Should Taxes be Progressive?

Bruce Bartlett doesn’t like taxation that redistributes income:

Inequality: A Problem?, by Bruce Bartlett: Normally, when one reads a proudly left-wing magazine like The American Prospect one expects to read vocal denunciations of inequality. So there’s a certain man-bites-dog quality to a recent article by Dalton Conley, dean of social sciences at NYU and card-carrying liberal. He argues that those on the left should stop worrying so much about inequality per se–its costs are overstated, as well as the benefits of greater equality. Instead, he argues, liberals should concentrate more on helping the poor and less on beating up on the rich.

At the risk of getting Conley’s membership in the liberal club revoked, I think he is right. I have never understood how I am worse off if the top 1% of households increase their share of national wealth or income as long as the absolute level of wealth and income of the other 99% is unchanged. It may be aesthetically displeasing, but it doesn’t impose any actual costs on anyone as long as the pie is not fixed. …

Implicitly, liberals tend to believe the pie is fixed. But, generally speaking, it isn’t. A rising tide does tend to lift all boats even if those at the top get lifted a lot more. But Conley is also right to ridicule the view, common among many conservatives, that enriching the wealthy somehow automatically benefits the poor. That’s obviously nonsense. But neither does it follow that there is no limit to how much we can soak the rich without average people suffering some of the consequences. We really don’t want the rich spending all their time figuring out how to hide their wealth from the tax man or engaging in conspicuous consumption; we’d rather that they invested their wealth in businesses that will increase their wealth but also create jobs and income for the rest of us, too.

For this reason, I have always been more sympathetic to programs that aid the poor than other conservatives. It’s not so much that it’s the right thing to do as that it’s a necessary price that has to be paid to maintain democracy, open markets, private property, a stable currency and a tax system that doesn’t punish success too much. To be sure, there is a heavy price to be paid when social welfare programs go too far. But at the same time I don’t think the social Darwinist, Randian state in which people are left to die if they don’t work is the one that maximizes growth or well-being for the producer class.

Where I think the left is mostly wrong about inequality is in thinking that taxes level the playing field. But the only way taxes really create equality is by discouraging the rich from earning income. The nation is not enriched when this happens. …

I think we should simply give up trying to redistribute income on the tax side and accept that it can only be done meaningfully on the spending side. … The left would accept that the only purpose of the tax system is to raise revenue and the right would accept that a fairly extensive social welfare state is here to stay. … That’s more or less the way it works in Europe, where conservatives accepted the welfare state in return for having it financed conservatively through a value-added tax. Liberals accepted this regressive form of taxation in return for conservatives accepting the legitimacy and permanence of the welfare state.

Over the years, I have asked a number of liberal friends if they would take this deal. They would get a pot of net new government spending of some amount–say 1% of GDP–to spend any way they like to help the poor. But in return, they would have to let me have a low-rate, consumption-based tax system and I would agree to raise taxes enough to pay for the additional spending. It seems like a free lunch to me, but I’ve never found a liberal willing to even consider the deal. They are too wedded to maintaining steeply progressive tax rates on income as a matter of equity.

I’ve commented on this in the past:

Personally, I’m not much on redistribution simply to make outcomes more equal. But there are (at least) three reasons to depart from this. First, when there is change such that makes one group better off at the expense of another as has happened recently with globalization, and when redistribution can leave everyone better off, then redistribution is justified.

Second, I think everyone should have equal opportunity to be a CEO or a hedge fund manager, or whatever they want to be. However, the playing field is far from level and there is a lot more we could do on this side of the equation. Not everyone will be a CEO of course, or achieve their dream job whatever it might be, but everyone should have an equal chance to be one of the winners. In the meantime, until more has been done to level the playing field, progressive taxation is a means of making up for inequality in opportunity. [And allowing people to reach their potential will increase productivity – this is why both the nation and the individuals are worse off without redistributive taxes that overcome inequality in opportunity.]

Third, for me at least, progressive taxation is justified by the equal marginal sacrifice principle (the last dollar paid should cause the same amount of disutility for everyone). Thus, even if opportunity is equal, and even if there were no winners and losers to worry about, justification for progressive taxation would remain. I think a more progressive tax structure than we currently have is needed to equalize the disutility of paying taxes.

We could list “preventing a political backlash” as a fourth reason for redistribution. But I’m not sure we need to invoke the political economy argument. If we use progressive taxation in accordance with the three principles above, then income will be more equally distributed and a backlash … is less likely to occur.

Let me also add one more reason. A hidden assumption in Bartlett’s comments is that the income received by those at the top is justified because it matches their contribution to society (i.e., it is justified by their high productivity). But much of the high productivity that financial executives were rewarded for wasn’t really there, something that the financial crisis has made all too apparent. And looking at executive compensation outside of the financial sector, it’s hard to believe that it is only due to their productivity, i.e. that their pay is not augmented substantially by some sort of market failure. Thus, in general, there’s a strong case that pay at the top levels exceeds the contribution to society To the extent that progressive taxes represent a claw-back of these false rewards or a claw-back of rewards for something other than productivity, the taxes are justified.

Finally, if market power is present to a significant degree, as I’d argue it is in many markets, that will distort the flow of resources and distort profits. In this case rewards will reflect, in part, market power and pay will exceed productivity. If progressive taxation removes these distortions, then the taxes are justified. In some sense, it simply returns the income to its rightful owners.

When the flow of profits is distorted and some people fail to get what they deserve while others get more than they’ve earned, when opportunity is limited and people fail to reach their potential, when the burden of taxes is unequal, and when the distribution of the costs and benefits of globalization or some other economic change is unequal, there is harm from inequality — social welfare can be improved through redistribution — so I don’t buy the argument that there are no economic costs associated with inequality, or that taxes cannot level the playing field. Some of it, e.g. the creation of opportunity, can be accomplished on the spending side as Bartlett suggests. But someone has to pay for that spending, and I see no reason why the burden shouldn’t be progressive.

Originally published at Economist’s View and reproduced here with the author’s permission.