Tax the Rich More, Reduce Inequality?
It doesn’t work like that.
By John Tamny
David Wessel recently wrote in the Wall Street Journal of a new policy proposal from the “pro-globalization crowd” that is meant to soften the blow of globalization. The plan — backed by former Bush administration official Matthew Slaughter on the right, and former Clinton Treasury secretary Lawrence Summers on the left — is to raise taxes on the rich in order to “thwart an economically crippling political backlash against trade prompted by workers who see themselves — with some justification — as losers from globalization.”
Summers argues that “It is best not to address salient concerns about inequality by interfering with trade.” So his solution is to use the tax code to penalize high earners as a way of reducing some of the inequality allegedly wrought by free trade. Specifically, he would return tax rates on incomes above $200,000 to the higher rates seen under President Clinton. Carried to its absurd extreme, Google — if its Internet search engine ultimately vanquishes those offered by Yahoo and Microsoft — would pay higher taxes to make the competitors it leaves behind feel better.
Despite the historical truth that income inequality is a major force behind innovative new ideas that regularly shift the mix and makeup of top earners, what Summers and Slaughter are proposing is at the core an attack on private property. The globalization they laud and decry at the same time represents progress. Income inequality is something separate, and barring inheritance it usually results from unequal levels of work, parsimony, perseverance, talent, and sometimes luck. To raise taxes for no other reason than to reduce inequality is to implicitly endorse expropriating the property of the rich just because they’re rich.
Slaughter and Summers might argue that the taxes raised in their scheme could fund education and training for displaced workers, but is there much evidence suggesting programs of that sort have had much success? And is it fair to penalize the most productive members of society in order to fund these utopian schemes?
Notably, Summers acknowledges that due to globalization, there’s a risk involved in taxing the highest earners, since they have the ability to “pick up their marbles and go somewhere else.” Indeed, as supply-siders have long noted, high incomes often disappear when the penalty for economic success rises. But rising tax rates also impact the willingness of the best and brightest to commit both work effort and capital. If the most productive among us do go elsewhere, or, cease working altogether, it would be quite a reach to assume that displaced workers will find their economic situations much improved.
Policymakers defy basic economics when they bemoan the plight of workers while at the same time advocating higher taxes on the rich. The two work at cross-purposes for the simple reason that job availability is a function of capital being available to fund the aforementioned jobs. High tax rates by definition erode the capital base, and in so doing, reduce the amount of capital that accrues to jobs and wages.
Summers and Slaughter make a good point that rising protectionism among the electorate is a major economic risk, since it may lead to contractionary protectionist legislation. But tax hikes on the rich will only serve to make workers even more uneasy when a smaller capital base negatively impacts both job availability and wages.
Mr. Tamney hits the nail on the head: the path to prosperity has never been through redistribution, it has been through maintaining the system that creates incentives to both make individuals more productive and to maximize scarce resources. This is done through the profit motive. The needs of society for different forms of labor and different products is expressed through prices. We can think of an individual's income as the price of labor.
Why does a grocery clerk make less than an engineer? There are two factors at play: the supply of individuals willing and able to do the job and the price an employer is willing to pay for them to do it. The supply is affected by many factors including training necessary to do a job, how enjoyable a job is, the difficulty of a job, danger of a job, and more. The supply is directly proportional to price.
The employer will hire workers at prices so long as they are still profitable to the company. The value of the marginal product of labor, or the value added to the company from hiring an additional employee, is the primary metric in this decision. An employer will hire up as many workers as it can, so long as each new employee is able to be hired profitably. The demand is inversely proportional to price.
Where the supply and demand for employees cross is the price of that labor, or what income that employee will be compensated. This income is very important to the correct functioning of the market and distorting it has unintended consequences. The engineer gets paid more than the grocery clerk because there are both fewer people able to do the work of an engineer and because the engineer creates more value for her company than the grocery clerk does for his.
The wages these employees earn conveys information to the marketplace. It tells the market that the job of an engineer is in both short supply and high demand. It communicates that information in the form of an incentive: high wages. These higher wages tell an employee that it is worth studying hard, getting postsecondary education, and going through the effort to learn what is necessary to be an engineer because you could be rewarded through increased income. Hell, physics is no picnic and many would rather do without higher-level math (our Allan not included). Without a powerful incentive such as a greater wage, we would no doubt see fewer engineers. The wage communicates to individuals that it is worth the effort of study because there is a reward at the end. This is why we see few people majoring in Grocery Clerk Studies here at Western, while more and more join the crowds at Parkview. Is there a governmental decree that this should happen? No, the market does this automatically, with less friction, and more quickly than any other mechanism.
However, what happens when we hose the rich by attacking them with high taxes? When government takes a large chunk out of the incomes of those higher wage earners, we create less of an incentive for people to earn more. Continuing with our example, it reduces the benefit of becoming an engineer without changing the costs. This will lead to fewer engineers in the workforce than is most beneficial to society. Whenever something is taxed, a deadweight loss is incurred. This is expressed through a lower supply of labor willing to do a particular job.
Does it make sense as a society to be distorting our incentives to be more productive? Why would one want to punish those who create more value in a position that fewer can do? Why would we want government to create a disincentive to obtain the training necessary to do a higher value-added task, a task fewer are willing or able to do, or both? The simple answer to these questions is that, as a society, we would not want this.
The simple answer is to stop attacking the rich.