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Marginal Revolution University has the following question in its Elasticity unit:

In 1993, then President Clinton passed a law raising income taxes. This tax hike was fully expected: He campaigned on it in 1992. What do you expect happened to executive income in the first year of the tax increases? What about in subsequent years? Hint: Top executives have a lot of power over when they get paid for their work: They can ask for bonuses a bit earlier, or they can cash out their stock options a bit earlier. Literally, this isn’t their “labor supply,” it’s more like their “income supply.”

Their answer:

In the first year income will decrease; in the long run it will remain nearly the same

I don't understand this answer; it made sense to me that the income would increase in the short term, as:

  1. the practices of assigning salaries and bonuses, etc, would be difficult to adjust in the short term (i.e. more inelastic), so they'd tend to stay the same, but also
  2. in anticipation of a higher tax burden, CEOs would want to give themself higher bonuses before the tax hike goes into effect, so income in the first year would be high

And it would make sense to me that, once companies adjust for higher taxes, the income of CEOs would tend to decrease to compensate in the long term.

Could anyone point out where my reasoning is falling short? I'm new to economics and haven't really developed my intution on the subject yet. Thanks.

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the practices of assigning salaries and bonuses, etc, would be difficult to adjust in the short term (i.e. more inelastic), so they'd tend to stay the same,

This might be true empirically (I am not an expert on CEO compensation), but if you are doing a test you have to follow assumptions in exercise (which will not always be realistic - undergraduate programs for example almost always assume linear demand and supply which is unrealistic save for some special cases).

In this case the exercise states:

Hint: Top executives have a lot of power over when they get paid for their work: They can ask for bonuses a bit earlier, or they can cash out their stock options a bit earlier.

This is basically teacher telling you throughout this exercise assume the salary can perfectly adjust even in short term.

in anticipation of a higher tax burden, CEOs would want to give themselves higher bonuses before the tax hike goes into effect, so income in the first year would be high

You need to read the set up of the problem very carefully. The set up says:

What do you expect happened to executive income in the first year of the tax increases?

So the question asks what happens to the income in the first year after the tax hike is passed. You are completely right that before they pass the tax hike the executives (within this problem) will ask for higher compensation before the tax hike, but note the problem asks you what happens in the first year after the tax hike already taken place. Well then the income will be lower as those executives within the assumptions of this exercise would rationally ask to be paid before the tax hike portion of money they would earn in the subsequent year. Hence their income in the in the first year of the tax increases will be lower.

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  • $\begingroup$ Thanks for the answer, it makes sense. Would it be right to say that in the long term, the income will tend to stay the same because CEOs can influence on whose shoulders the tax burden is placed, and therefore can choose to clear the same amount while average workers lose income? $\endgroup$
    – David J.
    Oct 3 '20 at 9:12
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    $\begingroup$ @DavidJ. its not completely right. Distribution of tax burden depends on a market forces. This distribution does not depend on what CEO, politicians or workers want. Generally it depends on how elastic is the thing you want to tax - the higher the elasticity relative to other side of the market - the lower is your share of tax burden. For example, if in some industry (I.T.) lets say worker's labor supply is very elastic and demand of firms inelastic the tax burden will fall mostly on the firm. However, this being said I guess its reasonable first assumption to say CEO's supply of labor is $\endgroup$
    – 1muflon1
    Oct 3 '20 at 9:18
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    $\begingroup$ very elastic and probably more so than the demand for them. So its reasonable to say their share of tax burden will be lower because of this. For example, Showalter, M. H., & Thurston, N. K. (1997). Taxes and labor supply of high-income physicians. Journal of Public Economics, 66(1), 73-97. find that high income physicians generally have quite large elasticity of their labor supply and can adjust it a lot in response to changes in marginal tax rates. I would tend to think that for CEO's the empirical evidence should show similar results. $\endgroup$
    – 1muflon1
    Oct 3 '20 at 9:24

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