Taxation and Instrumental Variables
By Arnold Kling
Should the income tax system include a tax credit for short taxpayers and a tax surcharge for tall ones? This paper shows that the standard utilitarian framework for tax policy analysis answers this question in the affirmative.
At first glance, this seems silly. On further reflection, it also seems silly.I can’t really follow the math in the paper–maybe because I’m only 63-1/2 inches tall. But it strikes me as sort of like an instrumental variables argument.
The theory is that income taxes are sub-optimal because they tax both ability and effort. A certain sort of social planner might want to levy a highly progressive tax on ability, as long as this tax did not adversely affect effort. I gather that this is called “optimal taxation” in some of the literature–it’s not my field.
When you have a variable that is a combination of what you want and what you don’t want, the big fad in economics these days is to use instrumental variables. So, if income includes both effort and ability, why not instead use an instrumental variable that is correlated with ability but not effort? Based on some previous research, height comes to mind.
The thing that economists seem to forget too often is that instrumental variables are not necessarily highly correlated with the variables for which they are instruments. Yes, there is a correlation between height and ability, but it is nowhere near perfect.
So, if you tax tall people and subsidize short people, what you will end up with is giving a real windfall to (the minority of) short folks who have lots of ability and a real penalty to (the minority of) tall folks who have minimal ability.
I think that one can reject that notion of taxing height without rejecting the “optimal taxation” framework. I think this is just a case where use of a weak instrumental variable causes more problems than it solves.