Eakinomics: A
Guide to the Tax-Hike Debate
One of the most high-profile policy promises in the 2020 cycle is Joe Biden’s
plan to raise taxes by roughly $2.8 trillion, with the taxes targeted on
those making more than $400,000. The key elements of the plan are a higher
individual income tax rate, higher dividend and capital gains tax rates,
imposing the Social Security payroll tax on labor income above $400,000, and
raising corporation income taxes.
One rationale for such a change is to use the resulting funds for programs
that are focused on low-income individuals. In effect, this tax hike makes
the overall tax-transfer system more progressive and seeks to reduce the
overall income inequality in the United States. From a conceptual
perspective, if individuals were simply born with a fixed earning power, then
it would make sense to use the tax-transfer system to offset any rise in the
inequality of these fixed endowments.
Of course, earning power is not fixed at birth. In particular, overall
earnings are influenced by the frequency and amount of work. To the extent
that raising taxes induces less participation and work, this is an efficiency
cost that argues for a less aggressive increase in taxes to lean against
rising inequality. I think it is safe to say that the consensus on the
liberal side of the policy aisle is that higher taxes have no real impact on
the labor supply of upper-income Americans, and thus there is no reason
to mitigate tax hikes out of concern for the growth consequences.
One more layer down, conditional on the amount of labor supplied, the
productivity of that labor will depend upon the quantity and quality of the
technologies, equipment, and other capital that is available to workers.
Higher taxes reduce the return to saving and investment, and thus diminish
the accumulation of capital, reduce the growth of productivity and real
wages, and thus are less
desirable for combatting inequality as a result. It is
precisely this channel that underlies AAF’s analysis of the
(draconianly progressive) Sanders and Warren wealth taxes. Because
over the long haul workers wages fall by $0.63 for every dollar of wealth
tax, it is undesirable to lean heavily on this redistribution.
There is a similar channel, however, that is often overlooked in the
inequality debate: human capital. Just as taxes defer the accumulation of
tangible capital, they can also deter the accumulation of human capital –
education, experience, and skills that result in higher wages. This channel
is featured in a new paper from Jonathan Heathcote, Kjetil Toresletten, and
Giovanni Violante entitled How Should Tax Progressivity Respond to Rising
Income Inequality?
In the words of the authors, “In this paper, we challenge on two levels the
traditional narrative on inequality and redistribution. First, we argue that
the tax and transfer system has not in fact become less progressive over
time. On the contrary, we argue that the amount of redistribution embedded in
the tax and transfer system has been rather stable on net between 1980 and
2016. Second, we argue that the appropriate policy to address rising
inequality depends on why income inequality is going up.”
In short, the authors carefully calibrate the sources of rising inequality,
separating out the portion that is a result of rising returns to human
capital. What does it tell us about the right tax-based response to increased
inequality? “When we model both the rise in returns to skills and the
increase in residual wage dispersion, counteracting forces emerge in the
optimal taxation problem. We conclude that progressivity should have remained
roughly stable over time.”
Some think that rising inequality makes a more sharply progressive income tax
system a no-brainer. But a careful consideration of all the economic impacts
suggests that considerable caution is in order.
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