Hard work. Technology. Globalization. Skills. Grit. These are just some of the reasons used to explain why the top 1 percent has more than doubled its share of the national income in the past thirty years. Whatever the cause, progressives have historically responded to inequality by advocating higher taxes on the wealthy.
Now some progressive economists are arguing that increasing taxes on the wealthy is the wrong focus for an inequality agenda: only by taxing everyone more, these economists argue, can we produce enough revenue to provide better services and stronger social insurance. This argument is put forward by several recent influential works, including Lane Kenworthy’s Social Democratic America and Edward Kleinbard’s We Are Better Than This. But while there’s a grain of truth in this argument, it reveals a fundamental misunderstanding of what taxes do.
Taxes don’t just produce revenue; they are capable of restructuring how the whole economy works. That the decline in the highest tax rates has insidiously created our runaway inequality is explored in a recent paper by economists Thomas Piketty, Emmanuel Saez and Stefanie Stantcheva, who set out to investigate the relationship between tax rates and the top 1 percent in several key countries.
For example, the top marginal tax rate in the United States was over 70 percent between the New Deal and the Reagan Revolution, but has been below 40 percent since then. The top tax rate in England went from 80 percent to 40 percent during the 1980s. These are also the two countries with the largest growth in inequality.
As shown in the graph, there’s a strong correlation between the growth in pre-tax income inequality and the decline in tax rates. The argument that economists usually put forward to explain this is a conservative supply-side argument: when people are taxed less, they work harder and thus make more money.
But there’s a more plausible—and more worrisome—explanation: wages are the result of bargaining in which the relative strength of each side is influenced by tax policy. As tax rates decline, executives have more reason to fight for higher salaries for themselves, especially through actions like stacking their corporate boards. Boards and other institutional interests are motivated to pay out the new wave of superstar salaries, since they aren’t being taxed away.
CHANGES IN TOP INCOME SHARE AND TOP MARGINAL TAX RATES
Source: American Economic Journal
This second explanation is worrisome because it’s zero-sum. Instead of CEOs working harder, creating value and building the economy, they just take more of the pie. Social norms around extreme salaries change, and it becomes expected that high-end executives deserve these unprecedented windfalls. In turn, the firms are structured to expend wealth at the top rather than through higher wages for workers, more innovation or lower prices for consumers. The researchers note that the decline in top income-tax rates has had no effect on growth in the countries studied, which indicates that this pie-hoarding answer is more important—and, they argue, justifies taxes of 83 percent on high-end incomes.