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The Income Inequality Obsession
One of the great political divides in the United States concerns the role of the state in redressing income inequality across individuals and groups. Recently, the outspoken conservative commentator Dennis Prager noted that in one representative debate during the 2016 presidential campaign, the words, “Wall Street”, “tax,” “inequality,” and “wealthy” were used 59 times by Democratic candidates. In contrast, “ISIS,” “terrorism,” “free,” “debt,” “liberty,” and kindred terms gathered a scant 10 mentions.
The choice of words reflects legislative priorities. As Michael Tanner of the Cato Institute observes, the Democratic position resonates broadly in the electorate given the increasing inequality of wealth. By noting the diminishing marginal utility of wealth, progressives hope to increase social welfare by taxing the rich in order to support the poor. Today, the top 1 percent of taxpayers, who earn just under 20 percent of total individual income, also pay just under 40 percent of all individual income taxes. So ironically, redistribution programs depend on continued successes at the top. In light of the relatively low economic growth and prolonged wage stagnation of recent years, what price is presently paid for the increase in social equity?
Right now, the Republican tax reform will take minor steps to reduce tax progressivity. The GOP’s policy does not stem from any deep conviction that richer individuals pay higher rates because they receive greater services from government. Quite the opposite: Government expenditures have moved smartly in the opposite direction, toward income and wealth transfers through Social Security, Medicare, Medicaid, unemployment insurance, food stamps, and more. There have also been declines in infrastructure spending, which benefits rich and poor alike.
It is therefore important to step back from the current controversies and ask whether responding to inequality of income and wealth should continue to receive pride of place. At the philosophical level, the basic debate boils down to a choice between the classical liberal position that seeks to maximize the total size of the pie, and the egalitarian position that seeks to reduce the differences in the size of the slices by combining progressive taxation with redistributive spending policies. It is important to spell out the implications of both positions in both the short and the long run.
Under the classical liberal tradition, the emphasis is on growth, by making Pareto improvements or changes in the tax scheme that generally leave each person better off and no one worse off. The Pareto constraint ensures that all social programs will create net social gains by supplying such public goods as defense, courts, and roads—but it also says little about the distribution of those gains. Ideally, to stabilize the political environment, those gains should be fixed across individual citizens in proportion to their own investment in the system, so that each person gets the same return on public investments as on private ones.
This regime creates the minimum disconnect between public and private investments. It also reduces wasteful political competition for a larger fraction of the gains from cooperative activities, and thus tends to maximize the total gains from collective schemes, while honoring an entrenched notion of fairness that holds that no person should get a disproportionate share of the gain from well-conceived social adventures. It furthermore simplifies the administration of any income tax because there is no longer any need to put into place complicated rules against income-splitting between parties or income-shifting over time, which are commonly used to minimize the brunt of the flat tax.
To be sure, by design, any flat tax necessarily increases the absolute differences in wealth between given individuals. Consider a program in which a social improvement worth $220 is funded by $110 in taxes. The person who pays $10 in taxes ends up with $10 in gains. But the person who puts in $100 ends up with $200 in gains. Hence the absolute gap in wealth rises from $90 to $180.
Yet from a dynamic point of view, these economic consequences are not as stark as they seem. The absolute increase in the size of this gap assures that those persons who do make it up the income ladder will continue to garner an ever larger fraction of the social surplus that comes from their own larger contribution. Nor, critically, are distributional consequences of this tax regime as dire as these simple numbers suggest.
First, the only feasible tax base comes from some combination of income and wealth. But most people attach equal or greater weight to their non-pecuniary assets, such as personal happiness, health and family satisfaction, than to their financial ones. But those former ones are beyond the power of any government to tax. The distribution of such non-pecuniary assets (which depends only in part on economic wealth) is much tighter than the distribution of wealth. Thus, consider the distribution of gains in life expectancy over time across all income levels—it has increased roughly from 47 years in 1900 to about 76 years in 2000. More specifically, increases in life expectancy for the black population has averaged 35 years for men and 41 years for women, compared to increases in the white population of 28 years for men and 31 years for women. Those gains are not concentrated in the top one percent. Though it is still better to be rich than poor when it comes to longevity, the gains are widely distributed through the population. It is not as though the rich can now live to be 200 years old. Similarly, simple vaccines and medicines available to no one in 1900 are widely distributed today, so that the increase in life expectancy is paralleled by a decline in morbidity for all groups of the population.
Second, the exclusive focus on income received ignores the importance of consumer surplus—the amount by which people value goods over the price that they pay for them. In other words, billionaires like Jeff Bezos, Bill Gates, and Mark Zuckerberg get only a small fraction of the social gains produced by their innovation. The lion’s share goes to the ordinary people who access new technologies or buy low-cost goods at a fraction the total value that they receive from those products. Yet those gains, because not realized in cash, are systematically excluded from the overall social calculus.
Third, for technical reasons, the traditional measures of income inequality overstate gaps between the rich and the poor. The distribution of income and consumption are not identical. There are major formal and informal income transfer systems—notably charitable giving and intra-familial transfers—that typically narrow the consumption gap between top and bottom. Indeed, that result still holds under a flat income tax devoted exclusively to public goods, because it is highly doubtful that a person who earns $1,000,000 in income each year gets 100 times the benefit from public expenditures as a poor person.
The egalitarian position emphasizing growing income inequality has given rise to the current discontent. Philosophically, the initial function of taxation and regulation has shifted from maximizing the size of the pie to minimizing the gap between rich and poor individuals. The strongest justification for that position is that it takes advantage of the diminishing marginal utility of wealth, which holds that redistribution can improve social utility even when, by design, it reduces social wealth. The great risk of this approach is that the resulting social losses could be steep.
To take a variation of the original example, the egalitarian could, in principle, support a social change that reduces the wealth of the rich person from $100 to $70 if it increases the wealth of the poor person from $10 to $11. Few people would wipe out $30 worth of wealth from one person in order to add $1 in wealth to another. But the challenge for the egalitarian is to offer some general approach for how wealth should be transferred by taxation (as opposed to charity). This is hard to do because no one knows how quickly utility diminishes with wealth.
The preferred approach, therefore, is first to try to minimize social losses by seeking to give poorer people a larger share of the gains from sensible social projects. But doing so turns out to be far more difficult than expected. Increasing progressivity risks hampering wealth creation. Lowering taxes somewhat should produce higher levels of growth but lower levels of redistribution. The political tendency, therefore, is just what we observe: locking the individual tax rates where they are and seeking to get social gains by lowering corporate rates and deregulating other areas of the economy.
Indeed, the first order of tax reform is to make sure that the individual tax rates do not become more progressive. But a bolder and more sensible program is one that cuts top marginal rates in order to stimulate growth increases that will counteract the wage stagnation at the bottom.
© 2017 by the Board of Trustees of Leland Stanford Junior University
Published in Economics, Law
There are no poor in this country.
A super-concise mini-rant in five steps:
[Added:]
Statements like “the top X wealthiest people own more than the bottom Y percent of the population combined” are misleading. Something like 25% of the US population has no net worth, their liabilities exceed their assets (ie., student loans.) So if you have any positive net worth, you have more than the bottom 30% or so combined. (Someone probably access to accurate numbers.)
Republicans have to turn stop quivering in the face of the income inequality argument. I’m proud to live in a country that’s still free though where, if you invent a better mousetrap, the world will beat a path to your door and make you fabulously wealthy. That’s a good thing.
What does the OP mean by “diminishing marginal utility of wealth”?
Also, aren’t wealth and income two different things? I’ve known people with high incomes who really didn’t have any wealth, which I think means accumulated assets.
I have to agree with Professor Epstein on the tax side, but not necessarily on the spending. A tax should raise the necessary income with the least distortions. A flat tax would do that as would a VAT. The base should be as broad as possible. A VAT does that as well. Spending is a separate issue. Generally, spending is guided by political interests constrained by the fact that some government expenditures are necessary. Income inequality is a political phrase/position without much meaning, but there is political spending that reduces human flourishing. Welfare in all it’s forms is such expenditure. There may be ways to transfer material benefits to relatively poor people but it certainly cannot be done by a remote and unaccountable Federal government. The issues and rhetoric surrounding these transfer issues are rooted in historical materialism, which assumes that materialism is all that matters to humans which is obviously not true and that remote bureaucrats who are not accountable for how they spend or the harm they do actually care, which is also obviously not true. Republicans are as intimidated by these issue as they are about race so they feed the beast even as the cede the ground and arguments to the dishonest demagogues.
One other thing, if we really wanted to tax the rich fairly we’d eliminate the corporate profits tax entirely and treat all profits as income of the holder of record. Unearned capital gains are the vehicle for extreme wealth that’s why the Soros Buffets and Gates of the economy invite income tax increases. They barely pay them.
I’m currently playing a game (don’t judge me) where the interpersonal interactions is like a microcosm of global politics. Its a bit more petty, but its a game and the pieces aren’t real – it can afford petty.
There is one man who is “pay to play” and incredibly wealthy. If I spent money on this game like he did, I’d be broke… and we are pretty well off.
It doesn’t matter what he does to us or what we do to him, he remains unharmed and we are destroyed because of how he spends money in this game. And yes, the rest of us are bitter about it.
But in this country, we have this thing called a US Constitution that declares we are all equal under the law. But in practice, this is not true. Overwhelmingly, by virtue of the completely acceptable in affording expensive lawyers or by corruption, the wealthy are a lot less affected by the law than the not-wealthy.
If you want to put an end to this pursuit of income equity, some effort needs to be put in to restoring equity before the law. And that needs to start with our elected officials. They don’t get to break the law and simply resign as punishment.
If you live paycheck to paycheck earning your first $100,000 is life changing. If you already earn $1,000,000, earning an additional 100,000 is nice, but not life altering. If you are Warren Buffet, the next $100,000 is a rounding error. You never notice it.
added- and I just realized that I too used income instead of wealth. But the diminishing marginal utility argument is the same…. the next additional unit conveys less usefulness/satisfaction than the one before.
That phrase caught my attention too. Wealth and income are two different things. I agree that some high income people have debts larger than their assets and live paycheck to paycheck. Taxing wealth seems wrong to tax what you already paid taxes on.
I thought the diminishing marginal utility of wealth could mean that at some point having more doesn’t mean much for quality of life. It never dawns on liberals that the wealthy have worries too. The rich guy worries a lot about losing what he has. If you don’t have assets, torts don’t enter your daily calculus. If you start to aquire assets, you take steps to protect those from being vulnerable to theft, lawsuits, etc. I have heard many times where someone didn’t sue an at fault driver because they didn’t have anything. All those call Lee free ads prey upon the insured or wealthy.
I agree that liberals really don’t like private property ownership (except theirs of course).
I tried to explain to someone who used the terminology “income inequality” that Warren Buffet having bajillions of dollars didn’t mean I had fewer dollars. It has nothing to do with fairness, either.
To me, it’s all about the choices we make: how to apply yourself and your skills in the world to earn and create personal wealth. If I decide to apply myself and study something that leads to a lucrative career, that is one choice. If I choose instead to sit on my butt and wait for someone else to take care of me, that would lead to a different outcome.
Agreed. People have to stop worrying about how much the other guy has and worry more about how to make themselves more valuable to an employer or customer.
The whole income inequality argument is, in general, the exact same logic used by your average armed robber:
I want money.
They have money
I’m going to use force to make them give me some of theirs.
I understand the theory behind the concept of diminishing marginal utility of wealth. A poor person who has no money for food will get more benefit from $10 (so he can eat) than would Bill Gates (who would never even notice an extra $10 of wealth). But this analysis only holds if you only look at individuals, and not at society as a whole. Leaving aside the rare to non-existent example of the starving person, it is not at all clear that society would be better off if everyone below the median income had some extra money, but companies like Microsoft, Apple and Amazon disappeared. Yes, Gates and Steve Jobs and Jeff Bezos have (or had) a lot of wealth in the form of ownership of their companies. But the very existence of those companies benefits society in ways that a marginal increase of wealth for the below median person could not.
After the Russian Revolution, all of the large estates were confiscated by the government and divided up among the peasants. As a result, the quality of life for everyone diminished.
Income inequality is another way of saying accumulation of capital. Accumulation of capital is what distinguishes well-off societies from poor and miserable societies. If you want to see what a society looks like if there is no income inequality, take a trip to Cuba or much of Africa. Everyone is poor, and there is no income inequality. That’s the leftists’ dream, isn’t it?
Somewhat random thoughts on the Income Inequality Topic:
Thank you. I appreciate the explaination.
It is the politics of envy. Some would rather have everyone reduced to poverty rather than have someone be better off than them. And then politicians are happy to play off this envy — so long as the politicians get to remain better off and out of poverty, or, paraphrasing George Orwell, be more equal than others.
Look, all of this philosophical talking is wasted time, bytes, etc. We are fighting the most basic of human urges.
The most powerful deadly sin is that of envy. It drives all of advertising, it provides most motivation for rich and poor alike. Everyone wants to “be somebody”, and all aspire to look good- the little kid says “Watch me, Mommy!” as he does a somersault.
When we “grow up” and become aware of peer groups other than our admiring parents, our “watch me” turns into buying cars, houses, clothes, iPhones, walking into exclusive restaurants, pretty girls all going after the Alpha Male- anything that measures our position relative to our peers. This drives almost everything.
So, if you are a politician who can feast on envy, jealousy of those who appear to have more, you are in great shape- because there is always someone out there doing better, looking better, than we are. Have you ever written a Ricochet member post and felt satisfaction at being promoted to the Main Feed? You just did the Ricochet equivalent of “Watch me, Mommy”.
So, in today’s world, we have unlimited TV showing the rich and beautiful, while we struggle along in our small and limited lives. Adults (of whatever age) who live by true values (most often inculcated by religious belief) understand that the real world is not Dynasty, and there is no conspiracy of Wall Street and Republicans Plutocrats holding you down. Most of us can easily see exactly why we are where we are in life; self-discipline/ability to defer gratification, inborn talent, and industriousness have a lot to do with it.
But it is always easier to appeal to envy and the unfairness of the 1% than it is to grow up. No reasoned arguments, no data will ever win this debate.
Life is not fair, and we need to spend more time looking for better answers that might help a little bit against the politics of envy. In years like this, especially when the rules of Congress and Congress itself are idiotic, we need to just batten down the hatches and hope that the train wreck is not as bad as it could be.
Note the compounding effect.
“Spreading the wealth” appeals to envy, the process has a consequence of enriching the politically connected, increasing “inequality”, requiring more wealth spreading.
That’s exactly right. Money isn’t like land or gold, meaning if one person has a lot, someone else has to have less. Wealth is created, not consumed, right? And it can be created pretty much ad infinitum. We dont have to take it from anyone.
This illustrates how out of date the argument over income/wealth inequality is. In Marx’s time (and his socialist predecessors), most of the wealth was derived from owning land or natural resources, and gold was money. Travel was also expensive, so it was hard to move to where land and resources were cheap. (Although millions came to the U.S.A for this reason). So a wealthy landowner or industrialist looked like a major obstacle to improving one’s lot.
Now, information technology generates most wealth in the form of intellectual property, bounded only by the laws of physics and our imaginations. Your getting rich from Angry Birds doesn’t keep anyone from developing Candy Crush. Intelligent men and women are the scarce resource, and then can go to whoever’s offering top dollar. The dynamic that Marx critiqued (inaccurately) scarcely exists in today’s economy.
We need to refuse to accept this as an “issue” and shame those who harp on it as outdated.
BTW, I’m not sure wealth cannot be consumed, although it is certainly created.
There is a tidbit from Behavioral Economics. People were asked to choose between:
A. Earning $100,000 and living in a neighborhood where everyone else earned 125,000
or
B. Earning 80,000 and living in a neighborhood where everyone else earned 60,000
Most chose B
I have a problem with this notion as it relates to either income or wealth. Diminishing marginal utility works nicely, and can be demonstrated experimentally for any specific thing, good or service. But when you are talking about wealth, you are really talking about something like command of many resources. So, why would we think that utility for every thing diminishes? If I have enough wealth and am able to purchase a Rembrandt, my marginal utility for a second Rembrandt may be increasing, and maybe it won’t decrease until my tenth or twelfth. In that case, how can the utility of the wealth required to buy a Rembrandt be said to be diminishing? If this is so, using the theory of diminishing utility for income as an argument for progressive taxation is wrong. Then, the best argument for progressive taxation is the same as Willie Sutton’s reason for robbing banks.
Probably not. It’s in The Wealth of Nations. Smith’s justification–alluded to by the OP–is that the wealthy derive a greater benefit from what the state does (military, courts, registrar of deeds) because they have property. Granted the argument would have been land tax vs. excise taxes and tariffs, but I can’t see how the same idea wouldn’t apply equally to a tax on income. What I don’t get entirely is how it applies to a country with a 63% home ownership rate and a social safety net.
Okay. I was only referring to Marx’s very specific “Heavy progressive or graduated income tax”.
A couple of factors that nobody has mentioned yet (I think):
One of the reasons capitalism defeated socialism in the 20th century is because, under capitalism, people who are good at engaging in economic activities gradually get a larger chunk of the economy to run. Whereas, under socialism, the economy eventually falls under the control of the (incompetent) relatives of powerful people, as well as people who are merely good at politics and bureaucratic intrigue. In other words, reducing inequality of wealth means taking from the competent and giving to the (relatively) incompetent.
The second point is that taxing corporations and businesses is merely a sneaky way of taxing the poor and middle class; i.e., the customers.
Actually, a large portion of the “poor and middle class” are the employees of corporations.
Good point: and taxing corporations makes those jobs go away.