Inequality update

Greg Mankiw has an excellent piece in an upcoming issue of the Journal of Economic Perspectives taking aim at the issue of inequality. While the entire essay is worth a read, particularly powerful are his rebuttals of a couple of common leftist arguments in favor of income redistribution:

The first is the suggestion that the tax system we now have is regressive. Most famously, during the presidential campaign of 2008, at a fund-raiser for Hillary Clinton, the billionaire investor Warren E. Buffett said that the rich were not paying enough. Mr. Buffett used himself as an example. He asserted that his taxes in the previous year equaled only 17.7 percent of his taxable income, while his receptionist paid about 30 percent of her income in taxes (Tse 2007). In 2011, President Obama proposed the “Buffett rule,” which would require taxpayers with income over a million dollars to pay at least 30 percent of their income in federal income taxes.  

There are, however, good reasons to be skeptical of Buffett’s calculations. If his receptionist was truly a middle-income taxpayer, then to get her tax rate to 30 percent, he most likely added the payroll tax to the income tax. Fair enough. But for Buffett’s tax rate to be only 17.7 percent, most of his income was likely dividends and capital gains, and his calculation had to ignore the fact that this capital income was already taxed at the corporate level. A complete accounting requires aggregating not only all taxes on labor income but also all taxes on capital income. 

 

The Congressional Budget Office (2012) does precisely that when it calculates the distribution of the federal tax burden—and it paints a very different picture than did Buffett’s anecdote. In 2009, the most recent year available, the poorest fifth of the population, with average annual income of $23,500, paid only 1.0 percent of its income in federal taxes. The middle fifth, with income of $64,300, paid 11.1 percent. And the top fifth, with income of $223,500, paid 23.2 percent. The richest 1 percent, with an average income of $1,219,700, paid 28.9 percent of its income to the federal government. To be sure, some taxpayers aggressively plan to minimize taxes, and this may result in some individual cases where those with high incomes pay relatively little in federal taxes. But the CBO data make clear that these cases are the exceptions. As a general rule, the existing federal tax code is highly progressive.

He then turns his sights on the notion that the rich should pay more for government because they benefit more from its services than others:

A third argument that the left uses to advocate greater taxation of those with higher incomes is that the rich benefit from the physical, legal, and social infrastructure that government provides and, therefore, should contribute to supporting it. As one prominent example, President Obama (2012) said in a speech, “If you were successful, somebody along the line gave you some help. There was a great teacher somewhere in your life. Somebody helped to create this unbelievable American system that we have that allowed you to thrive. Somebody invested in roads and bridges. If you’ve got a business -- you didn’t build that. Somebody else made that happen. The Internet didn’t get invented on its own. Government research created the Internet so that all the companies could make money off the Internet. The point is that when we succeed, we succeed because of our individual initiative, but also because we do things together.” 

 

In the language of traditional public finance, President Obama was relying less on the ability-to-pay principle and more on the benefits principle. That is, higher taxation of the rich is not being justified by the argument that their marginal utility of consumption is low, as it is in the frameworks of Okun and Mirrlees. Rather, higher taxation is being justified by the claim that the rich achieved their wealth in large measure because of the goods and services the government provides and therefore have a responsibility to finance those goods and services. 

 

This line of argument raises the empirical question of how large the benefit of government infrastructure is. The average value is surely very high, as lawless anarchy would leave the rich (as well as most everyone else) much worse off. But like other inputs into the production process, government infrastructure should be valued at the margin, where the valuation harder to discern. As I pointed out earlier, the average person in the top 1 percent pays more than a quarter of income in federal taxes, and about a third if state and local taxes are included. Why isn’t that enough to compensate for the value of government infrastructure?

 

A relevant fact here is that, over time, an increasing share of government spending has been for transfer payments, rather than for purchases of goods and services. Government has grown as a percentage of the economy not because it is providing more and better roads, more and better legal institutions, and more and better educational systems. Rather, government has increasingly used its power to tax to take from Peter to pay Paul. Discussions of the benefits of government services should not distract from this fundamental truth. 

Mankiw also makes this astute point:

In the end, I am led to conclude that concern about income inequality, and especially growth in incomes of the top 1 percent, cannot be founded primarily on concern about inefficiency and inequality of opportunity. If the growing incomes of the rich are to be a focus of public policy, it must be because income inequality is a problem in and of itself. [emphasis mine]

Something the left struggles mightily to demonstrate. Absent this, inequality continues to be a sham issue wielded by the left to justify the imposition of long desired agenda items.