How can we put the brakes on out-of-control economic inequality? The solution is surprisingly simple: by taking aim at the tax code.
A growing body of evidence suggests dramatic increases in the tax rates paid by the highest income brackets could significantly reduce inequality.
Currently, policymakers are focusing their attention elsewhere. There is a broad consensus in the Democratic Party favoring solutions aimed at lifting the bottom, such as expanding the Earned Income Tax Credit and raising the minimum wage. Heck, even Walmart is “looking at” supporting a minimum wage increase these days.
But while increasing the minimum wage is a vital step, by itself it won't do much to slow down skyrocketing economic inequality in this country. To dissipate the alarming concentration of economic and political power that has been accruing to the one percent, bolder steps are needed. We need policies aimed at not only lifting the bottom, but also at reforming the top.
One of the most compelling arguments economist Thomas Piketty makes in his important new book about economic inequality, Capital in the Twenty-First Century, is that the most effective way to combat what he calls “an endless inegalitarian spiral” is through taxes — ideally, through a wealth tax.
In future weeks in this space, I plan to write more about Piketty's proposed wealth tax. But for now, I want to focus on a new paper co-authored by Piketty that concerns a related subject: income taxes. (An earlier ungated version of the paper can be found here.)
In the current issue of the American Economic Journal: Economic Policy, Piketty and his collaborators Emmanuel Saez and Stefanie Stantcheva look at the relationship between incomes in the top one percent and marginal tax rates.
Piketty et al. examine two sources of data: the top one percent of income earners from 18 OECD countries between 1960 and 2010, as well as CEO pay in the U.S. between 1970 and 2006. The data used derives optimal tax rate formulas. The results of this study are important for economic progress.
First, Piketty and his researchers find a strong relationship between tax cuts for rich folks — the top one percent of earners — and the soaring economic inequality we've seen in the U.S. and many other countries since the 1970s. There is “a clear correlation between the drop in marginal tax rates and the surge in top income shares since 1960,” they reported in AEJ.
Second, their research shows tax cuts for the top one percent had no impact on economic growth. “We find no evidence of a correlation between growth in real GDP per capita and the drop in the top marginal tax rate in the period 1960 to the present,” the authors say.
Indeed, some of their models even suggest that low tax rates are “detrimental to growth.” Their findings are consistent with a bargaining model in which top earners extract rents at the expense of low- and middle-income workers.
Last, but far from least, there's this: the authors' estimate the socially optimal top marginal tax rate is 83 percent. Tax rates that high could encourage avoidance. If so, then we need to create a better designed tax system by increasing penalties for avoidance, eliminating tax shelters, instituting capital controls, and stepping up efforts at global coordination.
There’s also the objection that marginal rates of 83 percent are way higher than almost any elected official advocates for these days. I can already hear voices, not all of them conservative, denouncing such rates as “confiscatory.”
But “confiscatory” is indeed precisely the point. The purpose of very high marginal tax rates is not so much to raise revenue as to discourage economically and socially destructive activity. That's exactly how an income tax rate in the neighborhood of 83 percent for the highest earners would work. It would reduce inequality by distributing the gains from productivity more fairly, while at the same time not interfering with economic growth.
Finally, there's another point in favor of confiscatory taxes: they are as American as apple pie.
As Piketty points out in Capital, America virtually invented confiscatory taxes, implementing income tax rates above 70 percent in the immediate aftermath of World War I. Moreover, progressive taxes intervene in markets only in limited ways (which fiscal conservatives should appreciate).
As Piketty notes in his book, the progressive tax:
“…is a relatively liberal method for reducing inequality, in the sense that free competition and private property are respected while private incentives are modified in potentially radical ways, but always according to rules thrashed out in democratic debate. The progressive tax thus represents an ideal compromise between social justice and individual freedom.”
Conservatives and other defenders of the status quo often make the argument that Americans don't care about inequality. This is a curious notion.
Consider this fascinating data:
Respondents believe the top 20 percent of Americans own 59 percent of the wealth, and the bottom 60 percent own 20 percent.
Ideally, they would prefer the top 20 percent own 32 percent of the wealth, and the bottom 60 percent own 45 percent.
In reality, the top 20 percent in this country own a whopping 84 percent of the wealth, and the bottom 60 percent own just 5 percent.
This data strongly suggests many Americans are ready to support a tax system that is significantly more progressive than the one that currently exists.
As is often the case, the American people are ahead of elite opinion on this issue. The only question is whether the elites are ready to follow.