A “flat” income tax system cannot work in a mature, stable economy. A progressive income tax system ie. increasing tax rates with increasing income is a necessity.
If people on higher incomes have materially higher proportions of those incomes available for discretionary spending and investment, they will increase their wealth at a faster rate. Thus, wealth disparity will gradually increase, which due to human nature will lead to animosity and the loss of social cohesion, eventually destroying the amenity of the wealthy. Thus, the wealthy have as much vested interest in a progressive tax rate as the poor, albeit for different reasons.
Every so often, we hear people calling for a flat income tax rate. In its purest form, all income from your first dollar earned is taxed at the same rate. Most proponents modify the proposal so that all “earned“ income above a certain threshold (usually dependent upon household structure) is taxed at the single rate. Earned income is defined as wages. Inheritances, capital gains and interest on savings are tax exempt.
Former US presidential candidate Steve Forbes proposed a 17% flat tax on all company profits and earned personal income greater than a threshold equal to $13,200 for each adult, plus $4,000 for each dependent child. Others have proposed variations. More recently, there was the Taxpayer Choice Act in 2007, which was never passed. Last year, we had another Republican presidential candidate, Hermann Cain proposing his / Sim City’s 9-9-9 plan.
Somewhat strangely, “earned” income ie. money you suffered for, is taxed, whereas income earned by someone else on your behalf, such as interest or dividends is not. I’m being a little facetious here, since the tax break for interest and investment income is intended to promote savings and make capital available for businesses.
Still, a reduction in the tax rate for low risk savings and the ability to smooth capital gains over a number of years, rather than no tax at all would recognise that society in part made that money for you, whereas the wages you were paid for digging that ditch really were earned by you.
It seems like all these flat tax proposals come from fringe US Republicans and moreover, never get up. Actually, many eastern European countries have introduced flat income tax rates since the fall of communism.
An increase in investment, productivity and economic growth in these countries since the introduction of the flat tax system does not imply cause and effect. Even if it is found to be a contributing factor to these desirable outcomes, it does not follow that such a taxation structure will continue to have a beneficial effect as these economies mature.
How much of the total economic growth is due to local innovation and how much is due to inflows of foreign capital as a result of economic liberalisation requires deeper analysis than the scope of this article, but I’d hypothesise that the latter is a greater factor. This means that although the flat tax may have spurred economic growth in the short term, this was in economies in transition out of a failed system, where private wealth was being created largely from scratch (for all but a few party apparatchiks). It does not follow that the flat income tax system will continue to have positive economic effects.
The economies of Eastern Europe which introduced the flat income tax regimes were stagnant after decades of oppression by communism. There were few genuine markets and little private ownership. The result was a lack of investment, innovation and entrepreneurship.
Suppose that all of a sudden, the rules of economic interactions are greatly changed, so that those who do take risks, work hard and can attract capital get to keep most of their profits. The result will likely be an upsurge in economic growth. Even if most of the wealth increase is concentrated in a minority of the population, most people achieve a higher standard of living relative to their previous situation.
In the initial phase of the economic changes, the profits earned by the newly wealthy minority are largely reinvested in order to make more wealth, because that is the new avenue to power, influence and self preservation. It is only later that more of the wealthy’s incomes are spent on imported consumer goods, or funnelled out of the country.
This subsequent stage of economic development is when a progressive taxation system needs to kick in, now that there are sufficiently many high income earners and a significant proportion of their income is not being reinvested locally. Even if some of it is, there are now far more investment opportunities for the newly wealthy than most citizens, generating on average significantly greater returns.
That brings me to my main point. In any economy with a sufficient amount of economic freedom, wealthy citizens and profitable, well capitalised corporations will have surplus capital to invest. Individual citizens on or below the average wage will be spending almost all of their incomes on necessities. They will not have a significant amount of surplus capital to risk in a variety of investments. Even when they do invest, they will be constrained by both logical risk aversion and lack of access to many types of higher risk, higher return investments, due to comparatively less financial education and professional and social connections.
Thus, high income earners will have proportionately higher disposable incomes ie. for discretionary spending and investment, as well as usually a better understanding of financial markets and more beneficial professional and social connections to provide investment advice. Additionally, those with a higher proportion of their wealth available for investment can afford to take greater risks, not only due to diversification, but due to the consequences of financial loss being lower in absolute terms.
It follows that those on higher incomes have the opportunity to increase their wealth at a faster rate than those on average or lower incomes. This may be desirable in an economy which is transitioning out of a situation of wholesale stagnation and average poverty (relative to other societies), as it may promote economic growth in the short to medium term. However, in a mature economy with free economic interaction, it will lead to concentrations of wealth and social instability.
As wealthy people and corporations earn on average higher returns and increase their capital at a faster rate than everyone else, a greater share of the total wealth is concentrated in fewer hands, even if the total amount of wealth is increasing through real economic growth.
People may not see a problem with this in a rational economic sense, but that is not how human beings interpret the world.
At very low economic levels, people value things in close to absolute terms: Have I enough to eat? To wear? Do I have shelter?
With more economic complexity ie. with increased levels of absolute wealth, people start to value things in relative terms. There is a famous experiment in which each member of the control group is given $10. Each member of the subject group is given $20 or $50, by a random process, with each knowing what everyone else received. The people who received $20 were significantly unhappier with the outcome, as determined by responses to a questionnaire, than those who received the $10.1
If a society has a small number of individuals with a large proportion of the wealth, the above phenomenon will dominate, even if there is strong economic growth as a whole ie. on average. This will very likely lead to social instability, due to that other prevalent human characteristic: the urge to punish, even to one’s own detriment.
Eventually, a sufficient number of people will derive more emotional satisfaction from destruction of others’ wealth as some perceived “punishment” than working to create their own. Sufficiently many people will begin to see the wealth of the few as undeserved. We are already seeing it now with the loss of social respect of bank CEOs and the pirating of movies and music. Without remediation, the likelihood of violence on both sides increases dramatically.
It is possible to sustain significant income disparity over shorter horizons eg. a couple of decades, as in the United States in the late 1800’s, Eastern Europe 1995 – 2007 and as we are currently seeing in China. This is because a sufficient proportion of the population experiences such a growth in living standards that the absolute outweighs the relative.
In the long term, increasing concentrations of wealth lead to feelings of injustice in the majority of citizens. It does not matter if the wealthy class does not see this as reasonable, perhaps due to a high rate of overall economic growth. In this case the majority opinion will hold sway over the longer term. Social cohesion will break down, harming the amenity of the wealthy.
One of the simplest methods of remediation is via the income tax system. People earning higher incomes need to pay tax at higher rates because of humans’ evolutionarily derived emotional makeup, which significantly determines their sense of social right and wrong.
In a mature economy, it is thus also in the interests of the wealthy to institute a progressive income tax system. The only debate should be tax brackets and rates, which are to an extent derivable, with respect to the requirement of keeping the income distribution in a stationary state.
1 There are plenty of similar examples in Predictably Irrational, by Dan Ariely.
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