Taxes and Wealth Inequalities

I ran across an interesting observation in Fault Lines by Raghuram Rajan (a U of Chicago economist who has the distinction of being on of the economists who clearly and unequivocally warned of and predicted the recession well in advance of its occurance). Anyhow, I thought this quote fragment was insightful when viewing the distinct difference between left and right regarding income inequality, from the beginning of Chapter Nine:

Not all forms of income inequality are economically harmful. Higher wages serve to reward the very talented and the hardworking, identify the jobs in the economy that need the most skills, and signal to the young the benefits of investing in their own human capital. A forced equalization of wages that disregards the marginal contributions of different workers will deaden incentives and lead to a misallocation of resources and effort. 

However, when the only pathways to high wages are seen to be birth, influence, luck, or cheating, wage differentials may not act as a spur to effort. Why bother when effort is not the route to rewards? Ineed, as the political economists Alberto Alesina and George-Marios Angeletos argue, perception in a democracy as to how high wages or wealth are obtained can create self-reinforcing patterns. If society believes people earn high wages as a result of their training and hard work, it is less willing to tax high earners, thereby ensuring they have strong incentives to acquire skills and exert effort. If society believes people earn high wages because of connectedness, chance, or crookedness, then it will tax incomes more heavily, and since few of the honest will then bother to work hard, only those with influence, the lucky, or the cheats will flourish. 

The left and right in the US are distinguished in part by their willingness (or lack thereof) to tax high earners. The left like to pretend that the middle class right is “duped” into wanting to lower taxes on the wealthy because they are just stupid when in reality what is going on is that the middle class believes that the wealthy got that way in the main part due to their training and hard work. One might also observe that the left’s willingness to punish the wealthy will have its own negative social repercussions as noted above as well. 

Mr Rajan also points out that the willingness to tax high earners is higher than it was in the past and the above observation might be a clue to why that might be, that is our perception of who the wealthy consist as well as how they got that way is moving. This is unfortunate. 

 

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10 comments

  1. Boonton says:

    The left and right in the US are distinguished in part by their willingness (or lack thereof) to tax high earners.

    Kind of a strange thing to say when botht he Democratic President and Congress is pushing a tax cut for all taxpayers, high and low. Amazingly this is held up because ‘moderate’ Democrats join Republicans in demanding extra tax cuts for the top earners and refuse to pass anything that doesn’t give them it.

    Also very strange considering that if you go back just a few decades you have top tax brackets as high as 90%. The ‘willingness’ of either the left or the right to tax the highest earners does not seem to be very impressive. Objectively it seems to be less and less.

  2. Boonton says:

    Mr Rajan also points out that the willingness to tax high earners is higher than it was in the past and the above observation might be a clue to why that might be, that is our perception of who the wealthy consist as well as how they got that way is moving. This is unfortunate.

    But maybe the perception is correct. Over the last few decades the portion of GDP being generated by the ‘finance industry’ has increased faster than other pieces (except maybe health care)(and a lot of inequality is generated from inflating income there). It’s been an article of faith that this is because the finance industry does an essential job by driving savings into highly efficient investments providing investments with needed funds and savers liquidity. The collapse has raised legitimate questions as to whether the finance industry has gotten better or simply gotten more crafty.

    If higher incomes are not related to harder work or more intelligent work then higher taxes are not the harm that supply siders had legitimate complaints about when they were in the 70%+ zone.

  3. Mark says:

    Boonton,
    What are you claiming?

    That high earners are just that because of luck, inheritance, or cheating?

    That the left doesn’t want to tax the high earners more than the right?

  4. One can believe both that people earn salaries in the top 2% because of hard work and talent and that they should be taxed at a higher rate because they can afford it.

    It’s also important to note that lots of poor and middle-class people work just as hard but either don’t have the same talents (not their fault) or haven’t had the same opportunities (ditto.) There is plenty of luck involved in earning a salary in the top 2%.

  5. Boonton says:

    If by left you mean the President and the bulk of Democrats in Congress that would appear to be the case. Likewise if you’re arguing that we are ‘more willing’ to tax the wealthy then that too does not fit the historical record.

    Actually it’s not so much about luck or cheating but about a fundamental market inefficiency. IMO there’s something about finance that causes market results to be suboptimal. For example Wall Street has employed numerous math phd ‘quants’ to construct complex securities. Is this really a value added function or would the economy have produced more GDP if those ‘quants’ were, say, modelling fusion power plants or datamining health outcome databases for savings? Rajen’s hypothesis presupposes 100% of income differences are caused by ‘good factors’ such as greater effort, greater talent, greater risk taking etc. But to the degree its less than 100% higher tax rates can offset some of that distortion.

  6. Mark says:

    Boonton,
    Why is it “Rajan’s” hypothesis when he notes that this result is from a study and those study authors are noted.

    It seems to me that the hypothesis as given is reasonable and doesn’t “presuppose 100% of income differences” are from “good factors.” That’s quite a straw man you’re setting up.

    JA,

    One can believe both that people earn salaries in the top 2% because of hard work and talent and that they should be taxed at a higher rate because they can afford it.

    OK. So? How does that affect the thesis given above by those two economists or the suggestion that the differential opionions on left/right about taxing the wealthy is based on different impressions of how wealth is gained.

  7. Boonton says:

    What exactly is the hypothesis? That people who think the rich are more likely to have gotten their money thru luck or reasons other than ‘hard work and innovation’ are more likely to be friendly to proposals for higher upper tax rates? That’s not much of an insight. Kind of like saying people who think smoking is a selfish and self destructive activity are more likely to favor higher tobacco taxes.

    What’s more relevant is what is the reality. The argument against higher upper rates that makes sense is that upper income is earned by superior talent, effort or whatnot that will be withheld should it be taxed too much (let’s call it the Galt argument). This argument is 100% perfect if 100% of upper income falls into this category. But we know, of course, not all of it does. For example, lottery winners, if their ‘income’ was taxed at a higher rate society wouldn’t loose anything from their efforts because they aren’t doing anything productive but guessing numbers (which society doesn’t really need but if it ever did monkeys will be happy to do the job for jackpots a lot less expensive than $1M). This is a given but if the market systematically ‘overpays’ for whatever reason that undercuts, at least partially, the purity of the Galt argument.

  8. Mark says:

    Boonton,
    “what exactly is the hypothesis”, uhm, quoted from above

    perception in a democracy as to how high wages or wealth are obtained can create self-reinforcing patterns. If society believes people earn high wages as a result of their training and hard work, it is less willing to tax high earners, thereby ensuring they have strong incentives to acquire skills and exert effort. If society believes people earn high wages because of connectedness, chance, or crookedness, then it will tax incomes more heavily, and since few of the honest will then bother to work hard, only those with influence, the lucky, or the cheats will flourish.

    The issue is not just taxes, but it plays into investment by the young in human capital. I would suggest that this perception goes both ways, i.e., lowering taxes on the wealthy can signal to the young that the wealthy get there by dint of skill and effort and that the young should therefore apply themselves. That is that the perception is not just a self-fulfilling feedback loop, but that this perception can be influenced.

  9. Boonton says:

    It would seem there’s two hypothesis at play here. Taxes and perceptions. If high income is perceived as the result of crookedness that decreases the motivation for acquiring skills. Imagine people think winning gambling is the only way to achieve a high income. They will not invest in any skills beyond gambling. Lower taxes for the wealthy would just make things worse as it would increase the incentive to learn ‘honest’ skills for a middle class lifestyle since the ‘dishonest rich’ would be all the more richer.