Coase Lecture Examines the Intersection of Law and the New Dynamic Public Finance

When studying how different tax systems might improve social welfare, tax lawyers and scholars frequently turn to a tax model developed in 1971 by Scottish economist and Nobel Prize laureate James Mirrlees. This static model requires a number of simplifying assumptions—notably, it has no time dimension, so individuals cannot age, acquire savings, or bequeath their assets.

Stemming from Mirrlees’s static model is the new dynamic public finance literature, which removes many of these simplifying assumptions to provide critical insight about optimizing tax systems when people age, accumulate savings, and more. But despite its usefulness, tax law scholarship tends to overlook this dynamic model, Professor Daniel Hemel said during the 2021 Ronald H. Coase Lecture in Law and Economics.

“The static Mirrleesian model is reasonably familiar to tax lawyers, or at least to tax law academics,” said Hemel, who is a professor of law and the Ronald H. Coase Teaching Scholar. “More than 130 law review articles cite Mirrlees’s 1971 paper directly. Hundreds more reference a 1987 article by law professors Joe Bankman and Tom Griffith that explains the static Mirrleesian model to fellow lawyers in non-technical terms. By contrast, the new dynamic public finance literature is largely unknown in the legal academy.”

The overlap between law and the new dynamic public finance is fertile but largely unharvested terrain, Hemel said. He offered a series examples illustrating how the dynamic public finance literature can inform tax law, and vice versa, focusing in particular on age-dependent income taxation, capital taxation, inheritance taxation, and the dynamic political economy.

“The insights of the new dynamic public finance are relevant not only to tax law, but also to constitutional law, contract law, consumer credit law, and labor and employment law, among other fields,” Hemel said. “Meanwhile, insights from legal scholarship have important implications for economists working in the dynamic Mirrleesian tradition.”

For instance, Hemel said, the knowledge that income tends to rise with age might imply that income tax rates should rise with age as well. But a countervailing factor is that at around retirement age, tax rates increasingly influence whether or not people want to work, making taxes more distortionary.

“This phenomenon offers a strong rationale for lower labor-income taxes at older ages,” Hemel said. “When we put these together,” he added, citing research by New York University economist Abdoulaye Ndiaye, “we get something like a hump-shaped age-tax schedule, with taxes rising from youth until around age 64, and then falling after that. Ndiaye estimates that such a system would yield welfare gains equivalent to a 1.75 percent increase in aggregate consumption, which is quite substantial.”

Age-dependent tax systems can smooth consumption across the life cycle by transferring resources from the middle-aged to the young, Hemel said. They also highlight the impact of the intertemporal elasticity of labor income—or the notion that workers can receive income before or after performing labor. Examples include a signing bonus, which brings income from the future to the present, or a pension, which pushes income from the present to the future. If tax rates rise with age, employees may want to front-load compensation, whereas if they fall with age, workers may try to push compensation further into the future. The implications for tax law and employment contracts are enormous, Hemel said.

“Employees want contracts that front-load compensation, but it's actually very hard to stop an employee in the later years of a front-loaded contract from quitting,” he said. “Employers might try to lock employees into long-term contracts by including non-compete provisions, but this won't work in California, where non-competes are unenforceable. And even if states changed their laws to enforce non-competes, we simply haven't developed a legal technology that prevents an employee, in the later years of an employment contract, from slacking on the job.”

The dynamic public finance literature also reinvigorates the study of capital taxation—or the taxation of savings—Hemel said. He discussed a 1976 article by Anthony Atkinson and Joseph Stiglitz that has long been considered the benchmark model of capital taxation in public finance literature, which found that the optimal tax rate on savings is zero. The new dynamic public finance literature, however, calls this into question by presenting the possibility of two work periods and introducing uncertainty regarding the ability to work in the second period.

“Let's imagine that everyone works in period one, and that some individuals experience a random shock that renders them incapable of work in period two,” Hemel said. “The government insures against disability by transferring resources from second-period workers to second-period non-workers. [This] introduces a moral hazard—now, some individuals who don't experience the negative shock choose to mimic in order to claim benefits. This drains resources from individuals who are truly disabled.”

The challenge for the government is to discourage the work-capable from mimicking, and the new dynamic public finance literature suggests that a capital tax can serve as this deterrent. A tax on savings would increase the cost of the save-and-mimic strategy, thus mitigating the moral hazard problem. Additionally, a capital tax could prevent high-skilled individuals who have accumulated significant savings from choosing lower skill jobs. It would also allow the government to redistribute a portion of the savings of high-skilled individuals to people who are truly low-skilled.

Later in the lecture, Hemel discussed the ways in which dynamic public finance can inform inheritance taxation as well as the question of whether the government will adhere to the tax schedule it promises. With so much to gain by examining the relationship between law and the new dynamic public finance, Hemel hoped the lecture would encourage future research at the intersection of these two subjects.
“Like other joinders of law and economics, law and the new dynamic public finance does not yield a single set of unambiguous policies prescriptions, but it does help us understand aspects of our existing law,” Hemel said. “It causes us to question propositions that we previously took for granted.”

A full video of the 2021 Coase Lecture can be viewed above.

Tax policy