Taxes and Inequality: Lessons from Abroad

February 10, 2008

For most left-of-center Americans, the paramount concern with respect to taxes is progressivity. The aim: reduce income inequality. The means: raise income tax rates for the rich and/or lower them for the poor.

A look at the experiences of other affluent nations suggests consideration of an alternative — though by no means antithetical — strategy.

The following chart shows the amount of inequality reduction achieved by taxes and by government transfers (social security payments, unemployment benefits, the Earned Income Tax Credit, and so on) in the United States and nine other rich countries. The calculations are mine, using data from the Luxembourg Income Study database, which provides the best available comparative data on incomes. Inequality is measured using the Gini coefficient. I calculate inequality in each country using household incomes before and after taxes are subtracted; the difference between the two is the amount of inequality reduction achieved by taxes. I do the same for government transfers. Being farther to the right in the chart indicates greater reduction of inequality.

None of these countries achieves much inequality reduction via taxes. Instead, to the extent inequality is reduced, it is mainly transfers that do the work.

The chief contribution of taxes to inequality reduction is indirect. Taxes provide the money to fund the transfers that reduce inequality. The next chart shows this. On the horizontal axis is a measure of the quantity of taxation: tax revenues as a share of gross domestic product (GDP). On the vertical axis is the measure of inequality reduction via government transfers used in the first chart above. Not surprisingly, countries that significantly reduce inequality via transfers tend to tax more heavily.

The comparative experience thus suggests that for inequality reduction, it is the quantity of taxes rather than the progressivity of the tax system that matters most. Affluent countries that achieve substantial inequality reduction do so with tax systems that are large but no more progressive than ours.

What lesson should Americans draw for tax reform? In my view, the key one is that a national consumption tax — as a supplement to the income tax, not a replacement for it — is worth serious consideration (see more here and here and here).

The drawback is that consumption taxes tend to be regressive; because the poor (by necessity) spend a larger fraction of their income than the rich, they pay a larger share of that income in consumption taxes. Yet the degree of regressivity is a political choice. It can be greater or lesser, depending on whether certain items, such as food, are exempted.

A national consumption tax (we currently have state and local sales taxes) would help to raise revenue. As the following chart shows, one way other affluent nations generate more tax revenues than the United States does is by making greater use of consumption taxes.

One possibility to consider: a national consumption tax on the order of 5% that is earmarked to fund universal health care, universal preschool, and/or high-quality child care. This would reduce the progressivity of the tax system somewhat, but the payoff might well be worth it.

41 Responses to “Taxes and Inequality: Lessons from Abroad”

  1. Erich Says:

    The United States is different than the rest of the world and that difference can be something to appreciate. Based on the federal structure, these policy proposals can be tested in individual states as a precursor to a national roll-out.
    States like Massachusetts or Wisconsin can run a trial balloon for different health programs, and citizens will vote for or against them in elections and with their feet.
    Given success, other states will follow the good models and people would inevitably push for a federal level policy.

  2. matt Says:

    you’re right that a consumption tax could complement progressive marginal rates. but shouldn’t they both be expanded at the same time? because imposing a regressive consumption tax will make the tax code significantly less progressive, perhaps much more regressive than other countries. higher marginal rates on income would be necessary to maintain its relative progressivity.

    in other words, a consumption tax shouldn’t replace considering increasing marginal rates as much as it should complement it.

  3. just curious Says:

    Great analysis, I just happened on this blog and it is definitely going to my shortlist of things to read. I was wondering what do you make all your graphs with?


  4. Just Curious:

    I create the graphs with Stata. Very glad you like the blog.

    Lane


  5. [...] an attraction to progressive causes should read Lane Kenworthy’s post on the relation between taxation and inequality.  Lane is making an argument that I’ve found persuasive ever since I first encountered it a [...]


  6. [...] 21, 2008 by WDW Taxes and Inequality: Lessons from Abroad « Consider the Evidence February 10, [...]

  7. Jehovanna Arcia Says:

    An interesting approach appears in this weblog. I just wish someone like the author would dare to say something like about poor countries like mine, Panama, where we are experiencing an economic growth but not a real social development. We are facing an arrival of rich pickings in Panama coming from rich countries like the ones you aforementioned, so I truly consider that if you pretend your approach to be used in USA, a society I personally don’t consider to be an egalitarian one but the opposite, many more Americans will become tax evaders, learning the lesson from their Europeans, and Australians counterparts.
    I just don´t think that all these people in my country really care about inequality reduction. Our society has become a very nasty one, and based on another studies done by an epidemiologist from UK, inequality has a great impact in the level of criminology in a given society.
    Congratulation for your good approach and thanks for sharing your expertise with us.

  8. Todd Says:

    Hi Lane, I’d like to post a response on my new blog at http://www.neitherpropertynorstyle.blogspot.com. Permission to copy and paste one of your charts? What are the rules governing that kind of thing in the blogosphere? We’re new to this, so just wondering. Thx!


  9. [...] Taxes and Inequality: Lessons from Abroad For most left-of-center Americans, the paramount concern with respect to taxes is progressivity. The aim: reduce income inequality. The means: raise income tax rates for the rich and/or lower them for the poor. A look at the experiences of other affluent nations suggests consideration of an alternative — though by no means antithetical — strategy. [...]


  10. [...] What should we conclude? I think the first chart here better reflects the impact of the U.S. tax system. It does very little to alter the market distribution of income. Redistribution is achieved mainly by government transfers rather than by taxes. We aren’t unusual in this respect, though; it’s the case in most if not all rich countries. [...]


  11. [...] What should we conclude? I think the first chart here better reflects the impact of the U.S. tax system. It does very little to alter the market distribution of income. Redistribution is achieved mainly by government transfers rather than by taxes. We aren’t unusual in this respect, though; it’s the case in most if not all rich countries. [...]


  12. [...] want to embrace non-progressive revenue sources? Well, fortunately Lane Kenworthy did an excellent post on this a year ago that contains graphs I can steal. The first chart shows that if you look around the one at what it [...]


  13. [...] That’s What I’m Talking About Just in case you thought my posts talking about moving towards a relatively flat tax structure, but a big, universal spending structure were the ravings of a crazed man, I am not alone. [...]


  14. [...] today I was thinking about the same Lane Kenworthy post Matt Yglesias discusses here. The upshot is that if you want to reduce inequality through [...]

  15. Joe Calhoun Says:

    It seems to me that there are several things that need to be addressed if, as a country, we want government to occupy a larger portion of the economy. The European states are able to reduce inequality through transfers, but it comes at a high price to growth. We need to reduce the tax burden on capital/investment for a supply side shock and at the same time impose the VAT or sales tax. The regressive nature of the VAT or sales tax can be corrected through tax credits for lower incomes. You need higher growth to reduce unemployment or we will just end up lowering our overall living standards. There is a plethora of research showing that taxes on capital are less efficient than taxes on consumption. That being the case, a cut in taxes on capital and a concomitant imposition of a VAT or sales tax should produce a higher growth rate which in turn should produce higher revenue for government. I am not advocating eliminating taxes on capital or income, but reducing them to relieve the growth inhibiting behavioral consequences.

    Another thing that gets ignored in the inequality debate is the role of monetary inflation and political corruption. Living in Miami, maybe I have a better view of what causes inequality because I’m so close to Latin America, but it seems obvious that these two factors are correlated with inequality. There is academic research to back that up:

    http://econpapers.repec.org/paper/cprceprdp/3470.htm

    There are others as well, but I don’t have time to dig them up. There is also a correlation between gini coefficient and inequality.

    When I speak of inflation, I use the classic definition of an increase in money supply relative to demand. If one thinks about how inflation of money and credit is distributed, I think it becomes clear that inflation of the money supply is a signficant factor in producing inequality. When new money is created by the Fed or the banking system, it is the wealthy that benefit first from this new money. As it circulates through the system, the price of goods and/or assets rise. By the time it reaches the poor the purchasing power of the new money has diminished.

    Over the last two decades we have seen three asset bubbles. Ask yourself who benefitted most from the internet bubble, the housing bubble and the commodity bubble. The wealthy who funded the venture capital firms who in turn funded the internet companies were obvious beneficiaries of the internet bubble. Poorer people were stuck buying the inflated stocks after they were floated on the market. In the housing bubble, the wealthy or relatively wealthy, already owned real estate which rose in price. In the commodity bubble, the poor got killed by high gasoline and food prices which had a relatively minor impact on the rich.

    If we are to reduce inequality and fund higher levels of social spending we cannot do it without a higher growth rate. Merely adding new taxes, regardless of their efficiency, is not the answer. The answer is to find a balance between consumption taxes and capital and income taxes. Any real answer will also have to address the serial inflations of the Federal Reserve. While a gold standard has many drawbacks, it may be the only way to restrain the inflationary tendencies of a central bank. At a minimum, the Fed should have its mandate reduced to maintaining the purchasing power of the dollar and leave growth management to fiscal policy.

  16. Joe Calhoun Says:

    Sorry in my comment I should have said there is a correlation between gini coefficient and corruption.

  17. John V Says:

    Does your chart on tax revenues as a percent of GDP only refleft federal taxes or state and local as well?

    This is a worthy consideration since those countries in the chart are unlikely to have the amount of multi-layer taxes from Federal and state like the U.S.


  18. [...] in their distributional impact." Matt also had some snazzy charts, which in turn, he got from Lane Kenworthy. Kenworthy did his own analysis of the data and concluded that "The chief contribution of [...]


  19. [...] also had some snazzy charts–which, in turn, came from Lane Kenworthy. Kenworthy did his own analysis of the data and concluded that The chief contribution of taxes to [...]


  20. [...] also had some snazzy charts–which, in turn, came from Lane Kenworthy. Kenworthy did his own analysis of the data and concluded that The chief contribution of taxes to [...]

  21. anonymous Says:

    I don’t understand how funding social/welfare spending with regressive taxes is preferable (to most Americans) to funding with progressive taxes.

  22. Joe Calhoun Says:

    Anon,

    Governments can raise more revenue with consumption taxes because they aren’t as distorting as taxes on capital and income. You can fund higher levels of social/welfare spending with consumption taxes without limiting economic growth as much.


  23. [...] The obvious justice in this system would take the legs out from under Republican rage. This is the ultimate goal, because it would, in theory, make it easier to gain public support for social programs like universal healthcare. Universal healthcare could do more for the lower and middle classes than almost any form of progressive taxes. Not only is the government the only entity large enough to bargain for lower healthcare costs (MRI cost in America= $1,200, MRI cost in Japan = $98) but it’s been shown that government spending on social programs can be more effective than progressive taxation at closing the gap between the rich and the poor. [...]


  24. [...] tax, such as a value-added tax (VAT). We have state and local consumption (sales) taxes, but we raise less money from consumption taxes than any other rich country. Consumption taxes are regressive, and for that reason they’re [...]


  25. [...] tax, such as a value-added tax (VAT). We have state and local consumption (sales) taxes, but we raise less money from consumption taxes than any other rich country. Consumption taxes are regressive, and for that reason they’re often [...]


  26. [...] is only one way to reduce income inequality, and perhaps not even the most useful one. Yglesias and Kenworthy have shown that it’s not the tax system as such but targeted government spending that [...]


  27. [...] The obvious justice in this system would take the legs out from under Republican rage. This is the ultimate goal, because it would, in theory, make it easier to gain public support for social programs like universal healthcare. Universal healthcare could do more for the lower and middle classes than almost any form of progressive taxes. Not only is the government the only entity large enough to bargain for lower healthcare costs (MRI cost in America= $1,200, MRI cost in Japan = $98) but it’s been shown that government spending on social programs can be more effective than progressive taxation at closing the gap between the rich and the poor. [...]


  28. [...] pretty overwhelmingly indicates that the main reason these countries are more egalitarian is that they have equality-generating policies. Northern European countries do much more redistribution through transfer payments than we [...]


  29. [...] presents these charts from Lane Kenworthy demonstrating that Europe taxed more and reduced inequality via taxes and government transfers than [...]


  30. [...] We had eleven folks last night, a typical turnout in numbers but a better-than-average-quality discussion, I thought.  Thanks to Jim for his research, presentation, and for running the meeting.  The subject was poverty, but as a follow-up, let me start with a post on inequality.  Here is a chart that shows how much inequality the U.S. Government actually alleviates through taxing and spending, compared to nine other rich countries.  (source) [...]


  31. [...] What should we conclude? I think the first chart here better reflects the impact of the U.S. tax system. It does very little to alter the market distribution of income. Redistribution is achieved mainly by government transfers rather than by taxes. We aren’t unusual in this respect, though; it’s the case in most if not all rich countries. [...]


  32. [...] What should we conclude? I think the first chart here better reflects the impact of the U.S. tax system. It does very little to alter the market distribution of income. Redistribution is achieved mainly by government transfers rather than by taxes. We aren’t unusual in this respect, though; it’s the case in most if not all rich countries. [...]Forex Programming


  33. [...] of most other affluent nations are slightly regressive. Details from Peter Whiteford, Lucy Barnes, me, and more from me. Share [...]

  34. sudo Says:

    Nice post, thank you!


  35. [...] Taxes, transfers and inequality reduction. (wonkish, but a must read if you want to be a [...]


  36. [...] — you can move to a different country, but it’s harder, and given that the United States has a less redistributive tax and transfer system than any other advanced country, the option doesn’t really come into [...]


  37. [...] we need to come to terms with what “higher taxes” is going to mean in practice. U.S. taxation is actually as progressive as in Europe because we have taken so many families off of the income tax rolls. The added boost to raising [...]


  38. [...] ¿Por qué? si queremos redistribuir renta, los impuestos son un instrumento muy torpe. Echemos un vistazo a esta gráfica: [...]


  39. [...] The obvious justice in this system would take the legs out from under Republican rage. This is the ultimate goal, because it would, in theory, make it easier to gain public support for social programs like universal healthcare. Universal healthcare could do more for the lower and middle classes than almost any form of progressive taxes. Not only is the government the only entity large enough to bargain for lower healthcare costs (MRI cost in America= $1,200, MRI cost in Japan = $98) but it’s been shown that government spending on social programs can be more effective than progressive taxation at closing the gap between the rich and the poor. [...]


  40. What about fiscal policy? Almost half of US tax revenue is spent on the military. We’ve got the stingiest welfare system of any OECD nation. But we could afford to transfer more with the taxes we already have.


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