Dimensions: 8.75'' x 6'' 300 pages AEI Press  (Washington) Publication Date: February 2001 Paperback ISBN: 0844741442 Price: $ 20.00 Add to Cart   Hardcover ISBN: 0844741434 Price: $ 40.00 Add to Cart   Examination Copies

February 2001
Inequality and Tax Policy
Edited by Kevin A. Hassett and R. Glenn Hubbard

In this volume, leading specialists in public finance, macroeconomics, and political economy draw from the most current research to explore key interactions among policy, inequality, and the economy. The contributors offer their assessments of whether the current tax system is successfully achieving redistribution and whether the results would be worse under a flat tax.

Kevin A. Hassett is a resident scholar at AEI. He previously was an economist for the Federal Reserve System's Board of Governors in its Division of Research and Statistics. R. Glenn Hubbard is the chairman of the President's Council of Economic Advisers and was previously a visiting scholar at the Institute. Hassett and Hubbard have also coedited Transition Costs of Fundamental Tax Reform (AEI Press, 2001) and coauthored The Magic Mountain: A Guide to Defining and Using a Budget Surplus (AEI Press, 1999). A summary of Inequality and Tax Policy follows.

The public debate over tax policy frequently turns on distributional issues. Tax reform proponents, for example, argue that the long-run growth effects of lower marginal tax rates benefit citizens situated throughout the income distribution, while opponents argue that, by starting from a progressive tax structure, marginal tax rate reductions often benefit the wealthy the most and are therefore undesirable. Despite the strong views, references to academic findings in the course of this debate are rare, and many important questions lurk below the surface. How do taxes affect the distribution of income when all dynamic effects are accounted for? Does an equalization of the income distribution have important economic effects? Do changes in equality lead to changes in progressivity? Is entrepreneurial activity especially sensitive to attempts to redistribute income? Any rational position on economic policy must be informed about these key issues.

Inequality and Tax Policy presents six essays on these and other important questions concerning the many interactions between tax policy and inequality. The essays reflect each author's perspective concerning the keys to understanding the connections between policy and inequality. Each contribution offers new and supporting thoughts to extensive scholarly literatures and highlights consensus. Many of them break new ground. Each essay is also followed by a commentary from another distinguished economist.

The Effects of Inequality

The first chapter, Robert J. Barro's "Inequality, Growth, and Investment," explores the relationship between inequality and economic performance. Barro first discusses recent theoretical analyses of the macroeconomic consequences of income inequality, and then describes the latest empirical findings. After surveying the sizable literature and providing new evidence of his own, Barro finds scant evidence that inequality significantly affects overall economic growth, although some evidence suggests that higher inequality raises growth in developed countries and lowers it in less-developed countries.

In his commentary, Alan S. Blinder of Princeton University says that Barro's chapter is a fair-minded review of what is known, but argues that the correlations described by Barro may not be truly causal relationships. Blinder then highlights two examples that may describe well the absence of a clear pattern in the data. Perhaps high marginal tax rates accompany redistribution in wealthy countries, depressing growth, but in poorer countries, small amounts of redistribution can have a large beneficial effect on health and nutrition. Under such circumstances, one cannot draw firm conclusions about the impact of inequality changes on growth rates without investigating the policies that lead to those changes. Such an investigation should be the focus of future research.

One aspect of "fairness" that almost all economists agree on is the principle that government should not tax individuals in an arbitrary and capricious fashion. The second chapter, "Tax Policy and Horizontal Equity," written by the University of California at Berkeley's Alan J. Auerbach and volume editor Kevin A. Hassett, investigates whether it is possible to measure the extent to which government policy treats similar individuals in a like manner. Through an extension of Atkinson's social-welfare-based measure of vertical inequality, the authors develop a measure of horizontal inequality that allows them to separately measure the effect of the tax system on fairness among individuals and across income classes. Their method overcomes many problems that plagued past measures because it is based rigorously on an explicit mathematical formulation of social welfare. The authors then document a striking increase in horizontal inequality over the past decade, as various tax credits have increased the complexity of the fairly pristine tax code that emerged from the 1986 Tax Reform Act.

In his commentary, Louis Kaplow of Harvard University, however, argues that there is little philosophical support for the view, implicit in the Auerbach and Hassett analysis, that horizontal equity should be measured. New measures of social welfare should not be deployed until one knows what to measure and why. He says that Auerbach and Hassett, like previous authors on the subject, develop indexes of horizontal equity without addressing such foundational questions.

Chapter 3, "Entrepreneurial Saving Decisions and Wealth Inequality," studies the increasing inequality of wealth in the United States in recent years and explores whether the increasing success of entrepreneurs can explain it. Volume editor R. Glenn Hubbard finds that most of the run-up in inequality reflects the high savings rate and return on savings of entrepreneurs. He argues that this concentration of wealth likely reflects an imperfection in capital markets; apparently the best way to raise money to start a business is still to save it oneself. His results suggest that policies targeted toward increasing entrepreneurship might effectively combat inequality.

In his commentary, Roger H. Gordon of the University of California at San Diego notes that Hubbard provides intriguing evidence that entrepreneurs save substantially more and end up with higher wealth for any given income level than the rest of us. Gordon then examines Hubbard's explanation for the reported high savings rate of entrepreneurs and argues that it is not quite as robust as it appears. He compares this explanation with an alternative one, in which the high observed value for entrepreneurs' wealth or income is due to underreporting of income arising from income shifting between the personal and the corporate tax bases, and finds the latter equally plausible. Gordon outlines the implications of the two possible theories and provides a road map for future research.

Offsetting Discrimination

In Chapter 4, "The U.S. Fiscal System as an Opportunity-Equalizing Device," Marianne Page and John E. Roemer argue that fairness dictates equality of opportunity. They assess the degree to which the current U.S. tax system equalizes opportunities. They find that with respect to socioeconomic status the system does equalize opportunity well, but that it does poorly with respect to race. Their optimal policy would require that the tax system offset racial discrimination more than it actually does by creating a social safety net that provides benefits that depend on race as well as other economic factors.

In his commentary, the University of Chicago's Casey B. Mulligan reformulates Page and Roemer's approach by drawing on some of his previous work and finds that their conclusion might be reversed under some circumstances. In particular, redistributive programs often take the form of requiring individuals to spend their benefits on a particular commodity, for example, medicine. To the extent that these mandates impose regulations and constraints on those receiving benefits, it is possible that the recipients are worse off under the welfare program than they would be if it did not exist. In such circumstances, it is far more difficult to argue that welfare programs should be expanded in order to raise the well-being of the poor.

In the next chapter, "Balanced-Budget Restraint in Taxing Income from Wealth in the Ramsey Model," Edmund S. Phelps investigates the sensitivity of theoretical results that argue for zero taxation on capital on the grounds that much of the benefit of a consumption tax comes from the reduction in the tax on capital. Phelps finds that the result can be overturned if the government faces a balanced-budget rule that precludes it from hoarding large surpluses. He goes on to explore the forces that could reverse his own conclusion, using the Ramsey growth model to predict the sources of optimal tax results.

N. Gregory Mankiw of Harvard University, however, has mixed feelings about using the Ramsey model for this purpose. Mankiw mentions that it may be a good starting point if one is trying to model wealth accumulation. The Ramsey model may not describe the typical consumer well, but it may describe the typical wealth holder. Mankiw goes on to provide an example that highlights the robustness of the zero-capital tax result. In Mankiw's simple economy, two types of agents exist: workers and capitalists. Capitalists own the machines and receive the return on them. Workers receive a salary that depends on how productive they are. Mankiw shows that if workers had the majority in a democracy and could chose to set tax policy dictatorially, they would still chose a zero capital tax.

Has Inequality Increased?

One possible explanation for the increase in inequality seen in recent years is that lower marginal tax rates have induced high-income individuals to report more income. If this is true, then measured inequality might go up, even though underlying inequality is the same. In the final chapter, "Growing Inequality and Decreased Tax Progressivity," Joel Slemrod and Jon M. Bakija explore that possibility and related questions. Using optimal tax theory, they also probe the link between higher income inequality and higher progressivity. They document a sharp rise in recent years in the income share at the top of the income distribution, and they discuss the sources of this trend and the implications for the desirability of more progressive tax system. They find that it is unlikely that the lower tax rates alone could explain the increase in the income of the very wealthy. They also argue that models of public choice suggest that higher progessivity would be proscribed by social choice models if the increases in inequality were expected to continue.

James M. Poterba of the Massachusetts Institute of Technology commends Slemrod and Bakija for their careful study and then provides a number of alternative perspectives on the recent experience. First, by some measures, the progessivity of the tax system may have increased in recent years. Second, an analysis that focuses on the entire picture, including, for example, housing wealth, may reach alternative conclusions. Poterba concludes that if economists and policy analysts are to understand the determinants of recent changes in the income distribution, analyzing new and nonstandard data sources such as information from firm employment records may be necessary. Slemrod and Bakija's work, he adds, provides a vivid blueprint for further work.