Optimal tax theory in economics typically follows the approach pioneered by the English economist James Mirrlees, and has a trade off between efficiency and the redistribution of income that is said to represent “equity”. This is often a useful framework to discuss redistribution, although it does not provide any easy answers about what is the “optimal” degree of redistribution. Without claiming to know what that optimal is, one conclusion is clear: while redistribution should be part of the optimal policy mix, it is not the most important problem facing the US economy.
When equality and redistribution are pushed too far, devastating effects on behavior occur. I saw this clearly on a visit to China in 1981, just as China slowly started its first reforms. I was invited to China to speak about how markets operated, but I asked to visit several factories in Beijing. Everyone at these factories basically received the same wage, and essentially could not be fired for absenteeism or low effort. The result of this was that no one worked very much, or invested in education, patterns that were common in rural as well as urban areas. The enormous reforms that then took place in China led to major increases in inequality along with record-breaking rates of economic growth. China’s inequality is now comparable to that in the US, as measured by the Gini coefficient, a well-known measure of overall inequality.
Just as extreme equality would have enormous effects on behavior and efficiency, so too would extreme inequality, where a few families continued over time to control most of the wealth and income. In evaluating whether the US has too much inequality, a few facts are relevant. First is that the degree of inequality has grown rapidly since 1980, especially in the share of income going to persons in the top one percent of income, but also in the distribution of income among the remaining 99%.
At the lower end of the income distribution, real earnings of workers without a college education rose little since 1980, and may even have fallen, depending on the adjustment for changes in the price level. The gap between the earnings of persons with at least a college education and all others widened greatly during that period. The inequality between the earnings of men and women fell substantially, as women’s education grew more rapidly than men’s, and as the relative earnings of women of the same education as men also increased.
Despite this large growth in the gains from a college education, the fraction of young men who graduate from college did not increase by a lot during past 30 years. The big obstacle has been the high dropout rate from high school, which has only fallen modestly despite the large efforts being put into increasing the graduation rate. If completing high school could be given a large boost in an effective way, that would both reduce inequality of earnings and raise efficiency in the human capital investment process.
A highly disturbing fact is that a large fraction of young men are not at work, in school, or actively looking for work. For example, some one eighth of white men and one third of black men in their mid twenties to early thirties fall into this category, and much larger fractions of younger men do as well. Part of the reason is the low earnings of young men without much education or other skills that discourage them from looking for work. Another related reason is government welfare in the form of food stamps, unemployment compensation, medical coverage from Medicaid, and some rent subsidies when they do not work regularly.
These transfers are part of the already substantial amount of redistribution in the United States. A recent Congressional Budget Office study shows that the bottom quintile’s income share rose from 2.3% of aggregate income to 9.3% after adjustment for transfer payments and federal taxes. Similarly, the top quintile’s share of total income went down from about 58% to 47% after taxes and other adjustments.
In light of these facts, a small amount of further redistribution is unlikely to do much damage, but any significant amount would have negative consequences for efficiency of the economy. Lower income households would work less in order to qualify for welfare benefits, unless the redistribution to these households took the form of policies like the earned income tax credit (EITC) that subsidizes low-income earners. High income households would work less too, but probably more importantly, they would engage in additional efforts to hide income, invest abroad, shift to capital gains from regular income, and time their income receipts to reduce their tax burden.
The important point on efficiency is that the effect on the efficiency of the economy as taxes and subsidies rise does not increase linearly with the increase in taxes and subsidies, but increases at the square of these rates. Even a small increase in these rates would cause a big efficiency lose if it builds on a high tax or subsidy base.
The biggest problem for the American economy currently is not the level of redistribution, but the slow rate of growth because of depressed investments. Greater investment in technology and capital is a necessary ingredient of better growth. Some of these investments may reduce the demand for less skilled labor. This indicates that the best policies are those that increase investments and at the same time add to the earnings of lower income individuals and households. Greater investment in education and other human capital of those who do not invest a lot in themselves would be a prime way to do both.