Yesterday I offered a rousing defense of the use of simplified models in economics. So maybe it’s appropriate that today I offer a caution: you should use models, but you should always remember that they’re models, and always beware of conclusions that depend too much on the simplifying assumptions. And I have a case in point, which ties into one of my other big concerns: the appropriate taxation of capital income.

Greg Mankiw is upset at my suggestion that the Bush administration was motivated by class interests in its determination to slash taxes on capital income and eliminate estate taxes. He wants us to know that it was all about optimal taxation, as dictated by economic theory.

Well, we could have a political discussion: How many people really, truly believe that George W. Bush chose to slash taxes on dividends and phase out the inheritance tax because Greg Mankiw and Glenn Hubbard told him that this was the conclusion from economic theory? Can we have a show of hands?

But let me instead point out that the case for zero or low taxation of capital income rests on very strong, very unrealistic assumptions — basically perfectly rational intertemporally optimizing agents, with dynasties behaving as if they were infinitely lived individuals. Question those assumptions, and the whole case falls apart. Don’t take my word for it — read Peter Diamond and Emmanuel Saez (pdf), who also point out that the intertemporal optimizing model of saving is in fact rejected by lots of evidence.

And when it comes to bequests, read Irving Fisher (pdf):

The ordinary millionaire capitalist about to leave this world forever cares less about what becomes of the fortune he leaves behind than we have been accustomed to assume. Contrary to a common opinion, he did not lay it up, at least not beyond a certain point, because of any wish to leave it to others. His accumulating motives were rather those of power, of self-expression, of hunting big game.

The point here is that the economic case for not taxing capital rests on a stylized model that we know does a bad job of capturing real behavior; the case for taxing capital rests on considerations of equity and concerns about excessive concentration of wealth that are very much grounded in real-world observation. You don’t have to be a know-nothing to argue that the second case trumps the first.

Oh, and you can believe this without renouncing the use of intertemporal optimization as a useful simplifying gadget in some cases. My original liquidity-trap paper involving embedding a minimalist monetary framework in, yes, a model of perfectly rational, infinitely-lived individuals. I did that to clear out the clutter and focus on what I considered the core issue — but I wouldn’t have pursued it if I thought the results depended crucially on the truth of those assumptions.

Using models without believing that they represent The Truth is hard; it’s very easy to fall of that tightrope one way or the other. But it’s what you have to do if you want to do useful economics.