Wednesday, February 13, 2008

Inequality, tax and spending

Can we reduce inequality without tackling the super-rich?

Yes, apparently. An interesting analysis by Lane Kenworthy (via Chris) suggests that redistributive government spending plays a much bigger role than progressive tax in reducing economic inequality.

He compares the Gini coefficient (measuring the degree of inequality) for household incomes in ten rich countries, but he does so both before and after tax, and both before and after government transfers. The amount of inequality reduction that the tax and redistribution systems achieve is shown here:

Two things are clear: income transfers reduce inequality by much more than tax does; and there is much more variation in the amount of equalisation that results from redistribution than in that from tax.

Lane also observes that the degree of inequality reduction does depend on the overall level of government spending, which of course depends strongly on the total tax take. These taxes need not be strongly progressive, though, in order for equalisation to take place.

I have two thoughts to add to this, by way of possible explanation.

First, increasing tax rates on the highest earners will only reduce their income by a proportion above the given threshold – it won’t put a cap on it. (And, as Vino says, the wealthy may be able to avoid many taxes, so reducing the scope for higher taxes on them to have real bite.) But redistributing to the poor guarantees their income won’t drop below the level of the benefits they receive. So the latter would seem likelier to have an effect on overall inequality.

Second, a recent Institute for Fiscal Studies study looked at high-income individuals in the UK. They found that the average income for all taxpayers (in 2004/05) was a little under £25,000. To get into the top 10% of earners, you needed to earn over £35,000. To get into the top 1%, you needed £100,000. And to get into the top 0.1%, you needed £351,000.

Clearly, the most striking inequalities are those appearing in the steepening curve at the top of the income scale; however, these inequalities involve a fairly small number of individuals.

To substantially cut inequality by taxing these people more, you’d need quite a large number of income tax bands at the top end of the income scale, each covering fewer and fewer people with higher and higher rates (a single high rate for the top 1% would ignore the huge inequalities within that group). Quite apart from whether this would be politically feasible or what economic effects it might have, it seems pretty impractical.

Conversely, though, to promote equalisation via benefits, you’d need to give the most to the poorest – which administratively (and politically) is much easier. There’s far less variation within the bottom 10% than there is in the top 10% – or even the top 1% – so precision targeting is far less of a problem.

What’s more, my own view is that the ‘poor people falling behind’ side of inequality is more troubling than the ‘rich people zooming ahead’ aspect. The Gini coefficient doesn’t distinguish between the two, but I think the former is obviously bad while the latter is very debatable.

(None of this is an argument against higher taxes on the very rich; it’s just to caution that this would not in itself reduce inequality by nearly as much as government redistribution could – whether the money comes from the top or across the board.)

1 comment:

donpaskini said...

It's fair enough to point out that there aren't very many extremely rich people, and that the actual income distribution doesn't often get taken into account when discussing how to reduce inequality.

I am nervous politically, though, about advocating a strategy essentially of 'leave the rich alone and tax the middle classes more to transfer wealth to the poor'. Two thoughts:

1. Taxing the middle class can be a 'something for something' deal. Higher taxes to pay for better public services benefits poorer people the most, but middle class people as well. It's a pretty good deal, for example, to pay taxes for the NHS rather than having lower tax but high health insurance premiums. One obvious way of extending this would be much larger childcare and housing subsidies - the cost of these take up a significant part of the income of most poor people, but also hits the middle class.

2. Even though there aren't all that many rich people, it's possible to raise quite a lot of money off them without much pain. Raising tax on earnings above, say, £100,000 could pay for direct wealth transfers to lift one million children and their families out of poverty, for example. This would also be good for the economy, as it would transfer money away from people who won't spend it to people who will.

I think this twin-track approach, tax the middle class for public services, and tax the rich for direct wealth transfers, is probably a more sustainable approach to reducing inequality. It's certainly what Finland, Sweden and others do.