Should superstar earners pay supersized taxes?

Everyone agrees that inequality has increased in the U.S.— especially among the top 1 percent. And one of the hottest debates sure to carry into a new presidential administration is about whether the richest Americans should pay more taxes.

But Stanford economist Florian Scheuer is doing research that brings a sober perspective to the political mudslinging. Regardless of party affiliation, Scheuer says it’s crucial to consider why the rich are getting so much richer before deciding whether to raise, lower, or leave top-income taxes alone.

What if the market for CEOs has become like the market for superstar athletes — where the earnings of the most talented few far outpace the earnings of the rest of the pack? Or if, instead, CEOs are getting enormous paychecks because they’ve stacked their governing board with friendly directors willing to automatically dole out big bonuses and a fat payday?

Scheuer, an expert on public finance and faculty fellow at the Stanford Institute for Economic Policy Research, integrates these real-world features of labor markets into tax models to get at the answers. The conclusions can be surprising and highlight questions policymakers should consider before changing the tax structure for top earners.

Take the taxation of so-called superstars. The idea is that relatively small differences in ability or effort among workers are magnified by other factors such as technology or globalization that lead to dramatic differences in pay. (In a classic example, the advent of television enabled a small share of performance artists to capture a massive audience leaving other artists in the dust.) Many economists believe that "superstar effects" play a role in the rise of income inequality in some labor markets.

A superstar story has been used to explain the growing divergence in CEO compensation. In this narrative, more talented managers are snatched up by larger, more productive firms.

Being surrounded by more efficient workers, having access to better resources and commanding larger markets, gives these managers an extra kick to their productivity. Hence, the matching of slightly more talented workers with larger firms accounts for the large difference in income between superstar CEOs and the rest of the pack.

Should those highly effective superstars pay superstar taxes?

It turns out that superstar workers should be more responsive to changes in taxes than ordinary workers. Since additional work by superstars reaps outsized rewards, discouraging their effort — even a little bit — has larger revenue consequences and makes distortions from any given tax increase stronger, writes Scheuer in a forthcoming paper with Iván Werning of MIT.

"If we think the current earnings distribution is driven by superstar effects — rather than a traditional technology where earnings are proportional to effort — then, in fact, this is going to be a push for lower top-level taxes because now we realize that people are more responsive," Scheuer said.

To what extent policymakers should do this depends on empirical evidence. While it is easy enough to observe the growth in earnings inequality at the top, there is very little research into whether the responsiveness of top earners to taxes has changed over time — as would be expected if superstar effects were driving the growth of inequality.

"If we believe that this is an important channel it would be crucial to estimate the earnings responses of these superstar workers to tax changes," Scheuer said.

Moreover, superstar effects are likely not the only factor driving top-income inequality. What if some of the astronomical earnings at the top are not related to economic productivity? For instance, when CEOs can influence their own pay by stacking a board of directors in their favor.

In this case, policymakers might want to use taxes to discourage that unfair advantage.

Scheuer explores this issue in another paper with Casey Rothschild of Wellesley College.

They find that the critical question to ask in this case is whether the top-earners are benefiting at the expense of others and, if so, whom. If CEO pay hikes are at the expense of workers doing productive work, then raising taxes on CEOs will likely lead to an increase in more fruitful activities.

"In these cases you are going to have a force for even higher taxes than you would think based on a simple corrective taxation logic," Scheuer says.

But if top earners are making outsize profits from winning against others in the same line of work, raising taxes would backfire. One example of this would be high-speed traders. They make profits by being first to trade securities and compete by investing in locations, algorithms and hardware that give them fastest access to exchanges. If the most profitable high-speed traders faced higher taxes, then that would discourage their activity. But it would also make it easier for others who compete against them, potentially drawing more traders into the fray.

Scheuer's models can isolate different drivers of inequality and single out their tax implications. Ultimately, policymakers need to take all these pieces into account. Scheuer's work highlights the types of questions policymakers should consider when using tax policy to address inequality at the top.

Miriam Wasserman is a freelance writer.