The Ethics of Human Rights (29): Should Taxation Be a Tool For Economic Efficiency or For Social Justice?

Taxation is a recurring theme in political discussions between people of the left and right. People of the left see taxation as a tool for social justice. They tend to prefer rather high taxation rates and a progressive taxation system:

  • High taxation rates bring in revenues that are large enough to enable the government to spend on programs and transfers that are designed to promote social justice: unemployment benefits, poverty reduction policies, education, healthcare etc.
  • Progressive taxation rates are just because they impose relatively (and not just absolutely) higher taxes on people who are more able to pay, and, in addition, reduce income inequality and hence realize another goal of social justice.

People on the right usually favor low tax rates and a non-progressive taxation system (either a proportional system in which everyone pays the same share of their income, or a regressive system in which everyone pays more or less the same amount in taxes). Rather than on social justice, they focus on the economic effects of taxation.

  • They reject high taxation rates because they claim that these high rates discourage people and are a disincentive to hard work, effort and investment. Because high rates limit effort and investment, they also limit productivity, innovation, international competitiveness and job creation.
  • They also reject progressive tax rates because high tax rates for high incomes discourage those people who work relatively hard (they work hard supposedly because they earn a lot) and who are most likely to innovate, to be productive and competitive and to create jobs.
  • However, they don’t necessarily favor regressive taxes because they are equally hostile to high tax rates for low income people, albeit for other reasons. High taxes for low income people discourage them from entering the labor market and hence inflate unemployment. Still, they claim that the worst damage is done by high taxes on the higher incomes, which is the reason they reserve particular scorn for progressive taxation systems. Because high tax rates for the wealthy punish the most productive elements in a society, the whole of society suffers. More productive people will limit their productivity because they don’t want to fall into a higher tax bracket, and the money they pay in taxes can’t be invested in the economy. High tax rates, especially for the rich, have an unacceptable cost in terms of economic efficiency. Keeping taxes low, on the contrary, and allowing wealthy people to use their money in the economy, will ultimately benefit everyone (this is the so-called Trickle-Down theory).

Of course, this distinction between left and right is a caricature. Most people on the left are also concerned about economic efficiency, and most on the right are not insensitive to questions of social justice. The extremes are hardly ever encountered in real life: no one wants to limit taxes to such an extent that economic efficiency is promoted but no money is left for justice, and no one wants to put tax rates at such a high level that there is ultimately no more economy to tax. (The latter concern is expressed in the famous Laffer Curve arguing that beyond a certain level of tax rates government revenues in fact decrease instead of increase. At very high rates there is no longer any incentive for a rational taxpayer to earn any income and hence tax revenues will decline while tax rates increase. However, it isn’t clear what “very” in the previous sentence actually means and where exactly the tipping point is situated).

Personally, I believe that the concerns of both right and left are justified and need to be balanced, and that too much focus on either the element of efficiency or justice is detrimental to the other element. On the one hand, there’s only so much money a government can raise without wrecking the economy, and justice isn’t only about spending money (there can even be perverse effects such as unemployment traps, welfare dependency etc.). On the other hand, there’s only so much an efficient economy can do to realize social justice all by itself and quasi-automatically (remember the invisible hand…). To quote Matthew Yglesias’ sarcastic comment on the skyrocketing incomes of the U.S. top 400 earners in the decades leading up to the 2009 recession:

As is well-known, the Top 400 are considerably more talented than the rest of us. And [the] decline in their tax rates has created exciting new incentives for them to apply their talents. And that, in turn, is why the 2000s were a so much more economically successful decade than the 1990s, not just for the Top 400 but for the rest of us as well. Thanks to their skyrocketing incomes and falling tax rates, we’re currently [during the 2008-2009 recession, FS] all enjoying the fruits of prosperity, rapid growth, and low unemployment. Thanks rich guys! (source)

A similar sentiment is expressed in this clip from the Daily Show (skip to the 4th minute or so).

I believe taxes in the U.S. are relatively low and can be raised without too much harm to economic efficiency. The resulting government revenues could then be spent on improving the social safety net and promoting social justice. It’s difficult to imagine for a European that a country such as the U.S. doesn’t offer health insurance to millions of its citizens. Also, unemployment benefits are quite stingy in the U.S., both in terms of eligibility and duration: only one third of the unemployed qualify for benefits and only for 26 weeks (extendable during recessions if the Republicans don’t object, as they infamously did beginning of 2010).

The system of unemployment benefits could easily be improved without perverse effects or harm to economic efficiency. And there are other areas of possible improvement as well.

However, as a European in Europe, I think there’s a strong argument that the social safety net in Europe (at least in some countries) has harmed European competitiveness, labor market participation and innovation.

Still, is there evidence of this? What do the data say about high tax rates harming economic efficiency, in Europe and in general? Is the conservative case against taxes as strong as it seems? I’m afraid not. There’s some evidence that the effect of reasonably rather than extremely high rates on economic efficiency is minimal at best. Here’s more evidence from Lane Kenworthy about the U.S. and other affluent countries (always keeping in mind that correlation doesn’t imply causation and that the absence of a large negative effect of high taxes doesn’t preclude the possibility that lower taxes would have had a large positive effect). One measure of economic efficiency is economic growth. If we plot economic growth rates for the U.S. against tax rates for the wealthy we see that higher tax rates lead to more growth. But of course there can be catch-up effect: higher rates producing their effects only years later. That’s taken into account in these graphs, which also show that an international comparison doesn’t prove that countries with higher tax rates have lower growth.

If we have a look at the data about the effect of high tax rates on unemployment (another conservative concern), we also see that we shouldn’t panic about taxes.

Now, if there is no good reason not to tax at a moderately high level, based on concerns about economic efficiency, the question remains whether there is a good reason to tax based on social justice reasons. Given the caveat that social justice isn’t all about government spending (I argued <a href="http://here that it is primarily about something else) and that such spending can in some cases have perverse effects (see above), I do believe that some spending is necessary in some cases, and that relatively high tax rates are necessary to produce the revenues required for this spending.

Again following Kenworthy, I believe that relatively high tax rates are acceptable and even necessary to create the revenues required for social justice policies, but that progressive tax rates in themselves don’t do the job of reducing income inequality, contrary to what is often claimed as a justification for progressive rates. That doesn’t mean that we shouldn’t reduce income inequality (it’s quite high in the U.S.) – there are good reasons to try. It just means that progressive taxation in itself won’t do the job. The important thing is to have high tax revenues which can then be spent in transfers and services that reduce income inequality and achieve other goals of social justice. Yet, I still think a progressive system is required, not because of its supposed effects but simply because it is just in itself, compared to proportional or regressive systems. A person with more income can afford to pay, not merely more in an absolute sense but more in the sense of a larger share of his or her income.

The Causes of Human Rights Violations (19): Ideology

From Reinhold Niebuhr’s Moral Man and Immoral Society:

Since inequalities of privilege are greater than could possibly be defended rationally, the intelligence of privileged groups is usually applied to the task of inventing specious proofs for the theory that universal values spring from, and that general interests are served by, the special privileges which they hold.

That’s the basis of trickle down economics which is a theory about how inequalities ultimately benefit everyone. It’s also the basis of tax schemes such as a flat tax that limit forced redistribution, because the invisible hand will redistribute wealth or make it trickle down automatically.

And, when trickle down is discredited and when it turns out to be difficult to prove that inequality is a universal value, we hear that inequality isn’t as big a problem as it seems, and that this is the land of opportunity where even people who are on the wrong side of inequality can make it through hard work and discipline. Even Obama seems to believe this, as is clear from his inauguration speech. That’s a classic case of the anecdote turned into a “scientific” law. Data show that social mobility isn’t what the American Dream dreamers think it is. Implicit in this story is that existing inequalities are the sole responsibilities of individuals who haven’t made diligent use of the many opportunities this land has generously provided them. Discrimination, injustice, greed and lack of compassion are obscured as causes of inequality.

In reality, inequalities are indeed greater than could possibly be defended rationally, in the words of Niebuhr. The defense based on trickle down economics has failed, as has the defense based on the claim that inequalities are the sole result of individual choices and a lack of response to opportunities (this defense completely rejects effects of discrimination, which seems to be misguided).

However, it’s not because inequalities are greater than they should be that all inequalities are wrong. Some inequalities are unavoidable or even valuable. We do want Einsteins and Picassos. Society should reward merit. We all benefit from the recognition of exceptional individuals. Nietzsche for example rightly protested against the modern habit of cutting everyone down who dares to stick his head up. Equality of outcome is in many respects distasteful. And apart from the valuable inequalities, there are unavoidable inequalities. Some inequalities that are the result of the “lottery of birth” are impossible to correct: some people are born with more talent than others or with talents that are more appreciated in the economic or cultural market; and there will always be people who are born in privileged families.We wouldn’t want to engage in genetic engineering in order to redistribute talent, and neither would we be willing to redistribute children across families (at least not for the purpose of equality of opportunity).

Other aspects of the lottery of birth, however, are more difficult to defend. Why should the good luck of being born in a wealthy family with educated parents guarantee you a better education, better healthcare and better economic prospects? But of course it isn’t just the contingency of your place of birth that determines your opportunities and you future place in society. Some people are pulled down by discrimination or bad luck. We justifiably don’t accept that people’s prospects in life are fully determined by their family, luck or discrimination.

Again, equality of opportunity is different from equality of outcome: most of us don’t think it’s a good idea to strive towards equality of outcome in most spheres of life. We’re quite happy to accept that some people earn less money, have less vacation time, have lower social status and recognition levels and have more uncomfortable, dangerous, or physically draining work etc. What we don’t accept is that those outcomes are predetermined by the family they happen to be born in, by discrimination they suffer or by other instances of bad luck.

Economic Human Rights (32): The Economic Cost of Taxing the Rich

Taxation is linked to human rights in several ways:

I personally belief that a progressive tax is best in light of the last two concerns. In a progressive taxation system, higher earners pay a larger percentage of their income on taxes. Compared to a regressive taxation system (people with higher incomes pay less in percentage of their income, as in the case of a consumption tax or VAT) or a flat tax (the tax percentage is the same for all income groups), a progressive tax reduces income inequality: it makes incomes more equal in a direct way because it reduces the income of higher-earning families by a larger percentage than the income of lower earning ones; but also in an indirect way because this system – under certain conditions – yields more tax revenues which can then be spent on poverty reduction and the safety net. Also, it seems to be a good example of a just and fair system. The strongest shoulders should carry the most heavy burden. Someone earning a low income can end up in poverty after paying a small percentage in taxes; a wealthy person will perhaps not even notice paying a relatively large sum in taxes.

The counter-narrative states that high tax rates discourage people; they are a disincentive to hard work and effort. High tax rates for high incomes discourage people who work relatively hard (they work hard supposedly because they earn a lot). Because high tax rates punish the most productive elements in a society, the whole of society suffers. More productive people will limit their productivity because they don’t want to fall into a higher tax bracket, and the money they pay in taxes can’t be invested in the economy. Taxing the rich therefore has an unacceptable economic cost. Conversely, low tax rates for the rich produce benefits for all (this is trickle down economics, read also about the Laffer curve).

But this narrative doesn’t quite stand the test of data. As is clear from this link, high tax rates don’t slow down economic growth, and low tax rates don’t speed it up. This paper also supports the claim that moderate, as opposed to dramatic, increases in marginal rates don’t have any impact on the willingness of the wealthy to participate in the economy. They won’t go Galt. Atlas won’t shrug, except to signal indifference.

The top income tax rate was 91% (beginning at taxable income of $400,000) … [in] the period from 1951 through 1963. Those were the golden years of the U.S. economy, in which the average annual rate of productivity growth was 3.1% (compared with about 1.5% after 1981). Of course, the growth might have been even faster had the marginal tax rates been lower, but the coincidence of high rates and high productivity raises challenging questions for those who believe that high marginal tax rates carry an unacceptable cost. (source)

To be fair, marginal tax rates are a crude measures of tax burden. There’s a difference between marginal tax rates and effective tax rates.

  • A marginal tax rate is the tax rate that applies to the last dollar of the tax base (taxable income or spending, usually income). It’s not the rate at which all your dollars are taxed. It’s the maximum rate you’re paying on any of your dollars of taxable income.
  • An effective tax rate refers to the actual rate, i.e., the rate existing in fact, for the entire income, after tax deductions and credits and taking into account lower rates for lower income brackets (see here). It’s your total tax obligation (including your income tax and any other additional taxes and/or credits), divided by your total taxable income.

But even if we look at the effective tax rates of the rich, we see that this has steadily decreased over the decades, with little or no positive effect on overall economic performance.

And when there’s no positive effect of decreasing tax rates, there’s probably also no negative effect of increasing tax rates. To the extent that the wealthy (and productive, although those groups obviously don’t overlap completely) respond to changes in the tax system, their responses focus not on increased/decreased labor, productivity or investment, but on tax avoidance (see here).

Income Inequality (19): What To Do About It?

What to do about income inequality? Assuming of course that you agree that income inequality is a problem. How can we do something about the problem without destroying the incentives behind economic growth (assuming that much of economic growth is driven by financial rewards for effort, creativity, innovation etc. and that taking away resources from wealthy successful people takes away their will and creativity, hence driving down growth and making everyone, including the poor, worse off).

One thing that everyone thinks of is taxation, more precisely <a href="http://progressive taxation: this reduces the income of higher-earning families by a larger percentage than the income of lower earning ones. “Spreading the wealth around”, if you want. This makes incomes more equal in a direct way, but also in an indirect way because the tax revenues can be spend on poverty reduction (unemployment benefits, healthcare or education subsidies etc.). (An inheritance tax can also help, because it promotes social mobility and discourages income inequality that is not the result of economic incentives, and because a lack of social mobility is correlated with income inequality).

The problem, however, is that taxation is hardly ever progressive, even if it looks like it is:

Taxation in affluent countries does little to alter the market distribution of income. The reason is that taxes on income and corporate profits-which are progressively structured, reducing the incomes of high-earning households by a greater percentage than those of low-earning ones-are only part of the tax system. [But] their progressivity tends to be largely offset by the regressivity of payroll and consumption taxes. … Payroll and consumption tax rates usually are “flat”: the rate is the same regardless of individual or household income. Payroll taxes tend to be regressive because they apply to earnings rather than income, and wealthy households tend to get a smaller share of their income from earnings than do most households in the middle of the distribution. Also, payroll taxation often features a cap; in the United States, for instance, earnings above roughly $100,000 are not subject to the social security payroll tax. Consumption taxes apply to spending rather than income. They are regressive because lower-income households by necessity spend more of their income than their higher-income counterparts, so more of their income is subject to the tax. Lane Kenworthy (source)

Redistribution, then, does not occur through or because of the tax system itself, but through the systems of public spending.
Some interesting graphs
here. So it’s the amount of taxes, rather than the system of taxes, that enables governments to redistribute and reduce income inequality.

Income Inequality (15): Progressive Taxation

Yes, I know… another post (and a long one) on income inequality, something which isn’t even a human rights issue, strictly speaking. I repeat, the most important thing to me is the provision of basic necessities, not the unequal distribution of these necessities. The fact that someone is poor and homeless is a more important problem than the fact that some people earn more or have bigger houses. Human rights address the first problem, not the second. When human rights address the problem of inequality, it’s usually not income inequality but other types of inequality (unequal rights, discrimination, unequal representation or access to information etc.).

What’s the problem?

However, as I stated here, income inequality IS a problem. It can destroy the cohesiveness of a society when it surpasses certain limits. People lose their self-esteem when they see that they are relatively worse off (even though not necessarily poor), especially when their position in society isn’t completely their own fault, which is often the case. People’s income, even in supposedly meritocratic societies such as the U.S. and the U.K., depends heavily on their family and social environment, and not only on their own achievements. Income inequality therefore becomes a problem of justice, social justice. And it can also become a problem for democracy, in which case it becomes a human rights issue (democracy is a human right). On top of that, people tend to be healthier and to live longer in more egalitarian societies.

And finally, this paper shows that

increased income (or wealth) generally does not increase … happiness significantly, and to the extent that it does, relative income plays a greater role than absolute income. In light of this … redistribution, via a progressive income tax, will increase people’s utility (happiness) by improving their relative incomes.

What can we do?

So, there are many good reasons to reduce income inequality, or at least slow down the trend of increasing inequality. There are also many ways to do this. Progressive taxation, rather than regressive taxation or a flat tax, is one way, as stated in the quote (and here/here). Public social spending is another way, as are some measure to increase social mobility and reduce the correlation between parents’ income and that of their offspring (e.g. an inheritance tax). Better funding for education, and helping lower income people gain access to education (by way of vouchers or scholarships etc.) is also good policy.

In the current post, however, I want to focus on one aspect of policy, namely taxation. I want to defend progressive taxation against regressive or flat taxation, not because of reasons of economic efficiency – although these are important – but because it is a policy which can reduce income inequality.

What is progressive taxation?

Progressive taxation (an idea going back to Adam Smith if not before) means that those with a higher income pay a relatively larger share of their income on taxes, and that this share rises progressively when income levels rise. Earning more means paying more taxes, both in absolute terms (the amount of taxes paid) and in relative terms (the percentage of income paid on taxes). A concept often used to describe this is “increasing tax burden”, but that is misleading, as Ezra Klein has pointed out. A person paying more taxes both in absolute and relative terms, doesn’t necessarily carry a bigger burden:

A strong person carrying a 50 pound bag may feel less burdened than a weak person carrying a 20 pound bag.

Even if the 50 pound is larger compared to the body weight of the strong and healthy person than the 20 pound is to that of the weak and sick person. Klein again:

The average after-tax income of the average person in the middle income quintile is $52,100. That’s down from about $60,700 after an effective tax rate of 14.2%. In the top quintile, the after-tax income is $184,400, down from $248,400 after a 25.8% effective federal tax rate. The rich person certainly pays more, both in absolute terms and as a share of income. But is his burden greater than the middle-income taxpayer left with $52,100? It’s hard for me to see how.

A progressive tax system can also be defined by comparing it to the so-called flat tax. A flat tax usually means that everyone pays the same tax rate. As a result, rich people pay more taxes in absolute terms, but the same taxes as poor people in relative terms. Proponents of a flat tax system say that it stimulates economic growth because it takes away less money from the wealthy, who can then invest it in the economy. Such higher growth in turn leads to more revenue for the government, and hence more means to benefit the poor, for instance. A flat tax also leads to more revenue because lower tax rates for the rich means that they will be less inclined to cheat or avoid taxes, and because its simplicity eliminates loopholes and deductions.

However, these advantages, to the extent that they are real, don’t address the inherent injustice of the system.

How do you make taxation progressive?

The “progressivity” of taxes can be achieved in different ways:

  1. The most obvious way: a higher income means a higher tax rate.
  2. Rather than increasing the tax rate together with increases in the taxable amount (usually the wage or other types of income), one can also choose to increase the taxable amount for wealthier people while leaving the tax rate identical for everyone. Wealthier people would then have a larger “tax base”. For example, they may have less exemptions, deductions, tax credits etc., or they may have to pay taxes on luxury goods that only they can afford to buy. With one and the same tax rate for all, we still are able to introduce progressivity. This looks a bit like the flat tax.
  3. Or one can decide to have, like in the previous case, only one tax rate rather than rates rising with income levels, and exempt from taxes all income below $50,000 or something. This as well is a progressive tax, because people with higher incomes pay more taxes, both in an absolute and a relative sense.

Progressivity can not be achieved by moving the tax system away from income and towards sales taxes, VAT or consumption taxes. Such taxes are by definition regressive, because they impose a relatively higher burden on lower income taxpayers, who, after all, spend a larger proportion of their wealth and income on consumption, and therefore pay a greater share of their income on taxes.

Other options?

As mentioned above, progressive taxation 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 equalizes things. The important thing is to have a tax system that generates enough revenue to spend on counter-inequality measures (such as education, benefits etc.). Whether this system is progressive or not is secondary. According to Kenworthy, countries with higher tax revenues but not necessarily more progressive tax systems achieve more inequality reduction.