Tax Policy and Income Inequality

There’s an interesting post by Dylan Matthews at the WP’s Wonkblog that I want to commend to your attention. The post is, essentially, a commentary on this paper by Andrew Fieldhouse, a kid who works for the Economic Policy Institute as a “policy analyst”, which finds that the reduction in nominal tax rates for the top income earners of the 1980s hasn’t had much to do with the deteriorating condition of income inequality since then. That doesn’t particularly surprise me but I assume it will come as a bolt from the blue to the youngsters at Wonkblog, basically another word for the Center for American Progress.

Here’s the nugget. Imagine that the tax reforms of the 1980s hadn’t taken place. All other things being equal would that have prevented the increase in income inequality?

So, would we have avoided the increase in inequality over the period in question? Not even remotely. The 1979 scenario lines shows inequality rising a bit more slowly than what actually happened, but the underlying pattern is the same.

“Roughly 30 percent of the rise in post-tax, post-transfer inequality between 1979 and 2007 can be attributed to changes in the redistributive nature of tax and budget policy,” Fieldhouse concludes. “It is still the case, however, that shifts in the market distribution of income are the primary factors driving the rise in inequality.”

Again, not surprising. Sweden has experienced rising income inequality over the last couple of decades, too.

I think the essential problem is that you might increase the nominal tax rate on the highest income earners but it’s darned hard to raise the effective tax rate. That’s especially true when your tax system isn’t just a way of producing revenue for running the government but is also intended to reward good behavior (whatever that is) and punish bad behavior (ditto). People can change their behavior to reduce their tax liability and the higher your income the more freedom you have to do that.

However, let’s assume that tax policy can’t do much about income inequality and, further, let’s assume that you want there to be less of it. What do you do? Mr. Matthews presents his preferred list which, unfortunately, to my eye varies from the unlikely to the downright mistaken.

#1 on his list is increasing the density of trade unionism in the United States. Now, I don’t know what the economic effects of increasing trade unionism in 1930, 1940, or 1950 were but I have a pretty good idea of what they are today.

Think about a rectangle. You calculate the area of the rectangle by multiplying the height times the width. If the height of the rectangle increases, the area of the rectangle does not increase if the width decreases correspondingly. That’s how trade unions have worked for the last several decades. They’ve raised the height (wages) by decreasing the width (the number of people receiving the wage). As I write this we have 20 million people who are unemployed or underemployed. We don’t need to raise the wages of those who remain employed by throwing more people out of work.

Let me present a few proposals from my list.

First, stop redistributing from the top 1% of income earners to the next 9% of income earners. That would require a major overhaul in our healthcare system, either towards a full-fledged national health system or in favor of catastrophic care insurance only (AKA “high deductible plans”). Other things would be required as well, e.g. abolishing the payroll tax or lowering it and increasing FICA max, disincentivizing investment in purely financial assets (as opposed to expanding facilities, buying equipment, doing R&D, etc.), and so on. Sadly, practically all of our healthcare, education, immigration, and trade policy is predicated on the notion that if you redistribute within the top 10% of income earners it will trickle down to the remaining 90%. I see very little evidence of this happening.

Second, stop importing so much. Our high level of imports renders fiscal stimulus much less effective than it otherwise might be. Put more money in somebody’s pocket and it doesn’t increase economic activity so that their neighbors can find a job. Instead it increases economic activity in Germany, China, Japan, and South Korea.

Third, reduce military spending.

Fourth, make producing as much energy as inexpensively and cleanly as we can and distributing it more efficiently and securely a national priority. Not just “alternative energy”. Coal, natural gas, and nuclear, too. Use the proceeds from reducing military spending to improve the grid.

6 comments… add one
  • Ben Wolf Link

    “Sadly, practically all of our healthcare, education, immigration, and trade policy is predicated on the notion that if you redistribute within the top 10% of income earners it will trickle down to the remaining 90%. I see very little evidence of this happening.”

    Yet you advocate the same trickle down strategy. Look at your list:

    1) More energy production

    Turn over more natural resources to billionaires and hope jobs are produced.

    2) Restrict trade

    Hope jobs are produced.

    3) Cut military spending

    Hope less spending produces jobs.

    Have any of these things reduced inequality in other nations?

  • Piercello Link

    @Ben, not just “more energy,” but also “inexpensive, clean, and efficiently distributed” energy. Meeting that bar will most assuredly have trickle-down effects. I left New England because rising energy costs were undermining my business model as a traveling orchestral musician.

  • Piercello Link

    Cheap energy disproportionally benefits the poor.

  • Tom Lindmark Link

    Nice line about Wonkblog and CAP. I make myself grit my teeth and read Wonkblog. Given that it’s disappearing behind the paywall I’ll at least save some wear and tear on the enamel. I generally found the comments more thoughtful and nuanced than the articles, but I suspect it will become merely an echo chamber once the new regime is in place.

  • steve Link

    Given the global nature of this trend, I am becoming more persuaded that we are seeing a global glut in labor. With China and India joining the rest of the world, we have a lot more workers, but not a lot more capital. The returns to capital have gone higher and the returns to labor productivity have dropped.

    Other than unions, his solutions overlap with yours. He wants to lower medical costs by changing licensing requirements and letting in more foreign docs. He wants to decrease imports by weakening the dollar.

    I also think it is worth looking at the Saez idea. With tax rates much lower, execs have more interest in negotiating for higher salaries. Note that while everyone is seeing more income inequality, it is in the US where you see the huge discrepancies in CEO/exec pay. These differences are not as large elsewhere.


  • Andy Link

    I’ve linked to the data before, but many OECD countries have worse income inequality than the US before taxes and transfer payments are taken into account. After taxes and transfer payments their inequality is much less than the US. So I think the underlying dynamic is what steve suggests – that this is a global phenomenon.

    From a policy standpoint, I’m skeptical that German policies to reduce income inequality will work as well here even if they were politically possible. It’s much easier to bring about high taxes and redistribution in a largely homogenous nation state than it is in a political union like ours.

    All that’s to say that I don’t really know what will work for us. I think Dave’s suggestion are worth trying, but I also think we need to enact policies that reduce the incentives for for large firms to prosper at the expense of smaller firms. Here I’m thinking about patent, copyright and tax reform.

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