The Distribution of National Income (part 2)

February 21, 2017

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We have been looking at a report on the distribution of national income from the Washington Center for Equitable Growth, authored by Thomas Piketty, Emmanuel Saez and Gabriel Zucman. What makes it special is its attempt to account for all forms of income, not just those most often reported in surveys and tax returns. Based on this more complete accounting, the authors conclude that between 1980 and 2014, the top tenth of the adult population increased their share of the pre-tax national income from 34.2% to 47.0%. The share going to the next two-fifths of the population declined from 45.9% to 40.5%, and the share going to the bottom half of the population declined from 19.9% to 12.5%. During this period, economic growth was sluggish compared to the postwar era (1946-1980), but average real income more than doubled for the top tenth, while remaining essentially unchanged for the bottom half.

These figures are only for pre-tax income, however. They leave open the question of what role taxes and government spending play in the distribution of national income. Does post-tax income tell a different story?

Post-tax income

By considering the distribution of the entire national income, the report challenges the way we normally think about after-tax income. In our everyday experience, it’s what’s left after the taxes are taken out. That makes it always less than gross income. But in the national income accounting, total post-tax income and pre-tax income are the same! That’s because the national income does not go down just because some of it is taxed. The tax dollars are spent directly or indirectly on someone’s behalf, and so they can be counted as somebody’s income. Post-tax income is not a reduction in national income, but just a redistribution of national income.

The calculation of post-tax income from pre-tax income requires two steps: the subtraction of taxes paid, and the addition of government benefits received. Taxes include all levels (federal, state, local) and all types (income, sales, payroll, property). Government benefits include both monetary transfers (earned income tax credit, cash assistance payments, food stamps) and in-kind transfers (mainly health benefits through Medicare and Medicaid). Some cash income is already included in pretax income, such as Social Security payments.

The trickiest type of government benefit to account for is “collective consumption expenditures.” This is government spending on behalf of society in general. One might apportion it equally, on the assumption that each citizen gets the same benefit from it. But the researchers distribute it in proportion to other income, reasoning that higher-income people usually get more benefits from general public spending. For example, wealthier people are more likely to live in communities where the taxes support higher spending per student in the public schools. They are also more likely to be shareholders who benefit from the profits earned by defense contractors. The authors acknowledge that “our treatment of public goods could easily be improved as we learn more about who benefits from them.”

What if the government spends more than it receives in tax revenue? Then the deficit has to be allocated to individuals too, as a kind of negative benefit. Otherwise, total benefits received would be larger than total taxes paid, making post-tax income larger than total national income, upsetting the logic of the entire analysis.

The distribution of taxes and benefits

In general, the distribution of taxes and benefits is mildly progressive, but not markedly so. With all forms of taxation considered, higher incomes are a little more heavily taxed. The effective tax rates are 33.9% for the top tenth of adults, 28.6% for the next two-fifths, and 24.4% for the bottom half. The effective tax rate for the adult population as a whole is 30.5%.

Each group’s share of all taxes paid depends on how much income they have to begin with, as well as the rate at which it is taxed. In 2014, the top tenth got 47.0% of the pre-tax income and paid 52.2% of the taxes (hardly an unreasonable burden in my humble opinion). The next two-fifths got 40.5% of the income and paid 38% of the taxes. The bottom half of the population got 12.5% of the income and paid 10% of the taxes.

On the government benefits side, the top tenth got the smallest share–26.0%–which is lower than their share of income and taxes, but still much higher than their share of population. Although they didn’t qualify for means-tested assistance programs like Medicaid and food stamps, they got a lot of the general benefits of government spending. The next two-fifths, however, got the largest share–41.6%–roughly proportional to their share of the population. What they pay in taxes they get back in benefits such as good schools. The lower half of the population got 32.6% of the benefits, which is much more than their tax burden but much less than their 50% share of the population.

The redistribution of national income

The result of government taxation and spending is that a modest portion of national income is redistributed, primarily from the top tenth of the population to the bottom half.  A simple comparison of pre- and post-tax income shows this clearly.

Because the top tenth paid more in taxes than they received in benefits, their post-tax share of national income was 8 percentage points lower than their pre-tax share in 2014 (39.0% vs. 47.0%).

For the next two-fifths of the population, pre- and post-tax income came out about the same. They started out with 40.5% of the pre-tax income, paid 38% of the taxes, got 41.6% of the government benefits, and wound up with 41.6% of the after-tax national income. All the figures are roughly proportional to their 40% population size, so this group didn’t win or lose much from income redistribution.

The bottom half of the population gained more in benefits than they paid in taxes, so their post-tax share of national income was 6.9 points greater than their pre-tax share (19.4% vs. 12.5%). That difference consists mainly of non-cash benefits. That’s because their meager pretax incomes–averaging $16,200–were taxed at 24.4%, and that more than offset any cash benefits they received. The net benefits they got were primarily from health insurance programs.

To summarize, in 2014 the US transferred 8% of the national income by taxing the top tenth of the population, with 7 points of that going to the bottom half and 1 point to the other two-fifths. The transfer reduced the top tenth’s sizeable after-tax income by 17%. But the transferred income loomed much larger in the lives of the people at the bottom who received it in one form or another. Since they had so much less to begin with, it boosted their income by 54%. In dollar terms, it meant an increase in average income from $16,200 to $25,000, a significant improvement, but still leaving them far behind everyone else.

Redistribution and the trend toward inequality

Has the redistribution of income through taxes and government spending helped to offset the trend toward greater inequality? One would expect that as the rich got richer, they would be forced into higher tax brackets, increasing the tax revenue available for redistribution. One might also expect that as incomes at the bottom stagnated, political pressure would build to increase spending to augment them.

The point about tax revenue has some truth to it. Between 1980 and 2014, the top tenth increased their share of pre-tax national income from 34.2% to 47.0%, but some of that gain was offset by taxes. Still, their after-tax share of national income went from 29.5% to 39.0%. The increase in post-tax income was about three-quarters of the increase in pre-tax income. In other words, they got to keep three-fourths of their gains.

For the other nine-tenths of the population, tax offsets worked to reduce losses instead of gains. For the bottom half, the decline in their share of post-tax income was 85% as large as the decline in their share of pre-tax income. For the two-fifths of the population in between, the decline in their share of post-tax income was only  59% as large as the decline in their share of pre-tax income. To put it another way, the government absorbed 15% of the losses for the bottom half and 41% of the losses for the two-fifths in the upper middle of the distribution.

What the country did not do in those years was increase the overall rate of taxation or make the tax rates more progressive. The average tax rate considering all taxes went down slightly from 30.8% to 30.5%. Moreover, the effective rate of taxation went down for the upper half of the population (due mainly to income tax cuts), but went up for the lower half (due mainly to increases in payroll taxes). That’s why the government absorbed more losses for the upper-middle class than for the bottom half. Redistribution from top to bottom could still go up a little, because the rich had more money that could be taxed. But non-progressive tax policies left most of the increase in inequality untouched.

As for the second point, about political pressure to increase spending on the poor, that was outweighed by pressure to cut tax rates for the middle and upper classes. Between 1980 and 2014, the percentage of national income going to finance government benefits for the bottom half remained stuck around 10%, while benefits for the upper half remained around 20%. The upper middle class played a crucial political role here. With their own share of the national income shrinking, a majority of them sided with the rich in supporting low taxes, rather than with the poor in supporting policies to reduce inequality. I will have more to say about the political implications of the income distribution in my next post.

Continued


Trump’s Taxes: Can the Fox Guard the Henhouse?

October 6, 2016

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David Cay Johnston has come up with a plausible explanation of how Donald Trump used business losses to avoid paying federal income taxes. Johnston is an expert on how the wealthy use the tax code to their advantage. My aim in calling attention to this is not just to criticize Trump for minimizing his tax bills, but to raise the larger question of what kind of tax reform is needed and whether a Trump administration is likely to pursue it.

Turning business failure into personal gain

In the early 1990s, Donald Trump was the owner of failing casinos and other unsuccessful business ventures. He had borrowed and spent so lavishly that his businesses couldn’t make their loan payments and still turn a profit. Trump was like a homeowner living in a flashy mansion but going broke trying to make the payments on it. He reported net operating losses of $916 million in 1995 and was $3 billion in debt.

The operating losses had a silver lining, however. The federal tax code allowed him to use those losses to offset personal income for as many as 18 years, running from two years before the reported loss to 15 years after.

As for the debt, he got the banks to forgive almost $1 billion of it by threatening “endless litigation” if they tried to collect what he owed. Trump has boasted about his habit of paying less than he owes. “I’ve borrowed knowing you can pay back with discounts.” Many borrowers who lost their homes in the real estate meltdown would have liked that deal. Conservatives accused President Obama of “subsidizing losers” when he proposed assisting such homeowners.  Trump also got a tax break on his debt forgiveness, which would normally be considered a form of income. But Congress created an exemption that allows real estate owners to avoid this tax liability if they sacrifice future deductions for depreciation instead. (One of the tax benefits of real estate is the ability to take a deduction each year for property depreciation.) Trump had personally testified on behalf of the exemption.

Trump still had a problem, however. He still owned properties that were losing money, and they were now worth even less as investments because he had forfeited the future tax benefit of depreciation in return for an immediate tax benefit for himself. Nevertheless, he was able to sell the properties to a new stock corporation he created, Trump Hotels and Casino Resorts. The investors must have grossly overestimated the potential return, perhaps as Johnston says because they “saw gold in his brand name.” They bought the shiny image and overlooked the ugly reality. Could there be a lesson here for voters?

As the chairman of Trump Hotels and Casino Resorts, Trump was well paid whether the company succeeded or failed. He also had the company borrow more money in order to pay off his previous loans, thus saddling the corporation with what had been his personal obligations. With him in charge, the company lost over a billion dollars; the stock value plummeted, and the investors were wiped out. He walked away with millions of dollars in tax-free income, but everyone else lost–investors, contractors, and the taxpayers who subsidized his me-first business practices.

Why does it matter?

All of the financial moves I’ve described may have been legal. (Johnston does charge him with tax fraud in other contexts, but that’s another matter.) Trump’s defenders blame his economic failures on economic conditions beyond his control, justify his tax maneuvers as normal efforts to avoid paying more than the tax code requires, and praise his “genius” in achieving personal success in the face of financial adversity.

All of those claims are controversial. Rather than dispute them, I want to emphasize something else, which is tax policy. Donald Trump himself has said something like this: The tax system is rigged, but since I know the tax code so well and have brilliantly used it to my advantage, I’m the best person to fix it! Or to put it a little more whimsically, I’m the smartest fox to guard the henhouse, since I’ve been feasting on chicken for a long time!

This is a clever argument. The problem I have with it is that I see no evidence of Trump’s interest in tax reform. Democrats continue to complain loudly about his failure to release his tax returns. I wish they would call more attention to what he has released, which is at least the main outline of a tax plan. As I described it in an earlier post, it is standard Republican fare. It makes the tax code flatter and less progressive by lowering tax rates for the wealthy, and it includes new goodies like the elimination of the estate taxes that are paid by only the richest one-fifth of one percent. Surprise surprise, Donald Trump and his family stand to make a fortune from his own tax proposals. In contrast, Hillary Clinton wants to increase estate taxes and implement the “Buffet rule,” which would require those with million-dollar incomes to pay at least 30% in income taxes. I see little chance that her plan will get through a Republican-controlled Congress, but at least it’s an authentic proposal for reform.

So Donald Trump, who has cultivated the image of the populist outsider, defender of the working people, is really the protector of the rich and powerful. Hillary Clinton, the Washington insider, is really the progressive reformer. The cunning fox shows no sign of giving up his chicken dinners. If we want someone to guard the henhouse, we’d better elect a hen.


Clinton and Trump on Fiscal Policy

August 16, 2016

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I am hoping that some potential voters are still interested in hearing about policy differences between the presidential candidates. As the election campaign stands now, it seems to be mostly a debate over the candidates’ character. Does Donald Trump have the right temperament to be president? Is Hillary Clinton trustworthy? Their actual policy proposals are often overshadowed by the latest mini-scandal, what Trump said about so-and-so, or what was found in an email on Clinton’s server. I watched the CBS evening news the day that Clinton presented her economic plan, and they made no mention of it. They did, of course, do a story on Trump’s description of the President as the “founder of ISIS,” which he later said he meant sarcastically, sort of.

Meanwhile, the country faces a number of difficult policy decisions, which will remain important regardless of who wins, but on which the candidates have taken very different positions.  Decisions about fiscal policy–how to tax, how to spend–are among the most important. They affect what the federal government is able to do, and what impact it has on the economy.

Spending

Both candidates promise to accomplish things that require new spending, although they often describe their goals without trying to put a price tag on them. One goal they have tried to price out is repairing and improving the nation’s infrastructure. Hillary Clinton has proposed to spend $275 billion over five years, and Donald Trump has promised to out-build her (that’s what he’s good at) with his own $500 billion plan.

Each candidate has other initiatives that will also need funding. Clinton wants to increase federal aid to education so that students from families with incomes below $85,000 can attend state colleges tuition free. (That threshold would rise to $125,000 over the next four years.) Trump wants to put more money into strengthening the military.

The candidates differ dramatically on how they would pay for their new spending. Clinton is the more fiscally conservative here, proposing to pay for new spending with higher taxes targeted specifically at the wealthy. Trump, on the other hand, wants to cut taxes, so at least in the short run the government would face a double whammy of more spending but less revenue. (He hopes that the government would recover at least some of that revenue when his tax cut stimulates the economy; more on that later.) Trump proposes to offset some spending with reductions in “waste, fraud and corruption,” a familiar goal to be sure, but I couldn’t find any proposals for specific budget cuts on his website. He has also said that he is willing to run a larger deficit and take on more debt. He has boasted about his ability to manage debt, but we know from his business history that his methods include declaring bankruptcy and repaying debt at less than full value. At one point Trump even suggested that the United States could also shortchange its bondholders, something that the country has never done. (That could very well end up costing the country more, since it would shatter confidence in our bonds and force the Treasury to pay higher interest rates.)

So on the face of it, Clinton seems to be the fiscal conservative, and Trump the fiscal risk-taker, which makes some Republicans very nervous. However, his “borrow and spend” approach isn’t that much of a departure from what Republican administrations actually do, as opposed to what conservative orthodoxy says they should do. While Republicans sound like the ultimate deficit hawks when they are opposing Democratic spending plans, their record on reducing deficits and balancing the budget is actually very poor. Both Ronald Reagan and George W. Bush ran up large deficits by doing a lot of what Trump wants to do, increase military spending while cutting taxes.

Ever since the 1980s, Republicans have supported their tax proposals with an argument from “supply-side” economics. Tax cuts aimed at corporations and the wealthy provide more capital that businesses can use to expand, create jobs, and boost incomes. That in turn increases tax revenues, so the tax cuts don’t really increase government debt in the long run. Not very many economists subscribe to this view today, at least with regard to cuts in personal income taxes. We have had relatively low taxes on the wealthy for 35 years, and we have experienced sluggish growth and a soaring national debt. In contrast, during the great period of economic growth in the mid-twentieth century, tax rates were higher, but growth rates were also higher and deficits were smaller.

Personal income taxes

As I said, Hillary Clinton proposes to increase taxes on the wealthy. She would put a 4% tax surcharge on incomes over $5 million, in effect raising the top tax bracket rate from 39.6% to 43.6%. She would also like to make anyone with an income over $1 million pay at least 30%. Although millionaires are in the 39.6% bracket now with regard to “ordinary income,” they can pay as little as 20% on income from capital gains. That’s why Warren Buffet can point out that he pays taxes at a lower rate than his secretary. (He is supporting Clinton’s plan, by the way, even though it will raise his own taxes.) The proposal for a 30% minimum rate for millionaires was previously proposed by President Obama, and has come to be known as the “Buffet rule.”

Clinton is not proposing any major tax changes for the non-millionaire majority. Donald Trump, on the other hand, is proposing “lower taxes for everyone, making raising a family more affordable for working families.” His first proposal cut taxes so much that most analysts dismissed it as fiscally irresponsible. More recently, he has apparently adopted the plan put forth by House Republicans, at least with regard to tax rates. The details are not entirely clear because they are not yet available on the Trump website.

We do know that the Trump plan proposes to simplify the rate structure by replacing the current seven tax brackets with only three: 12%, 25% and 33%. To keep the presentation brief, I will focus on households headed by married couples filing joint returns, but the general conclusions would be true for single filers as well. Here is how the plans would affect households with various taxable incomes (after deductions and exemptions):

  • $25,000: Currently this household is in the 15% bracket, but their effective tax rate is only 11.3%, since the first $18,550 is taxed at only 10%. Their tax is now $2,822. After Trump’s simplification, all their income is taxed at 12%, so their tax rises slightly to $3,000.
  • $30,917: I’ve picked this odd number because it is the break-even point where Trump’s plan makes no difference. The household is currently in the 15% bracket, but their effective rate is 12% already, and it remains 12% in Trump’s plan. Their tax is $3,710 either way.
  • $50,000: This household is also in the 15% bracket under the current system, with an effective rate of 13.1% and a tax of $6,572. After Trump’s simplification, they are taxed entirely at 12%, for a tax of $6,000 and a savings of $572.
  • $100,000: This household is currently in the 25% bracket, but with an effective rate of 16.5%. Under Trump’s plan, they are still in the 25% bracket, but their effective rate drops to 15.2% because the first $75,300 of their income is taxed at his 12% rate. Their tax goes down from $16,542 to $15,211, a savings of $1,331.
  • $1 million: Currently they are in the top 39.6% bracket, with an effective rate of 34.2%. Trump’s top bracket is only 33%, so their effective rate comes down to 30.2%. Their taxes fall from $341,666 to $301,695, a savings of $39,970.

And so it goes. The greater the taxable income, the larger the tax reduction, not only in dollars but in rate. Like all Republican tax proposals, this one gives the greatest tax relief to the wealthy who pay the most taxes, with the aim of making the rate structure flatter and less progressive.

In addition, the Trump plan does not address the “Buffet rule,” and so it continues allowing millionaires to pay a lower rate if their income is primarily from capital gains.

The Trump plan is marketed as “lower taxes for everyone, making raising a family more affordable for working families.” But the family with a $50,000 taxable income saves $572, while the family with the million-dollar income saves $39,970. Why should the government give up badly needed tax revenue to help families that are already doing fine?

A word of caution: a complete analysis of a tax plan would have to consider more than just the tax brackets and rates. For example, the House Republican plan (and maybe the Trump plan?) also proposes to increase the standard deduction from $12,600 to $24,000, while eliminating the personal exemption. Some households, especially those without children, would see their taxable income fall. Others, especially families with two or more children, could lose more from the loss of exemptions than they gain from the increased standard deduction. I don’t think that changes my basic conclusion, but it is not simple. The candidates need to post their plans with as much specificity as possible, so that outside experts can evaluate them.

One suspects that the real objectives of the Republican plan are probably something else besides providing tax relief to the working class. Many Republicans sincerely believe that more tax cuts for the wealthy will promote economic growth, although doing that from the top down is a dubious proposition. Democrats are more likely to believe that government spending on useful job-creating projects is a more direct path to growth. The difference is even starker, since some Republicans have advocated tax cuts specifically to deprive the federal government of revenue in order to keep government small and weak, “small enough to drown in a bathtub,” as anti-tax crusader Grover Norquist has put it. As far as I know, Donald Trump has not made that argument. He really can’t, since he is promoting increases in both military and domestic spending. But it may be an objective of House Republicans, who could be very influential in a Trump administration. They do want to reduce domestic spending, although they have to be careful about how they present that to the public. Better to speak of “entitlement reform” than “cutting social security benefits”; better to speak of “reducing dependency on government” than “taking away food stamps from hungry children.” Surveys have found that Americans like the idea of limited government in the abstract, but rarely rally around when specific programs are on the cutting board.

A presidential campaign should be an opportunity to have an honest, fact-based debate over fiscal policy, among other things. Right now, that’s just not the kind of thing that get’s voters’ attention.

In the next post, I’ll discuss differences between the candidates on estate taxes and corporate taxes.

Continued


Rewriting the Rules of the American Economy (part 2)

March 10, 2016

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The central message of Stiglitz’s latest book is this: “The American economy is not out of balance because of the natural laws of economics. Today’s inequality is not the result of the inevitable evolution of capitalism. Instead, the rules that govern the economy got us here.”

We have been operating under a set of rules that were inspired by the largely discredited “supply-side” economics. The aim was to free up capital by cutting taxes, regulation, and wasteful social spending. That would promote more investment and economic growth, with the benefits flowing to all levels of society (what critics call “trickle-down” economics). This was in contrast to the traditional Keynesian approach preferred by liberals, which stressed the importance of maintaining aggregate economic demand through government spending beneficial to the middle class and the poor. Stiglitz and his co-authors regard the supply-side approach as a failure. “These policies increased wealth for the largest corporations and the richest Americans, increased economic inequality, and failed to produce the economic growth that adherents promised.”

Greater wealth at the top does not necessarily translate into greater productive capacity for the economy. Wealth becomes capital only when it is invested in productive activity, but wealth that is not so invested can still produce an economic gain. Property owners in a hot real estate market can collect rents and/or capital gains without making anything or creating any jobs. If the rules of the game encourage it, those with wealth and power will devote too many resources to “rent-seeking,” that is, “obtaining wealth not through economically valuable activity but by extracting it from others, often through exploitation.” The rule changes inspired by supply-side economics shifted the balance of power toward the wealthy and made it easier to make money without serving society very well.

Deregulation of industries such as airlines, railroads, telecommunications, natural gas, and trucking, as well as legal rulings limiting regulation in general, made it easier for big companies to accumulate market power and ultimately limit competition. Some public policies have contributed directly to that accumulation, such as intellectual property rights laws that favor the rights of pharmaceutical companies to profit from a drug over the rights of other companies to make it and sick people to obtain it at a reasonable cost. International trade agreements that failed to include proper safeguards made it too easy for corporations to locate their operations wherever worker bargaining rights and environmental laws were weakest.

The rapidly growing financial sector was allowed to shift “away from its essential function of allocating capital to productive uses and. . .toward predatory rent-seeking activities.” Never had so many people become so rich by producing so little of real value. Market power became enormously concentrated, with the share of assets held by the top five banks increasing from 17% to 52%. The complexity of modern finance puts ordinary consumers at a disadvantage to begin with, but the lax regulatory environment made it worse, allowing predatory lending, fraud and discrimination to run rampant. Meanwhile, the financial industry became less efficient at performing its basic function of providing credit, since the cost-per-dollar of credit actually went up.

Within corporations, the “Shareholder Revolution” increased the pressure on CEOs to generate quick profits. CEO compensation was increasingly tied to rising company stock prices. “The idea that corporations exist solely to maximize current shareholder value and that all other goals are secondary reversed decades of management theory that prioritized firm longevity and saw corporations as more broadly advancing societal interests.” This encouraged several unfortunate corporate practices: favoring shareholder payouts over long-term investments, taking excessive risks (since executives with stock options could profit from financial bubbles), paying executives much more than their productivity could justify, and treating employees “as short-term liabilities rather than as long-term assets.” The bottom line: “Corporate profits are at record highs, with no increase in investment.” Here, corporate culture is as much to blame as public policy, a reminder that the relevant rules of the game include private social norms, not just public policies and laws.

The Reagan and Bush tax cuts favored the wealthy by reducing both the upper-bracket income tax rates and the taxes on dividends and capital gains. This contributed not only to greater after-tax inequality, but surprisingly, to greater pre-tax inequality as well. It increased the pressure on companies to pay out more in executive compensation and dividends, since the payments would be more lightly taxed. International comparisons show that such tax cuts increased economic inequality but failed to boost per capita income. US Federal Reserve policy also contributed to inequality by prioritizing fighting inflation over reducing unemployment, although both goals are mandated by law. The impact of unemployment on family income varies by social class, reducing income by a higher percentage at the lower end of the income scale. In addition, “episodes of below-full employment do lasting damage to productivity, equity, and opportunity.”

During this period, US employers were generally successful in resisting any expansion of worker rights. Within the 30 democracies in the OECD, “an average of 54 percent of the workforce is covered by union collective bargaining agreements, 4.5 times more than in the US.” Companies increasingly used outsourcing and franchising to circumvent labor laws, while continuing to set the terms of employment. Wage growth fell far behind productivity growth (19% vs. 161% between 1973 and 2013), and the federal minimum wage failed to keep up with inflation. To make matters worse, one study found that about a quarter of low-wage workers were getting paid less than the minimum wage, and three quarters weren’t receiving the overtime pay they were due. One major goal of public policy was to reduce dependency on government by creating jobs and cutting social welfare payments. Instead, spending on programs like Medicaid and food stamps remained high as more working families found themselves unable to make it on their own. Conservatives deplore this, but generally oppose efforts to raise wages or strengthen the bargaining position of workers.

The final post will cover the book’s recommendations for rewriting the rules.

Continued

 


Capital in the Twenty-First Century (part 4)

May 23, 2014

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The twenty-first century state

The final part of Piketty’s book deals with the role of the state in 21st-century capitalist society. He focuses on two main objectives:

  • modernizing–but not dismantling–the modern “social state”
  • controlling the trend toward economic inequality by increasing the taxation of capital

The social state

The relatively strong economic growth and greater social equality of the 20th century was accompanied by–and promoted by–a larger government with greater power to tax and spend. Taxes consumed a much larger share of national income: 31% in the US, 40% in Britain, 46% in France and 54% in Sweden at their peak around 1980. (The share had been less than 10% in those same countries in the 19th century.) Public support for such high rates was easier to come by when economies were growing rapidly. High taxes enabled the state to take on new social functions. Governments invested more in the health and education of their citizens, and they provided more income security through retirement systems and support for the disabled, unemployed or otherwise economically needy.

Piketty does not expect to see a further expansion of the social state, since “the state’s great leap forward has already taken place.” He also acknowledges the need to re-examine what we already have: “The tax and transfer systems that are the heart of the modern social state are in constant need of reform and modernization, because they have achieved a level of complexity that makes them difficult to understand and threatens to undermine their social and economic efficacy.”

Piketty notes that modern taxation is no longer very progressive when all types of taxes are taken into account. He believes that how government taxes the largest incomes and fortunes is important for either reinforcing or reducing economic inequality. In the United States, tax rates on the top bracket of income averaged 81% between 1932 and 1980. Today, the top rate is 39.6% for income over $400,000 ($450,000 if married, filing jointly). As noted earlier, the recent reduction in top rates gave executives more incentive to fight for pay increases, since they could now keep most of them. Piketty does not advocate a return to the “confiscatory” rates of the past, but he would like to see a rate of at least 50% for all income over $200,000, “in order for the government to obtain the revenues it sorely needs to develop the meager US social state and invest more in health and education (while reducing the federal deficit)….”

In the US, the maximum rate for capital gains is only 20%, so the effective tax rate on total income is often lower for rich taxpayers than middle-income taxpayers. Countries have been competing against each other in a race to the bottom, trying to attract capital by taxing it lightly. Piketty hopes that more European cooperation can eventually reverse that trend. As for the United States, he ends his discussion of taxes on a pessimistic note:

The history of the progressive tax over the course of the twentieth century suggests that the risk of a drift toward oligarchy is real and gives little reason for optimism about where the United States is headed….Without a radical shock, it seems fairly likely that the current equilibrium will persist for quite some time. The egalitarian pioneer ideal has faded into oblivion, and the New World may be on the verge of becoming the Old Europe of the twenty-first century’s globalized economy.

By “Old Europe,” he means, of course, the land of inherited wealth and extreme inequality.

A global tax on capital

What is most needed to curb excessive inequality and make taxation fairer is “a progressive annual tax on individual wealth–that is, on the net value of assets each person controls.” Since it is a tax on accumulated wealth, not just current income, it would need to be set rather low, just “a few percent.” Like a property tax, it would be small, but much fairer because it would include the financial assets that make up the bulk of large fortunes. Ideally it would be imposed all over the world, but since that is unlikely to happen, the next best thing is to impose it in large areas such as the United States and a more united Europe. Otherwise capital can too easily move around to avoid it. Several European countries have taxes on capital, but they have too many loopholes to be effective.

The main justification would be “contributive”. Net assets is a fairer measure of a wealthy person’s capacity to support government than current income, which doesn’t count unrealized capital gains. A secondary justification would be giving the owners of capital more incentive to seek the best possible return. Those who earned too low a return would have to sell assets to pay their taxes, “thus ensuring that those assets wind up in the hands of more dynamic investors.”

Private wealth, public debt

Piketty finds it shameful that the richest countries in the world have such poor, indebted governments. Virtually all the capital in these countries is private capital, since whatever assets governments hold are offset by their liabilities. Financing the operations of government by borrowing rather than taxing works fine for wealthy people who would rather buy government bonds than pay taxes, but it is less efficient and less just.

Piketty’s preferred method for reducing government debt is higher taxation of capital. A second method is inflation of the money supply, which shrinks the value of the debt while spreading the cost widely through society. Inflation was the main way of reducing public debt in the 20th century, but it has to be used sparingly or it can spiral out of control. The worst method of reducing debt is austerity, which hits the poor the hardest, inhibits economic growth and increases the advantage of capital over labor, in accordance with the book’s main argument. Piketty says that “if the choice is between a little more inflation and a little more austerity, inflation is no doubt preferable.”

Economic conservatives would vigorously disagree. They place the highest priority on fighting inflation and opposing tax increases, so that austerity becomes the preferred method, at least by default. Milton Friedman and the monetarist economists saw regulation of the money supply as the central economic function of government and social spending as dangerously inflationary. “The work of Friedman and other Chicago School economists fostered suspicion of the ever-expanding state and created the intellectual climate in which the conservative revolution of 1979-1980 became possible.”

The European Union developed as a “currency without a state and a central bank without a government” at a time when inflation-fighting was coming to the forefront of public policy. The European Central Bank’s focus on controlling inflation works well for a creditor country like Germany, which can count on low inflation to preserve the value of their loans. It narrows the options of debtor countries like Greece, especially at a time when financial crisis has reduced their tax revenues and undermined confidence in their bonds. They cannot borrow at low interest rates. They cannot devalue the euro to reduce the value of their debts. They cannot effectively tax capital, or capital will just leave the country. So they are forced to prolong recession with unpopular austerity measures.

Piketty wants to see a European Union that is more of a real government, with a fiscal policy as well as an inflation-fighting monetary policy, giving it the capacity to share the debt burden and raise taxes on capital to alleviate that burden.

While the trend of the last few decades has been to deregulate capital and defund the social state, Piketty advocates a different approach for the 21st century: “Although the risk is real, I do not see any genuine alternative: If we are to regain control of capitalism, we must bet everything on democracy–and in Europe, democracy on a European scale.”