Reducing inequality: how to pay for it

April 17, 2009

The Labour Party returned to power in the U.K. in 1997 based in part on a pledge by Tony Blair and Gordon Brown not to raise taxes’ share of the British economy. In his 2008 presidential campaign, Barack Obama promised to reduce taxes for the bottom 95% of Americans. In both instances this commitment succeeded in insulating the progressive candidate from what had become the right’s most powerful electoral club: stoking fear of tax increases by the left.

But while it may be smart electoral politics, committing not to increase taxes’ share of GDP, as Blair did, or to lower taxes for most of the population, as Obama has done, makes it difficult for a government to make much headway in addressing income inequality. Obama has some leeway; the economic crisis has necessitated increases in government spending that can justifiably excuse some backtracking on his campaign pledge. Fully consistent with his promise, he should increase the tax rate on high-end incomes (beyond simply letting the Bush reductions expire). Two other progressive tax reforms are worth pursuing, though they would affect some in the bottom 95%. One is to reduce or end the homeownership subsidy. More than 80% of the $160 billion in foregone revenues from the deduction for mortgage interest and property tax payments goes to households in the top income quintile. The other is to introduce a modest tax on financial transactions.

But should the focus be confined to steps that make the tax system more progressive? Many on the left view heightened progressivity as the key to inequality reduction. Yet in the United States and other rich countries the tax system overall, including taxes of all types and at all levels of government, is essentially flat; households throughout the income distribution pay roughly similar shares of their market income in taxes. As the following chart shows, inequality reduction is achieved not through taxation but with government transfers (and services).

Taxes help to reduce inequality mainly via their quantity rather than their progressivity. The greater the tax revenues, the more government is able to boost incomes and living standards of those in the lower half of the distribution with transfers and services.

Moderate or high levels of tax revenue can’t come solely from higher rates or new taxes on the rich; the math simply doesn’t work. To significantly increase spending on transfers and/or services, President Obama and/or his successors will need to increase taxes on the middle class. One way to do this would be via a federal consumption 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 dismissed by the American left. But they can be tweaked to limit the degree of regressivity. And if the money is put to progressive use, the benefits may outweigh this drawback.

7 Responses to “Reducing inequality: how to pay for it”

  1. beezer Says:

    I’m for using all available tools. If a “tweaked” consumption tax, in combination with more pregressive tax rates, does the trick, then do it by all means!

    The challenge is being able to convince the population that some strong benefit will result. Universal health care is such a benefit that must be sold. Unfortunately, it must also be delivered in relatively short order. Incremental improvements won’t turn the trick.

  2. Norman Says:

    So, when the ‘inequality’ is reduced by taking money away from the highest earners what will people do about it? Since most all of the ‘inequality’ comes about through the upper end being much more educated than the lower end, as higher taxes start to bite our young people get a whiff of this they’ll decide that college just isn’t worth it any more. So, gradually we’ll get less and less highly educated people in the workplace (like in Europe). And what this will mean is that our productivity and real GDP growth will decline. People will react in their own best self interest, like it or not. They just won’t work their butts off knowing that a big piece of their effort will go to others.

  3. gordon Says:

    This comment (with links in place) appeared under Prof. Kenworthy’s cross-post here at Crooked Timber.

    Even if Prof. Kenworthy is right and the effective household rates over all forms of tax are effectively flat, is that an argument for introducing a regressive VAT?

    I note in passing that individual effective rates for all taxes in the US aren’t flat across income quintiles (ack. Economist’s View), and household rates for Federal taxes alone aren’t flat(.pdf) (ack. CBPP) either. That doesn’t prove that Prof. Kenworthy is wrong, but maybe he could give us a reference.

  4. Zephyr Says:

    I think the attraction of a VAT is that it is simple and harder to avoid.

    It also taxes people based on their lifestyle – the better you live the more you are taxed. And the rich do indeed spend far more than the poor.

    And a VAT could be structured to reduce the tax burden on the poor by exempting the most basic needs that dominate their budget. Thus, it could be progressive.

    A VAT is less subject accounting gimmickry to reduce tax. Besides, corporations just pass most of their income tax through to consumers anyway, in the pricing. So the poor are already indirectly paying more tax than people recognize.

    But I do not think we could rely entirely on a VAT. The rate
    would be too high.

  5. 2slugbaits Says:

    Zephyr,

    Today’s VATs (mainly in the form of state and local sales taxes) have a fairly high self-enforcement rate, but I think that’s largely because those taxes are not all that large and in most cases not worth the avoidance costs. But if we start talking about adding a federal VAT to replace the income tax, then all bets are off. Then you’ll start seeing all kinds of tax avoidance schemes coming out of the wall.

    We need to go back to the philosophy of the Bradley 1986 tax reform; we need to flatten rates in exchange for broadening taxable income. Prior to the 1986 tax reform, credit card interest was deductible. Congress was right to eliminate that tax deduction. The same should apply to mortgage interest rate deductions…although due to immediate problems in the houseing market it might not be a good idea to eliminate that deduction right away.

  6. matt Says:

    In a previous post you support a broad expansion of the EITC. So let’s say President Obama had promised that instead of the MWP credit. How would he then justify raising taxes?


  7. Gordon: I’ve now added a link in the post to another post showing how our tax system is essentially flat.

    Zephyr and 2slugbaits: No, we shouldn’t replace the income tax with a consumption tax, for a variety of reasons.

    Matt: He’d argue that the money is needed for a program that will provide broad benefits — universal health care, high-quality child care, enhanced public transportation, supports for victims of economic change, and/or others. The expanded EITC would then function to partially or fully offset the increase in taxes. This would be a bit analogous to the EITC’s initial rationale, which was to offset payroll taxes.


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