The Causes of Wealth Inequality (22): Non-Progressive Taxation and Weak Transfers

This post applies to the U.S., but I guess the same conclusion are valid for a number of other countries as well. In the case of the U.S., very high levels of income inequality could, in theory, be reduced in several ways:

Unfortunately, very little of this is happening. Let’s focus on the last two options. The tax system in the U.S. is not progressive at all. As you can see from this graph, taxation in the U.S. hardly influences income shares.

The poor only get a little bit more thanks to taxes, and the rich only lose a little bit. This is all the more regrettable given the fact that the rich have done very well over the last decades.

Higher tax rates for the wealthy and other more progressive taxes such as a higher inheritance tax, a higher capital gains tax, a Tobin tax etc. are politically impossible it seems.

Increased benefits for the poor are equally unrealistic given the fiscal situation and the predominant ideology. Although the poor in the U.S. do profit from the existing benefit system in absolute terms (unemployment insurance for example saves millions from absolute poverty), income inequality barely moves because of it. Income shares after benefits are hardly less unequal than before. This graph shows the influence on income shares of the sum of taxes and transfers, but you get the picture.

Taxes and transfers result in the poor having a bit more and the rich having a bit less, but fundamentally they don’t change the distribution of income.

More posts in this series are here.

The Causes of Poverty (53): Poor Economic Growth

As an update of this previous post, here’s some more information about the nature of the relationship between economic growth and poverty reduction.

In a recent paper, Lane Kenworthy has compared growth and income data for 17 developed countries. Specifically, he looked at the ways in which the incomes of people in low to middle income groups benefit from economic growth. “Growth” here means increases in the amount of per capita GDP – this caveat is necessary in order to filter out economic growth that is the result of population growth and that doesn’t make the average person better off (although it obviously can make some persons better off, immigrants for instance). “Income” includes both wages and welfare benefits or other government transfers. Another preliminary remark: it’s wrong to think that growth automatically and by definition makes everyone – and hence also the poor – better off. It just makes the average person better off. That means that it can also in some circumstances make some people – e.g. the poor – worse off. Growth numbers are silent about the distribution of the effects of growth.

The question which the paper tries to answer is the following. Given that poor people can benefit from economic growth in two ways:

  1. either growth “trickles down“: more aggregate national income or production means more jobs, better paid jobs etc.
  2. or growth can increase the government’s tax base so that the welfare system can be made more generous,

which of these two mechanisms has been most prominent in the 17 countries examined in the paper?

The answer is “number 2”. Why? Well, in some of the selected countries economic growth was accompanied by a significant rise in low-to-middle household incomes, while in the other countries the effect of economic growth on the incomes of people in low-to-middle income groups was much smaller or zero. If economic growth trickles down (1), then one would assume it trickles down in all or most countries. After all, if growth results in more and better paid jobs for the poor, then there’s no a priori reason why this result would occur in one country but not in another.

The nature of government transfer systems is the reason why the effect of growth on the incomes of the poor is not the same in all countries:

when households on low incomes got better off, it was due most often to a rise in net government transfers. Where net transfers increased, incomes tended to increase in concert with economic growth. Norway, the UK, Sweden, Finland, and Denmark illustrate this pattern. Where net transfers were stagnant, income trends were decoupled from growth of the economy. We observe this in the United States, Canada, and Switzerland. This is an important finding. It means that, as a general rule, growth has not trickled down to low income households through wages or employment. And it means that, when government transfers haven’t grown, wages and employment haven’t stepped in to take their place. (source)

Looking at all this from the perspective of the causes of poverty: it’s clear that poor economic growth in wealthy countries cannot, by itself, explain poverty, because these countries can witness both growth and stagnation of the lowest incomes (as a result of their failure to implement the necessary transfer programs). Hence you can have growth without poverty reduction. If lack of growth is the main cause of poverty, then growth would by itself and automatically reduce poverty. We see that this is not the case.

In poor countries, on the other hand, growth can perhaps be sufficient. Those countries start from a lower base and more can trickle down. A lack of growth can, therefore, explain the persistence of poverty in developing countries, but probably not in developed countries. The latter have a basis of wealth that is large enough to fund welfare programs even if growth is poor. Growth helps to make this funding easier, but it’s not really necessary. A more progressive tax system, coupled with some good legislative will, can also do the trick.

More here.

Income Inequality (23): Income Inequality and Poverty

At first sight, income inequality and poverty are completely different things. Poverty is clearly a human rights issue, while income inequality is clearly not, at least not directly (it can have an impact on some human rights). Income inequality is a relative indicator, not an absolute one, and is, for this reason, claimed to be not about poverty at all. Poverty, it is said, is about absolute deprivation and is a lack of the resources necessary to satisfy certain basic needs. Income inequality just describes the unequal possession of resources, basic or otherwise. And indeed, it’s possible to imagine a very rich society in which no one is poor in the sense of lacking basic resources, but in which the distribution of resources is very unequal. Vice versa, there may be countries in which everyone is (almost) equally poor.

However, if we compare countries, we see that the more unequal a society, the larger the numbers of people suffering from poverty. Does that mean that high income inequality leads to more poverty? Not necessarily. That would probably be the case if we saw that a country’s poverty rate grows with increasing inequality. But that doesn’t happen:

If we look across the rich nations, it turns out that there is no relationship between changes in income inequality and changes in the absolute incomes of low-end households. The reason is that income growth for poor households has come almost entirely via increases in net government transfers, and the degree to which governments have increased transfers seems to have been unaffected by changes in income inequality. …

In some countries with little or no rise in income inequality, such as Sweden, government transfers increased and so did the incomes of poor households. In others, such as Germany, transfers and the incomes of low-end households did not increase.

Among nations with sharp increases in top-heavy inequality, we observe a similar disjunction. Here the U.S. and the U.K. offer an especially revealing contrast. The top 1%’s income share soared in both countries, and through the mid-1990s poor households made little progress … But over the next decade low-end American households advanced only slightly, whereas their British counterparts experienced sizable gains [thanks to the Labour government, FS]. (source)

So, in other words, there are countries with soaring inequality that still manage to make the poor better off in absolute terms (not in relative terms obviously) through redistribution. Other countries that witness the same evolution of inequality don’t make their poor better off. And trickle down also doesn’t seem to work, by the way. Vice versa, the less unequal countries also differ in the way they treat the poor. Income inequality doesn’t produce poverty because it doesn’t affect the welfare state.

It’s often argued that income inequality not only fails to produce poverty but actually helps to reduce it. That argument goes something like this. High levels of income inequality – and therefore high wages at the top – are necessary for economic growth. If the top economic performers are allowed to earn very high wages, they will have an incentive to produce and innovate. That will lead to economic growth, which will in turn, through a trickle down mechanism, benefit everyone, including the poor and those earning very little.

However, from the quote above it follows that it’s government transfers rather than automatic mechanisms that have helped the poor during the last decades of increasing inequality. If inequality by itself would reduce poverty, these government transfers would not have been necessary. An increase in income inequality by itself does not improve low-end incomes, as is shown by the example of the US.

And even if it could be shown that rising inequality pushes up the absolute income of the poorest, there are other reasons to object to inequality (such as this for example).