Appropriate Taxation for Stable, Reasonable Inequality

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For my own part, I believe that there is social and psychological justification for significant inequalities of incomes and wealth, but not for such large disparities as exist today.  There are valuable human activities which require the motive of money-making and the environment of private wealth-ownership for their full fruition.  * * * [I]t is not necessary for the stimulation of these activities and the satisfaction of these proclivities that the game should be played for such high stakes as at present.  Much lower stakes will serve the purpose equally well, as soon as the players are accustomed to them. – John Maynard Keynes [1]   

In  The 30-Year Growth of Income Inequality we discussed how the Reaganomics contention that “cutting taxes” (read: “for rich people”) stimulates growth is wrong.  It doesn’t stimulate growth – it actually persistently depresses growth and leads to greater income and wealth inequality.  I.e., Reaganomics is the direct opposite of how the economic system actually works.

When people accumulate wealth they try to invest it wisely for more growth.  Corporations respond only to the profit motive, and over time enrich their owners.  These earnings are increased wealth, and if the history of the last 30 years proves anything, once this wealth is obtained it is not gratuitously returned to the people at the bottom that originally produced it.  Instead, corporations struggle constantly to decrease costs (including exporting jobs) and manipulate markets to maximize profits.

As we have discussed, stimulus requires getting more money into circulation, so in a recession (like today) taxes must be cut for people who will spend money, not people who will simply increase their wealth.  Likewise, a healthy economy requires a consistently healthy supply of money in circulation, and a consistent, optimal inequality of incomes and wealth.  When the rich have too much money and everyone else does not have enough, not only is economic justice sacrificed, but the economy can’t do as well as it should.

It is the demand for goods and services that stimulates economic activity, and leads to an increased supply of goods and services, not the other way around.  Growth depends on increased productive economic activity, and that in turn depends on the economy functioning at a high level of employment, and people receiving income sufficient to increase demand.  Optimizing growth, therefore, requires a taxation policy that optimizes the inequality of income and wealth and income.  We discuss why this is so in a separate post on progressive taxation and a stable inequality stable inequality in the context of the Reagan Revolution.

An optimal taxation policy would likely have resulted in about 1.50% more growth over the last 30 years.

            It’s impossible to know exactly what would have happened over the last 30 years without the Reagan Revolution.  However, we do know that in the period of American prosperity, the previous 35 years, income grew at a faster rate than over the last 30 years.  Let’s take another look at the graph showing this [2]:

For the 35 years prior to 1980, we think 8.5% is a reasonably conservative estimate of the average annual income gains for the entire economy. [3] Over the last 30 years, as we have seen, income gains have been almost entirely limited to the top 1%, so its rate of income gain (7%) is representative of the period’s growth. We think it’s reasonable to conclude that an optimal taxation policy over the last 30 years could have produced additional annual income growth on the order of 8.5%, about 1.2x the income growth that actually occurred.

That’s a huge difference. But of course we must not forget this:  For people in the middle class and lower, who would have potentially seen 8.5% growth rather than the 1% or less growth they actually experienced, the full effect of Reaganomics and unbridled capitalism has been catastrophic.   

The top income tax rate for income and wealth distribution stability is approximately 70%.  

As discussed earlier, wealth and incomes tend to accumulate at the top. The only way to prevent that from happening in a modern economy is to use the tax mechanism of government to redistribute wealth back down, effectively neutralizing this natural tendency.  In practical terms, an optimal tax rate enables free enterprise to be at its best, providing optimal innovation and growth. 

As the tax rate graph shows, in the 35 years between WWII and the Reagan presidency, the top income tax rate ranged between 70% and 90%:

          That was America’s period of prosperity, a period that provided optimal growth, and opportunity for the average citizen and the middle class.  The income distribution graphs [4,5] show that from 1947 to 1980, the top 10% pretty consistently received about one-third of all income, and the top 1% consistently received about 10% of all income.

It is apparent that the 70% marginal tax rate on personal income successfully reined in excessive incomes and created equilibrium in the inequality of incomes and wealth.

Today’s Taxation

2011 Tax Rates

Tax Bracket Married Filing Jointly Single
10% Bracket $0 – $17,000 $0 – $8,500
15% Bracket $17,001 – $69,000 $8,501 – $34,500
25% Bracket $69,001 – $139,350 $34,501 – $83,600
28% Bracket $139,351 – $212,300 $83,601 – $174,400
33% Bracket $212,301 – $379,150 $174,401 – $379,150
35% Bracket Over $379,150 Over $379,150

Current rates for capital gains:

Below the 25% bracket:   0%

Above the 25% bracket:   15%

NOTE:  If you make $140,000 this year, you are in the 28% bracket.  Multi-millionaires and billionaires will pay at the marginal 35% rate for all earned income above $379,150.  Much if not most of their incomes, however, will be taxed at the 15% capital gains rate.

Big corporations like General Electric, Mobil/Exxon and Bank of America, most of whom have a global presence and global accounts, are getting better each year at avoiding U.S. taxes.  Some, like G.E., did not pay any taxes in 2010.

JMH – 4/11/11

__________

[1] John Maynard Keynes, The General Theory of Employment, Interest, and Money, first printing 1935, Harvest/Harcourt, Inc., 1953, 1964 ed., 1991 printing, p. 374.

[2] iTulip.com http://www.itulip.com/incomedistribution.htm , where the conclusion is affirmed that “persistent inequality leads to lower economic growth.”

[3]  We can safely assume that the weighted average rate of total income growth was dominated by the top three quintiles.  The linearly weighted average of the top three quintiles is about 8.8% average income growth over entire period.  That estimated percentage is probably high, however, because the increase in incomes from quintile to quintile is almost certainly non-linear.  A precise figure would have to be generated in a computer analysis, but an estimate of 8.5% overall growth appears reasonably conservative.

[4] Numerous sources: See ataxingmatter.blogs.com http://ataxingmatter.blogs.com/tax/democratic_egalitarianism/

[5] econfix.wordpress.com

[6] fivecentnickel.com

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