetty, Looney and Kroft provide experimental support to the notion that tax salience matters. Though this particular paper focuses on the effects of sales taxes and consumer purchasing decisions, it is reasonable to believe that its conclusions apply also to the impacts of other taxes. (More evidence is provided in the field of public finance- there is a reason why governments are more willing to raise fees than to raise taxes, and that is salience.)
What does this mean to the effects of progressive taxation on human capital investment? Certainly income taxes are relatively visible; people are obviously aware of them. So it would seem to follow that they have a high degree of salience. However, I would argue that their salience is actually fairly low. Generally speaking, people are unaware of their marginal tax bracket, let alone fully understand how marginal taxation works. How many people, if asked, could say what their total income tax had been in the previous year? Very few, indeed.
Thus, income taxes, while very well known, have a small amount of salience. It is almost as if they exist in the ether. And, as has been shown by Chetty et al, low levels of salience will not distort decisions in the same way more salient ones will. It is therefore difficult to believe that a vague understanding of possibly higher taxes in the future accounts for much underinvestment in human capital.
Then what does drive individuals’ decision to invest in human capital? I would argue that there are a host of factors at play, and that they vary among individuals. For some the decision to invest is motivated by an inherent value placed on learning. Others value learning and education, but only as an instrumental value toward furthering their prestige, status or future income.
There are an almost infinite number of factors that influence the decision to invest in human capital. And, for some people (the super-rational), that may include weighing the costs of progressive taxation of future income streams that could be gained by such an investment. But for the vast majority of people, future rates of income taxation are just not salient enough to affect their decision one way or the other.