Three Cheers for Income Inequality

The 2008 election was supposed to bring to the United States a higher level of civil discourse. Fast-forward three years and exactly the opposite has happened. A stalled economy brings forth harsh recriminations. As recent polling data reveals, the American public is driven by two irreconcilable emotions. The first is a deep distrust of government, which has driven the approval rate for Congress below ten percent. The second is a strong egalitarian impulse that directs its fury to the top one percent of income earners. Thus the same people who want government to get out of their lives also want government to increase taxes on the rich and corporations.  They cannot have it both ways.

   
 Illustration by Barbara Kelley

I voiced some of my objections to these two points in an interview on PBS, which sparked much controversy. The topic merits much more attention.

What are the origins of inequality? Start with a simple world in which all individuals own their labor. Acting in their self-interest (which includes that of family and friends), they seek to improve their lot in life. They cannot use force to advance their own position. Thus, they are left with two alternatives: individual labor and cooperative voluntary ventures.

Voluntary ventures will normally emerge only when all parties to them entertain expectations of gain from entering into these transactions. In some cases, to be sure, these expectations will be dashed. All risky ventures do not pan out. But on average and over time, the few failures cannot derail the many successes. People will make themselves better off.

The rub is that they need not do so at even rates. The legitimate origin of the inequality of wealth lies in the simple observation that successful actors outperform unsuccessful ones, without violating their rights. As was said long ago by Justice Pitney in Coppage v. Kansas, “it is from the nature of things impossible to uphold freedom of contract and the right of private property without at the same time recognizing as legitimate those inequalities of fortune that are the necessary result of the exercise of those rights.”

So why uphold this combination of property and contract rights? Not because of atavistic fascination for venerable legal institutions. Rather, it is because voluntary exchanges improve overall social welfare. This works in three stages.

First, these transactions, on average, will make all parties to them better off. The only way the rich succeed is by helping their trading partners along the way.

Second, the successes of the rich afford increased opportunities for gain to other people in the form of new technologies and businesses for others to exploit.

Voluntary exchanges improve overall social welfare.

Third, the initial success of the rich businessman paves the way for competitors to enter the marketplace. This, in turn, spurs the original businessman to make further improvements to his own goods and services.

In this system, the inequalities in wealth pay for themselves by the vast increases in wealth.

Any defense of wealth inequalities through voluntary means is, however, subject to a powerful caveat: The wealth must be acquired by legitimate means, which do not include aid in the form of state subsidies, state protection, or any other special gimmick. The rich who prosper from these policies do not deserve their wealth. Neither does anyone else who resorts to the same tactics.

As an empirical matter, large businesses, labor unions, and agricultural interests that have profited from government protections have drained huge amounts of wealth from the system. Undoing these protections may or may not change the various indices of inequality. But it will increase the overall size of the pie by improving the overall level of system efficiency.

The hard question that remains is this: To what extent will the United States, or any other nation, profit by a concerted effort to redress inequalities of wealth?

Again the answer depends on the choice of means. Voluntary forms of redistribution through major charitable foundations pose no threat to the accumulation of wealth. Indeed, they spur its creation by affording additional reasons to acquire levels of wealth that no rational agent could possibly consume.

Forced transfers of wealth through taxation will have the opposite effect. They will destroy the pools of wealth that are needed to generate new ventures, and they will dull the system-wide incentives to create wealth in the first place. There are many reasons for this system-wide failure.

First, the use of state coercion to remedy inequalities of wealth is not easily done. The most obvious method for doing so is by creating subsidies for people at the bottom, which are offset by high rates of taxation for people at the top. The hope is that high taxes will do little to blunt economic activity at the high end, while the payments will do little to dull initiative at the low end.

But this program is much more difficult to implement than is commonly supposed. The process of income redistribution opens up opportunities for powerful groups to secure transfers of wealth to themselves. This does nothing to redress inequalities of wealth. Even if these political players are constrained, there is still no costless way to transfer wealth up and down the income scale.

The administrative costs of running a progressive income tax system are legion. Unfortunately, that point was missed in a recent op-ed. Writing in the New York Times, Cornell economist Robert H. Frank plumped hard for steeper progressive income tax rates as a way to amend income inequality.

There is no costless way to transfer wealth up and down the income scale.

Yet matters are not nearly as simple as he supposes. In his view, the source of complexity in the current income tax code lies in the plethora of special interest provisions that make it difficult to calculate income by recognized standard economic measures. Thus, he thinks that it is “flatly wrong” to think that the flat tax will result in tax simplification. After all, it is just as easy to read a tax schedule that has progressive rates as one that has a uniform flat rate.

But more than reading tax schedules is at stake. First, one reason why the internal revenue code contains such complexity is its desire to combat the private strategies that people, especially those in the top one percent, use to avoid high levels of taxation. Anyone who has spent time in dealing with family trusts and partnerships, with income averaging, with the use of real estate shelters, and with foreign investments, knows just how hard it is to protect the progressive rate schedule against manipulation.

Second, the creation of these large tax loopholes is not some act of nature. Frank, like so many defenders of progressive taxation, fails to realize that progressive rates generate huge pressures to create new tax shelters. Lower the overall tax rates and the pressure to create tax gimmicks with real economic costs diminishes. Overall social output is higher with a flat tax than it is with a progressive one.

Third, the dangers posed by the use of progressive taxation are not confined to these serious administrative issues. There are also larger questions of political economy at stake. The initial question is just how steep the progressive tax ought to be.

Keep it too shallow, and it does little to generate additional public revenues to justify the added cost of administration. Make it too steep, and it will reduce the incentives to create wealth that are always unambiguously stronger under a flat tax system. But since no one knows the optimal level of progressivity, vast quantities of wealth are dissipated in fighting over these levels. The flat tax removes that dimension of political intrigue.

Fourth, sooner or later—and probably sooner—high tax rates will kill growth. Progressives like Frank operate on the assumption that high taxation rates have little effect on investment by asking whether anyone would quit a cushy job just to save a few tax dollars. But the situation is in reality far more complex. One key to success in the United States lies in its ability to attract foreign labor and foreign capital to our shores. In this we are in competition with other nations whose tax policies are far more favorable to new investment than ours. The loss of foreign people and foreign capital is not easy to observe because we cannot identify with certainty most of the individuals who decide to go elsewhere. But we should at the very least note that there is the risk of a brain drain as the best and brightest foreign workers who came to the United States in search of economic opportunity ultimately may return home. They will likely not want to brave the hostile business climate that they see in the United States.

Fifth, sophisticated forms of tax avoidance are not limited to foreign laborers. Rich people have a choice of tax-free and taxable investments. They can increase transfers to family members in order to reduce the incidence of high progressive taxation. They can retire a year sooner, or go part-time to reduce their tax burdens. And of course, they can fight the incidence of higher taxation by using their not inconsiderable influence in the tax arenas.

The incentives to create wealth are stronger under a flat tax system.

Sixth, the inefficiencies created by a wide range of tax and business initiatives reduces the wealth earned by people in that top one percent, and thus the tax base on which the entire redistributive state depends. Defenders of progressive taxation, like Frank, cite the recent report of the Congressional Budget Office, which shows huge increases of wealth in the top one percent from 1979 to 2007. The top one percent increased its wealth by 275 percent in those years. The rest of the income distribution lagged far behind.

Unfortunately, the CBO report was out of date the day it was published. We now have tax data available that runs through 2009, which shows the folly of seeking to rely on heavier rates of taxation on the top one percent. The Tax Foundation’s October 24, 2011 report, contains this solemn reminder of the risks of soaking the rich in bad times:

In 2009, the top 1 percent of tax returns paid 36.7 percent of all federal individual income taxes and earned 16.9 percent of adjusted gross income (AGI), compared to 2008 when those figures were 38.0 percent and 20.0 percent, respectively. Both of those figures—share of income and share of taxes paid—were their lowest since 2003 when the top 1 percent earned 16.7 percent of adjusted gross income and paid 34.3 percent of federal individual income taxes.

It is worth adding that the income of the top one percent also dropped 20 percent between 2007 and 2008, with a concomitant loss in tax revenues.

There are several disturbing implications that flow from this report. The first is that these figures explain the vulnerability in bad times of our strong dependence on high-income people to fund the transfer system. The current contraction in wealth at the top took place with only few new taxes. The decline in taxable income at the top will only shrink further if tax rates are raised.  A mistake, therefore, in setting tax rate increases could easily wreck the entire system. Indeed, the worst possible outcome would be for high taxation to lower top incomes drastically. Right now, for better or worse, the entire transfer system of the United States is dependent on the continued success of high-income earners whom the egalitarians would like to punish.

Put otherwise, if a person at the middle of the income distribution loses a dollar in income, the federal government loses nothing in income tax revenues. Let a rich person suffer that decline and the revenue loss at the federal level is close to 40 percent, with more losses at the state level. The slow growth policies of the last three years have cost far more in revenue from the top one percent than any increase in progressive taxation could possibly hope to achieve. The more we move toward an equal income policy, the more we shall need tax increases on the middle class to offset the huge revenue losses at the top. Our current political economy makes the bottom 99 percent hostage to the continued success of the rich.

The dangers of the current obsession with income inequality should be clear. The rhetorical excesses of people like Robert Frank make it ever easier to champion a combination of high taxation schemes coupled with ever more stringent regulations of labor and capital markets. Together, these schemes spell the end of the huge paydays of the top one percent. Those earners depend heavily on a growth in asset value, which is just not happening today.

But what about the flat tax? Frank and others are right to note that a return to the flat tax will result in an enormous redistribution of income to the top one percent from everyone else. But why assume that the current level of progressivity sets the legitimate baseline, especially in light of the current anemic levels of economic growth? What theory justifies progressive taxation in the first place? The current system presupposes that this nation can continue to fund the aspirations of 99 percent out of the wealth of the one percent. That will prove to be unsustainable. A return to a flatter tax (ideally a flat) tax will have just the short-term consequences that Frank fears.   It will undo today’s massively redistributivist policies. But it will also go a long way toward unleashing growth in our heavily regulated and taxed economy.   

The United States is now in the midst of killing the goose that lays the golden eggs. That current strategy is failing in the face of economic stagnation, even with no increase in tax rates. It will quickly crumble if tax increases are used to feed the current coalition of unions and farmers who will receive much of the revenue, while the employment prospects of ordinary people languish for want of the major capital investments that often depend on the wealth of the privileged one percent of the population.

The clarion call for more income equality puts short-term transfers ahead of long-term growth. Notwithstanding the temper of the times, that siren call should be stoutly resisted. Enterprise and growth, not envy and stagnation, are the keys to economic revival.