Last week, William
Gale, Melissa Kearney, and Peter Orszag (henceforward “GKO”), all of the
Brookings Institution, published the result of a simulation
ostensibly showing that increasing top-bracket ordinary income tax rates would
have little impact on inequality. Unfortunately, their negative conclusion
arises more or less automatically from the measures of inequality they report,
which do not capture variation in inequality in the tails of the income distribution
very well. This morning, John Quiggin made
that point, which I expand on below.
The specific
scenarios GKO model are increasing the top marginal tax bracket from its
current 39.6% to either 45% or 50% and rebating the revenues to low-income
households. Their primary analysis simply quantifies the mechanical effect of
this policy on income inequality, assuming no behavioral response to tax
changes. In this discussion, I confine my attention to the effect of the tax
increases on tail inequality and do not discuss the issue of redistribution.
There are two key
reasons why these tax scenarios do not affect inequality very much. First of
all, the rich earn a great deal of their income in categories other than
“ordinary income,” to which these tax rates apply. Those categories are grouped
under the somewhat-misleading heading “capital gains,” though tax advisors are
skilled at re-categorizing many things to fit the broad definition. This is the
nature of the controversy over the “Carried Interest Loophole,” a tax shelter available to employees
of Private Equity, Venture Capital, and Hedge Funds—meaning that the
beneficiaries of that loophole, who increasingly comprise the top 1% and top
0.1%, would be significantly shielded from the GKO scenarios. News stories in
recent years have focused on the low effective tax rates paid by Mitt Romney
and Warren Buffett, precisely because those very high-income individuals avail
themselves of those loopholes. By looking only at tax rates on ordinary income,
the Brookings scenarios ignore them.
The other reason why
this scenario doesn’t do much for inequality is that GKO measure inequality by
the Gini Coefficient. But the scenarios only affect individuals comfortably
within the top 1% of the income distribution. The top tax bracket kicks in at
taxable income of $457,601 for married couples filing jointly, which is above the
threshold for the top 1% of the taxable income distribution. The Gini Coefficient is insensitive to measuring inequality
in that group.
That is why Thomas Piketty and his many collaborators on the World Top Incomes Database focus on measured top
income shares. Other measures of inequality that GKO consider, like the ratio
of 99th to 50th percentile income, are also inadequate
for the same reasons. Indeed, one of the authors, Orszag, conceded
as much on
Twitter, and Lucas Goodman, a graduate student who worked on the analysis, made a similar point on his
personal blog
as well.
Using data that
Goodman kindly
provided to
my colleague Ben Zipperer, it’s possible to estimate what happens to inequality
as measured by the top 1% income share under GKO’s scenario. Goodman reported
the Gini Coefficients in GKO’s after-tax income data for both the bottom 99% of
the distribution and for the distribution as a whole, either under current tax
law or under the GKO scenario of increasing the top bracket rate to 50%. Using
the formula for converting partial distribution Gini Coefficients to top income
shares derived by Alvaredo
(2011), it
appears that the policy would reduce the top income share in GKO’s data
(after-tax income distribution of tax units) by about one percentage point.
That drop is actually quite substantial. The context is not precisely the same,
but for comparison, the Congressional Budget Office estimates that the after-tax income share
for the top 1% of households increased by a total of 5.2 percentage points
between 1979 and 2011, so the reduction in the top 1% income share as a result
of the GKO scenario is just under 20% of the total increase in inequality over
the whole period the CBO analyzes—a much more substantial impact than the one
highlighted by GKO.
GKO are continuing a
debate that played out this past year concerning policies that would combat
income inequality and wage stagnation. At a public
appearance
sponsored by the Hamilton Institute in February, Lawrence Summers said that
focusing on education is a distraction from the challenge facing workers, which
is that “there aren’t enough jobs.” The following month, he, Kearney, and
Bradley Hershbein published an
analysis
that argued that a 10% increase in the share of men with college degrees would
not substantially impact tail inequality. John Schmitt and I commented on that
analysis here, and the authors responded here. All of us agreed with the conclusion
that dramatically expanding higher education attainment would not affect
inequality very much because it wouldn’t impact the tail of the income
distribution. Now, in essence, GKO are saying “well, sure, education wouldn’t
affect tail inequality, but neither would higher taxes on the rich,” and
they’ve constructed a scenario and employed ill-fitting metrics to support that
rhetorical move.
A final word about
behavioral responses: the most important research on the effect of top marginal
tax rates on the behavior of those liable to pay them is the recent
paper by
Piketty and his coauthors Emmanuel Saez and Stefanie Stantcheva (henceforward
“PSS”), which my colleague Nick Bunker summarized here, and which I discussed before here. The paper describes three elasticities
by which top tax rates affect economic behavior. Aside from the classic
“supply-side” elasticity, which conjectures that people work less when they’re
taxed more, there are two additional responses. PSS’s second elasticity (not
original to their paper) is the re-categorization of labor income as capital
gains or some other tax-preferred category, and their third elasticity (which
is their original contribution) is that in response to higher taxes, rich
individuals face a diminished incentive to bargain for a share of the corporate
pie.
If the scenarios GKO
model were in fact implemented with no other changes, top-bracket taxpayers
would enjoy an even larger incentive to re-categorize their income as capital
gains than they already do, limiting the ability of such rate changes alone to
affect inequality without also tightening up the loopholes available to the
rich. On the other hand, they would also have less reason to bargain hard in
wage negotiations, which would increase the effect of such a policy on
inequality. PSS provide evidence that the third elasticity is more important in
explaining behavior than the second. Furthermore, they show that declines in
top marginal tax rates across countries are the primary driver of rising tail
inequality, implying that a reversal of that policy would have the opposite
effect. These questions are far from settled in the literature, so future
discussion of the effect of top tax rates and the tax system more broadly on
inequality should aim at confirming or disproving the arguments in PSS, not on
scoring rhetorical points.
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