Inequality and progressive taxation

As Andrew Jackson points out, there are some interesting musings in the US about progressive taxation. In a recent post, Mark Thoma cites four good reasons for progressive taxation:

Personally, I’m not much on redistribution simply to make outcomes more equal. But there are (at least) three reasons to depart from this. First, when there is change such that makes one group better off at the expense of another as has happened recently with globalization, and when redistribution can leave everyone better off, then redistribution is justified.

Second, I think everyone should have equal opportunity to be a CEO or a hedge fund manager, or whatever they want to be. However, the playing field is far from level and there is a lot more we could do on this side of the equation. Not everyone will be a CEO of course, or achieve their dream job whatever it might be, but everyone should have an equal chance to be one of the winners. In the meantime, until more has been done to level the playing field, progressive taxation is a means of making up for inequality in opportunity.

Third, for me at least, progressive taxation is justified by the equal marginal sacrifice principle (the last dollar paid should cause the same amount of disutility for everyone). Thus, even if opportunity is equal, and even if there were no winners and losers to worry about, justification for progressive taxation would remain. I think a more progressive tax structure than we currently have is needed to equalize the disutility of paying taxes.

We could list “preventing a political backlash” as a fourth reason for redistribution. But I’m not sure we need to invoke the political economy argument. If we use progressive taxation in accordance with the three principles above, then income will be more equally distributed and a backlash against globalization is less likely to occur.

At least one other really important consideration is that we tend to think of progressive taxation only in terms of income taxes, but we also have to take all other taxes into account. This is the domain of tax incidence studies. I have done some work on this topic for Canada that will be published later this year, and the general finding is that the tax system is less progressive today than it was in 1990. Back then, as a classic study of Vermaeten, Gillespie and Vermaeten in the Canadian Tax Journal found, the tax system in 1988 was progressive up to the median then relatively flat thereafter. In my preliminary estimates, the system is less progressive through the bottom half, and regressive thereafter.

In our PEF session on taxation and social democracy at the CEA meetings, Andrew Jackson suggested that there is scope for higher marginal income tax rates as a means of offsetting the top of the distribution pulling away from the middle, but also noted that much of the reduction in inequality in the Nordic countries stems from transfers rather than taxes. This relates to Stephen Gordon’s presentation in which he highlighted the use of value-added taxes in getting taxes-to-GDP up closer to Nordic levels, but that an enhanced GST credit could serve to offset the regressive impact of such a move, and could even serve as the basis for a guaranteed annual income. All of these are good ideas that are not incompatible with each other, and I would add that we should also enact changes (such as easier unionization in the service sector, higher minimum wages, and capping the tax deductability of excessive executive pay) that make the labour market – the source of rising inequality – do more of the heavy lifting.

The session raised an interesting debate between Erin Weir and Stephen Gordon about how much we should rely on corporate taxation as a base. I won’t get into that right now, but suffice it to say that the Nordics show us what’s possible, and the tools are there. The real issue is political will and whether we as a society want to go there.

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