Economic research increasingly indicates that some professions have “spillovers,” meaning the social value of an individual’s work can be much higher, or much lower, than that individual’s compensation. The job market does not account for all social value. Spillovers jam the signals in the economy, misdirecting talented students. What if, for instance, teachers faced a different tax rates than lawyers? Although some sectors do receive subsidies, the notion of widespread profession-specific taxation represents a much more radical departure than reformed income tax rates. A recent paper examines this question, and estimates that imposing profession-specific taxes could grow the economy dramatically.
This fall, college seniors across the U.S. are making a choice that will shape the rest of their lives: which career to pursue after graduation. It’s a breathtakingly complex decision, involving trade-offs among prestige, job security, quality of work life, and compensation.
Yet these career choices affect not only the students themselves but also the rest of society. Economic research increasingly indicates some professions have “spillovers,” meaning that the social value of an individual’s work can be much higher, or much lower, than that individual’s compensation. The job market does not account for all social value.
Some spillovers are quite large. Given how much good teachers raise the eventual incomes of their students, we calculate that spillovers from teachers are twice as large as the salaries teachers are paid. The benefits from medical research are even larger, amounting to over one-fifth of total income in the U.S. On the other hand, some sectors involve “zero sum” endeavors, in which profits come at the expense of other market participants. Examples include excessive litigation or financial traders trying to beat the market.
Spillovers jam the signals in the economy, misdirecting talented students. This can lead to severe misallocations of the talent pool — arguably a nation’s most valuable asset. Recent work in macroeconomics indicates that when economies fail to allocate assets to their best uses, growth slows and incomes stagnate. Although economists have long focused on policies that promote the acquisition of human capital through education, the efficient allocation of the resulting talent is just as important.
What policies can encourage talented workers to choose socially beneficial careers? Our recent paper, “Taxation and the Allocation of Talent,” studies this question. Going back to the work of noted British economist Arthur Pigou, economic experts have advocated subsidizing activities with positive spillovers and taxing those with negative spillovers. Our paper applies this idea to the allocation of talent. To calculate spillovers of different careers, we draw on several studies that estimate the effect of work in various occupations on the economy at large (see our paper for details, or this write-up).
We consider two different types of tax policies. In the first, the government amends federal income tax rates overall such that lower-paying, positive-spillover jobs seem more appealing on an after-tax basis. (More on how this works in a moment.) In the second, the government taxes (or subsidizes) some professions more than others. For instance, teachers could face a different tax rates than lawyers. Although some sectors do currently receive subsidies, the notion of widespread profession-specific taxation represents a much more radical departure than reformed income tax rates.
To evaluate these policies, we use data on the occupational choices and incomes of U.S. workers. Our data shows, for instance, that 18% of multimillionaires work in finance, while only 1% of them are professors and scientists. Moreover, career choices are highly sensitive to changes in compensation; as salaries in finance professions rose sharply from 1980 to 2005, the share of workers in investment banks, hedge funds, and similar financial establishments more than doubled. We fit an economic model to this data, which allows us to estimate the likely impact of these policies on the economy.
We find that the first (and more modest) policy of adjusting income tax rates would do little to spur economic growth. The idea here is that raising top tax rates would encourage workers to choose lower-paying jobs, and in some cases that might translate into more workers choosing more-socially-valuable professions. But, by our estimates, few of these workers would choose high-spillover jobs, such as medical research. Instead, many of them would become entertainers or enter sales — careers that may be more flexible or enjoyable, but for which there is little economic research suggesting large social spillovers. Furthermore, raising top rates could encourage multimillionaire scientists to work less hard. Although few in number, these scientists are extremely productive, generating much of the total social spillovers from research.
In contrast, the second, more radical policy — imposing profession-specific taxes — could grow the economy dramatically. Such taxes directly incentivize workers to enter professions with the highest social spillovers.
Does this mean governments should overhaul their tax codes to introduce different rates for different jobs? We see two reasons why doing so works better in theory than in practice. First, precisely defining occupations would be very difficult, especially with trillions of dollars of tax revenues at stake. It is easy to imagine a new cottage industry of accountants and lawyers devoted to exploiting ambiguities in these definitions. Second, profession-specific tax rates create opportunities for profession-specific lobbying. The resulting tax rates might favor sectors with the most political clout rather than the largest spillovers.
Instead, we advocate addressing spillovers on a case-by-case basis outside of the income tax. Most positive spillovers come from two professions, teaching and research, that already receive much of their funding from governments. In the U.S., for example, higher funding for the National Institutes of Health and National Science Foundation could raise the salaries of scientific researchers, while merit pay for teachers could draw more of our best and brightest to devote their talents to educating the next generation. These policies could spur economic growth far more than many current tax reform proposals.
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