Finding a New Marcoeconomics: (5) Inequality and Taxation

Fairness requires that people who make more money pay a higher portion of their incomes in taxes than people with less money. That’s called a progressive tax system, and it’s been a foundation stone of America’s tax code. [1] – Robert Reich 

Each of the seven reforms that we have described yield a double dividend: enhanced economic efficiency and increased equality. But even after we do that, large inequalities will remain, and to provide revenues for public investment and other public needs, to help the poor and the middle class, to ensure the existence of opportunity for all segments of the population, we’ll have to impose progressive taxes and, most importantly, do a better job in closing loopholes. As we’ve seen, in recent decades, we’ve been creating a less progressive tax system. [2] – Joseph Stiglitz 

In Chapter 7, we saw that tax cuts didn’t create the Great Divergence, because changes in the distribution of pretax income were much larger than changes in the distribution of posttax income. Nonetheless, the federal tax system’s ability to mitigate income inequality has diminished. * * * A more progressive tax system would increase the government’s impact on income distribution, which was (and remains) substantial. [3] Timothy Noah  

These statements are from the latest books, all published in 2012, of three of the leading participants in the effort to save our economy from the strangulation of growing inequality. These are the most influential books on inequality coming out in 2012, but unfortunately they have left us hanging on the question of taxation.  

This is not a small matter: All three support higher taxation at the top of the income ladder, but none of them acknowledge that tax progressiveness is fundamental to controlling income and wealth distribution. The inequality cycle that has landed America in another depression began in 1980, with the expansion in the Reagan administration of the profitability of corporations. The huge reduction in taxation of the corporations and people who have received these excess profits has allowed them to keep and hoard huge chunks of the money supply, forcing the bottom 99%’s economy into an ever-worsening depression.  

What I have been saying for the better part of the past two years, but have not seen anyone else argue, is that because inequality is an ongoing process with hundreds of billions of dollars of wealth transferring to the top every year, the survival of the U.S. economy depends upon increasing taxes at the top to their former degree of progressiveness.  Vastly more taxation is needed to counter the continuous redistribution of income and wealth to the top through excess profits and other forms of economic rent. 

To attribute the need for higher taxes on top incomes only to “fairness” as Robert Reich does, and President Obama has been doing, overlooks this macroeconomic need for higher taxation at the top. Yes, tax progressiveness is a foundation stone of America’s tax system, but Reich has not yet (so far as I am aware) argued that the degree of tax progressiveness controls the degree of inequality growth, and that a certain degree of progressiveness is essential to economic survival.  To implicitly concede that tax increases at the top are not essential to growth and recovery is to implicitly grant supply-side advocates like Grover Norquist and Paul Ryan their argument that further tax reductions will not harm the economy — and their corollary argument that taxes at the top must not be increased.       

Joseph Stiglitz has presented the best analysis of income inequality to date, and he has recommended seven reforms to increase efficiency and reduce the ability of corporations and their owners to collect economic rent, all excellent suggestions.  He acknowledges that his proposals will take time to become effective, and that they will not be sufficient.   That’s important, because as the facts and analysis in the last two posts in this series suggest, the holes through which excess profits and other economic rents are siphoned to the top can only be partially plugged.

“After we do that,” Stiglitz states, “we’ll have to impose progressive taxes and, most importantly, do a better job in closing loopholes.” Although Stiglitz may not be suggesting that we actually wait until his other proposed reforms are in place before implementing tax reforms, still this hardly seems like a ringing endorsement of progressive taxation. If Stiglitz agreed with me that more progressive taxation is essential to recovery and growth, why would he argue that closing loopholes is more important than raising tax rates?  

A Paul Krugman protégé, Timothy Noah puts tax reform at the front of his list, even though Paul Krugman himself does not even mention increased taxation in his latest book as a potential factor in economic recovery and growth. [4] Noah actually does emphasize the redistribution function of income taxation:

The income tax is . . . directly redistributive.  The government takes money from one group of people (through taxes) and then hands it over to another group (through government benefits and appropriations).” [5]

His train quickly derails, however, with his conclusion that “tax cuts didn’t create the Great Divergence, because changes in the distribution of pretax income were much larger than changes in the distribution of posttax income.”  This conclusion is both incorrect and confusing: If a more progressive tax system “would increase the government’s [substantial] impact on income distribution,” how could a less progressive tax system (reducing the top income tax rate) fail to increase income inequality? We’ll review Noah’s reasoning after we review the relationship between taxation and income inequality.

Progressive Taxation and Inequality

Once the distributional effects of taxation are recognized, the causal relationship between taxation and inequality is apparent.  Concentrating income and wealth at the top, we noted earlier, restricts consumption and demand, constricting the 99%’s economy.  That’s why we’re in a depression.  The obverse proposition is also true: Reducing the concentration of income and wealth at the top expands the 99%’s economy.  

It is worth noting that this was obvious to Keynes and others of his day.  Immediately after he started his last chapter by identifying “the failure to provide for full employment” and the “arbitrary and inequitable distribution of wealth and incomes” as the two outstanding faults of the modern market economy, Keynes remarked:     

Since the end of the nineteenth century significant progress towards the removal of very great disparities of wealth and income has been achieved through the instrument of direct taxation — income tax and surtax and death duties — especially in Great Britain. [6]

In their 2007 study, Thomas Piketty and Emmanuel Saez provided this definition of “progressive” taxation:

[A] tax system can be defined as progressive if after-tax income is more equally distributed than before-tax income, and regressive if after-tax income is less equally distributed than before-tax income. [7]  

This is an excellent definition of tax progressiveness, because it depends on more than just tax rates: Increasing tax rates at the top and/or decreasing tax rates at the bottom will tend to make taxation more progressive, but given that today all income growth is going high within to the top 1% (121% to the top 1% in 2009-2011), much depends on how government spends incremental tax revenue so as to redistribute income back down. The distribution of after-tax income would not become substantially more equal if people were effectively required to spend their money at “the company store;” for example, if a huge increase in unemployment insurance payments all had to be spent at Walmart. 

In addition to higher taxation and government spending, dynamic changes in the economy are required, including improved employment, median incomes, and small business earnings, for the economy to work its way back to a healthy income distribution.  But no amount of stimulation will work, as I will show in this blog series, without sufficiently progressive taxation to stop the bleeding.  Recovery will be much more difficult than it was for reduced tax rates at the top to aggravate inequality and cause income decline over the last 30 years, as detailed in the last two posts in this series, while both insufficiently “progressive” taxes (as defined by Piketty and Saez) and a Walmart-style excess profit machine have been at work in the economy.  Why? Because regardless whether inequality is increasing or decreasing, an unfettered capitalist economy is constantly creating more excess profits and inequality. That’s what it does; it’s the ultimate objective of every for-profit enterprise:

DP8675aThis graph, which I have discussed extensively in other posts, including most recently “Amygdalas Economica: Perspectives on Taxation” (here), pretty much says it all. The economists who created the graph (Thomas Piketty,  Emmanuel Saez, and Stefanie Stantcheva) explain their conclusions regarding the information it presents:

Two important lessons emerge from this panel. Considering first the top income share excluding realized capital gains which corresponds roughly to income taxed according to the regular progressive schedule, there is a clear negative overall correlation between the top 1% income share and the top marginal tax rate: (a) the top 1% income share was high before the Great Depression when top tax rates were low (except for a short period from 1917 to 1922), (b) the top 1% income share was consistently low between 1932 to 1980 when the top tax rate was uniformly high, (c) the top 1% income share has increased significantly since 1980 after the top tax rate has been greatly lowered. * * *

Second, the correlation between the top shares and the top tax rate also holds for the series including capital gains.  Realized capital gains have been traditionally tax favored (as illustrated by the gap between the top tax rate and the tax rate on realized capital gains in the figure) and have constituted the main channel for tax avoidance of upper incomes. [8]

They did not present regression results to show the high inverse correlations between the top tax rate and capital gains tax rate and income inequality; the close correlations are apparent on close visual inspection.  

Their explanation of inequality growth has evolved considerably since their first paper in 2001, in which they suggested: (1) that “the ‘technical change’ view of inequality dynamics [suggested by Kuznets in 1955] cannot fully account for” the U-shaped pattern of income inequality change over the century; (2) that “the large shocks that capital owners experienced during the Great Depression and World War II seem to have had a permanent effect;” (3) that “a plausible explanation is that steep progressive taxation, by reducing drastically the rate of wealth accumulation at the top of the distribution, has prevented large fortunes to recover fully yet from these shocks”; and (4) as for the recovery of top wage shares since they “dropped precipitously” during WW II, “we emphasize the role of social norms as a potential explanation for the pattern of wage shares.” [9]

As an initial cut at explaining the strange new income distribution patterns they had discovered, this was a creative effort.  At least they acknowledged then that progressive taxation reduces the rate of wealth accumulation — although they only focused on how “steep”  progressiveness had “drastically” reduced wealth accumulation after WW II, when the middle class was growing and American prosperity was rising. Ten years later, they no longer suggest this favoritism toward wealth accumulation, so far as I am aware, but their “social norms” explanation was still being promoted in 2012 by Paul Krugman [10] as the best explanation for income inequality growth, while he ignored the macroeconomic effects of taxation they now emphasize.    

The Piketty and Saez data show that top income shares respond immediately to reductions in the effective taxation of top incomes. The reason for this seems straightforward: reducing taxation of top incomes immediately increases the conversion of economic rent into idle wealth, depressing the active economy. The after-tax incomes of the very wealthy are immediately increased by hundreds of billions of dollars, while the bottom 99% money supply is correspondingly shrunk, as a large portion of those billions are retired from active circulation.   

In November of 2012, the Congressional Research Service (CRS) published a regression study by Thomas L. Hungerford confirming the Piketty and Saez 2011 results.  His study shows a high correlation between the top 0.1% of incomes and the top tax rates, from 1945-2010: top tax rates and income shareAlthough the import of these results is clear, Hungerford only cautiously reported them: “The top tax rate reductions appear to be associated with the increasing concentration of income at the top of the income distribution. * * * Tax policy could have a relation to how the economic pie is sliced — lower top tax rates may be associated with greater income disparities.” [11]  Maybe. 

It is startling to see this point hedged, since everyone from Keynes to Piketty and Saez have virtually taken it for granted that taxation redistributes income. Nonetheless, the CRS withdrew this report “against the advice of the agency’s economic team leadership,” after Senate Republicans “raised concerns about this paper’s findings and wording.” [12]

Hungerford’s study also confirmed that since 1945, and especially since 1980, the average effective tax rates for the highest-income taxpayers have declined significantly: [13]

Average taxes highest income taxpayers 145-2009Timothy Noah’s Mistake

Timothy Noah concluded, we pointed out at the top, that  “tax cuts didn’t create the Great Divergence (the growing income inequality over the last 30 years), because changes in the distribution of pretax income were much larger than changes in the distribution of posttax income.”  The logic chain that leads to this confusion begins this way:

[T]ax brackets, including the top one, tell you only the marginal tax rate, that is, the rate on that portion of earnings exceeding a given threshold.  The percentage of total income that you actually pay in taxes is known as the effective tax rate.  And the effective income-tax rate on top incomes, you might be surprised to learn, didn’t change all that much. [14]

Noah is correct that what matters is the effective tax rate on top incomes, because it reflects the actual impact of taxation. However, his conclusion that the effective rate on top incomes has not declined much is wrong: As shown in the previous graph from the Hungerford study, the effective tax rates of both the top 0.1% and the top 0.01% have fallen dramatically since 1980.  The Hungerford study suggests that the U.S. needs effective tax rates in the 40-45% range from its top earners (along with a restoration of former corporate earnings tax levels) to counter inequality growth. 

For the effective tax rate not to decline when the marginal top rate was being slashed would have been nearly impossible; there would have to have been a major, continuous offsetting increase in tax loopholes, over the thirty years, as the top rate declined. 

Noah got off track during his review of the study of the progressiveness of the entire federal tax system Piketty and Saez published in 2007. [15] Whether federal taxes are high enough to be sufficiently progressive to retard inequality growth is an important question, but that’s a different question than whether effective income tax rates declined when the marginal rates did.

Noah’s erroneous conclusion that effective taxes on top incomes have not declined over the past thirty years appears to stem from a source of confusion in the Piketty and Saez 2007 study.  That was a study of all income-related taxation and, as they explained, the category “corporate tax” allocates among income classes corporate retained earnings using capital gains (computed from income tax returns in their data base) as a proxy. Capital gains were therefore excluded from the computation of “individual tax” amounts to avoid a double-count. 

This graph displays for both 1960 and 2004 the cumulative effective tax rate of each of the four federal taxes included in the study, over the entire range of income classifications:

fed tax rates 2004 and 1960

“Capital gains” are shown here as “corporate tax,” so the graph shows the effective income tax rate on top incomes, including capital gains, declining from about 50% in 1960 to about 30% in 2004.  This history is entirely consistent with both the correlation between the top marginal rates and the top 1% share Piketty and Saez identified in their 2011 study, as well as the correlation between the top effective rates and the top 0.1% and 0.01% income inequality  shown by Hungerford.

Optimal Taxation of Top Incomes

The data from the studies reported in this post indicate that it is only when the top marginal income tax rate is at or above 70% and the effective tax rates on top 0.1% and 0.01% incomes are in the 40-45% range that we have not seen rapidly rising income inequality.  A capital gains rate of at least 35% seems essential. Of course, all taxation has income and wealth redistribution effects, and it would be an oversimplification to argue that income and capital gains taxes are the entire issue. However, those are the taxes that are applied to the money that the wealthiest among us take as excess profits and other forms of economic rent, so it should not be surprising to find that the progressiveness of top income taxation is so highly, and inversely, correlated to the growth of inequality and the decline of the economy.

Inequality is about the accumulation of wealth at the top when that wealth is not taxed back down. There is a continuous accumulation of transferred wealth to the top, perpetual income inequality growth, and a continuous decline for the bottom 99% whenever taxation of top incomes and wealth is inadequate to keep this process in check.

I find these conclusions inescapable: (1) The top economic responsibility of government is to regulate income and wealth distribution, and; (2) Maintaining a sufficiently progressive tax system is its primary tool in doing so. The high correlation Piketty, Saez and Stantcheva have shown among wealthy countries between their top tax rates and their top 1% income shares confirms that this is the reality we face.

Conclusion

So far, these conclusions are not materially shared within the economic community.  Stiglitz and Reich have come closest to this position.  However, Paul Krugman, America’s most influential Keynesian, continues to ignore the macroeconomic role of taxation.  The next post will address this lingering marginalization of distribution issues and explain how it is creating confusion and muddling the debate over appropriate policy, enhancing the effectiveness of the efforts by the “trickle-down” forces to prevent the policies needed for recovery and economic health.         

JMH – 5/15/2013

______

[1] Robert B. Reich, Beyond Outrage: What has gone wrong with our economy and our democracy, and how to fix them, Random House, Inc., NY, Kindle Edition, 2012, KL1151.

[2] Joseph E. Stiglitz, The Price of Inequality: How Today’s Divided Society Endangers Our Future, Norton, NY, Kindle Edition, 2012, p. 273.

[3] Timothy Noah, The Great Divergence: American’s Growing Inequality Crisis and What We Can Do about It,  Bloomsbury Press, NY, 2012, pp. 179-180.

[4] Paul Krugman, End This Depression Now!,  W.W. Norton & Company, NY (2012), Ch. 12, “What It Will Take,” pp. 208-223.

[5] The Great Divergence, supra, p. 110.

[6] John Maynard Keynes, The General Theory of Employment, Interest and Money, Signalman Publishing, Kindle Edition, 2010, p. 251.

[7] “How Progressive is the U.S. Federal Tax System? A Historical and International Perspective,” by Thomas Piketty and Emmanuel Saez, Journal of Economic Perspectives, Volume 21, Number 1, Winter 2007,  p. 4 (here).

[8] “Optimal Taxation of Top Labor Incomes: A Tale of Three Elasticities,” by Thomas Piketty,  Emmanuel Saez, and Stefanie Stantcheva, Centre for Economic Policy Research (CEPR), DP No. 8675, November, 2011, pp. 24-25 (here).

[9] “Income Inequality In the United States, 1913-1998,” by Thomas Picketty and Emmanual Saez,  National Bureau of Economic Research (NBER), Working Paper 8467, September, 2001, p. 1 (here).

[10] Paul Krugman, End This Depression Now!,  W.W. Norton & Company, NY (2012) p. 81.

[11] “Taxes and the Economy: An Economic Analysis of the Top Tax Rates Since 1945” by Thomas L. Hungerford, Congressional Research Service (CRS), September 14, 2012  (here).

[12] “Nonpartisan Tax Report Withdrawn after G.O.P. Protest,” by Jonathan Weisman, The New York Times, November 1, 2012, here.  The report was subsequently updated on December 12, 2012 (here).

[13] Id.

[14] The Great Divergence, supra, p. 111.

[15] “How Progressive is the U.S. Federal Tax System? A Historical and International Perspective,” supra.

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