Income distribution is a divisive subject. Fairness, more so. The standard way of evaluating income distribution is the GINI Coefficient, an extremely complex equation that produces a number between 0 and 1. With GINI = 1, one person in an economy gets all the money, and everyone else has nothing. At GINI = 0, everyone is absolutely identical.
There are no nations at either end.
The current approach to ensuring some degree of fairness is to use the tax system. And, here presented, are various systems of taxation as well as the impacts of targeted changes to tax systems. It does involve some maths, but it is presented as simple tables. Like this one…
Figure 1: Equal Taxation
Much of modern economic theory has been about reducing the gap between rich and poor, and making a more equitable society. Troublingly for social scientists, GINI varies wildly irrespective of economic system. However, poor and autocratic societies tend to be more unequal than wealthy and free ones. And even where income disparities are wide (as in the US, where the poorest 20% of Americans earn as much as the richest 20% of Russians) it doesn’t always mean that the poorest are scrabbling in the dirt while the rich dine on caviar.
In Figure 1, we have a tax system that really would be unfair. But first, the rules behind these graphs:
- Total GDP (or Gross Domestic Product – the wealth generated by the entire “nation”) is set at 100;
- The income brackets of this society have been divided into five, with income presented pretty much as it breaks down in the US, with the top 20% earning some 9 time more than the bottom 20%. The sum of all the incomes adds up to 100, so the top 20% earn 45, and the bottom 20% earn 5;
- Total tax levied against the nation is 17 – this is equivalent to what the US raises from its citizens currently – note that the current deficit of 4% implies that there is a tax under-collection of 19% which is where the current national debt comes in;
- The blue bar is the gross income accrued by the particular income bracket;
- The red bar is the total tax levied from that particular income bracket;
- The green line is a % and reflects the proportion of income that is paid in tax (this definition will change in later figures, but I’ll let you know when);
- You can click on the images to see a larger figure (and so read the text).
Back to Figure 1
Here, total tax is 17 and has been divided equally (and fairly) across the population. So, everyone gets to pay 3.4. Only problem is, income is not distributed equally, so the poor pay relatively more than do the rich. This is a recipe for riots. There aren’t really any countries in the world that practice this one on purpose.
Lets try some redistribution
There are many different tax systems in the world. Some breathtakingly complex (the US one is quite frightening), and some quite straightforward. One of the easiest (at least, to understand) is the concept of a flat tax. The government intends to raise 17% of GDP to spend on things it deems important, therefore everyone must pay 17% of their revenue to the state.
This looks like this:
Figure 2: Flat Taxation
This is much better, don’t you think? The rich are clearly paying much more in absolute terms than are the poor, and everyone pays the same proportion of their incomes. There is little incentive to try and manipulate things by changing tax brackets, because there is only one bracket.
What’s this bracket thing? Well, the alternative to a flat tax is what is known as a progressive tax. This basically means that income is divided into a set of brackets and, depending on what you earn, you pay a different amount of tax. This is the most popular form of income tax around and results in monstrously complex tax law. The reason is that the last thing any government wants is to create moral hazard here. For instance, if you knew that a salary raise was going to place you in a higher tax bracket and your net take-home pay would actually be LESS than what you were earning before, you wouldn’t want a raise.
Worse, is that investors wouldn’t invest either since any increase in their profits would leave them worse-off than if they hadn’t invested at all. So there are usually all sorts of grants, and back-payments and things like that to make sure that it remains “fair”. Now you get that usual distribution curve where the people at the bottom don’t pay taxes, and the people at the top cover the bill:
Figure 3: Progressive Taxation
This is the situation for most taxpayers in most democracies. Unfortunately, this system creates a lot of problems. Actually … let me demonstrate.
Progressing the tax further
Say a government decides to give tax relief to the middle class (i.e. bracket 3 and, to a lesser extent, 2; brackets 4 and 5 don’t pay tax anyway so you’ll never hear anyone offering to give them tax relief). Let’s take a look at how everyone imagines this will work out (and here, the green line reflects – not the % of income paid as tax – but the % change in gross income, where negative numbers imply a decrease):
Figure 4: Redistributive Taxation
This is what we imagine will happen. The rich will trouser the 2.4% loss to their gross income, while the middle classes earn an extra 1.7% to 4.1%, while the poor don’t experience much of an impact and the net tax effect is neutral since the total collection remains 17.
However, money is liquid and mobile and the rich are – by virtue of the fact that they’re in the top 20% – quite good with money. They have options. For starters, they can simply increase their fees (either in their time, or for the products they sell):
Figure 5: Scenario 1 – Increased Prices
The rich were expected to absorb a 0.9% decrease in their overall take-home pay. Instead, they increased their charges. Their total revenue went from 45 to 45.9. You can see the impact which is felt equally across society. Brackets 2 and 3 are still up from their original salaries – the redistributive tax has still left them better-off – but the poor have taken it in the neck. The poorest 20% have actually seen their salaries negatively impacted by 4.4%.
In other words, a redistributive tax has the impact of making the rich richer and the poor poorer. Exactly the opposite effect of what was intended. But this isn’t the worst scenario.
You see, the rich really do have other options. They could decide to invest their money offshore.
The rich may decide that the tax option of declaring an income one bracket down is very attractive. So they move a proportion of their investment offshore. Either they close down a factory and move it to China, or they place their investment equity holdings in an emerging market. Consider, emerging markets are expected to grow by 6 to 8% over the next 12 months, while US and EU economies are either to hold still, or even contract. A lot of cash could start moving in unusual directions – especially since US and EU banks now belong to their governments.
Figure 6: Scenario 2 – Investing elsewhere
The richest 20% decided to become the 2nd richest 20%, and sent the rest of their money overseas. Now the total tax take has changed dramatically. Instead of collecting 17, the state now collects 5.1.
Instead of the deficit being 4, the deficit now expands to 15.9. In other words, for every $1 that the state raises through taxes, it is spending another $4.1. That is a recipe for economic collapse.
The most likely result of a tax redistribution is a mix of scenarios 1 and 2. The US deficit will go up as a result of taxing the rich more heavily, but inflation (as the rich raise their fees) will also erode the gains experienced by the rest of the population while increasing the absolute levels of inequality.
Now, we can argue about this. Maybe the rich shouldn’t be so “selfish”. Maybe you can come up with a way to stop them taking the money they already have away. What you can’t do is force investment that did not happen to happen.
You can’t force the young inventor who would have built his new factory in the US from seeking a more favourable tax environment elsewhere. You can’t enslave the young engineering graduate to prevent her from taking her skills to a more favourable country.
The only way is to offer ostensible advantages.
That’s if you want them at all.