Taxes, Incentives, and the Wage Gap in America

Before I write this, I should make it clear that I'm not an economist. I studied economics for three years and feel that I got a pretty good grounding in the theoretical aspects of the discipline, but have little ability to crunch the relevant numbers. That said, the underlying theories of economics can be instructive in understanding the impacts of a policy, even if those impacts can't be quantified.

And this is what has made me largely doubtful about the notion of further leveling the tax code in an effort to inspire faster growth in the economy.

The common argument behind supply side economics is that lowering taxes on upper income brackets and investment income encourages harder work by those at the top of the socioeconomic spectrum. This harder work generates trickle down effects and also encourages increased investment. The investment, in turn, generates productivity growth which is supposed to bring about increased average income.

This last trick of mathematics is downright spurious. Productivity is simply a measure of production, measured in relation to the number of workers in an economy. Average income is simply the amount of income in an economy divided by the number of people. Given that income and production are equal (this is a tautology) and that the number of workers and the number of people in a country are going to be closely correlated, this relationship works out to a mathematical truism. When production increases, income has to increase too.

What the relationship doesn't say is what happens to the typical worker. In other words, all of the increase in income can easily accrue to the top.

This, of course, is all based on the notion that there actually is an increase in wages resulting from changes in the tax code.

But one of the things pointed out by James Galbraith (who can claim to be an expert on the number crunching end of economics) last week was that a flat tax may lead a small one-time boost in production, something along the lines of a 1% one-time boost in the size of the economy. Now let's assume this is true, that all sounds well and good, but it's still not a desireable outcome, at least not for progressives.

Why is that? Well, it largely has to do with the shifting incentives that come into play from a flattened tax code.

Let's imagine a simple tax code for a second. For less than $25,000 a year, there is no tax. For the marginal income between $25,000 and $100,000 a year, the tax rate is 20%, and it is 40% for income over $100,000.

Now let's imagine a firm with one owner and two employees. The owner makes $200,000 a year, has one full-time employee who earns $50,000 and has one part-time employee earning $20,000.

Now let's say the economy grows a bit and this firm enjoys a bit more income than it thought it would encounter. The boss considers giving bonuses to his employees and himself. Effectively, taxes are an additional cost on those bonuses, so that while a $1,000 bonus for his part-time worker only costs $1,000, a similar sized bonus for the full-time worker costs $1,250, and a bonus for himself would cost $1,666. But pretend then that the tax was flattened so they all paid in the 20 percent bracket. It would be just as cheap for the boss to direct the tax cut to himself as it would be to give the bonus to his part-time worker.

In essence, we move to a system that (relatively speaking) encourages wealthier people to give themselves more money and their low-income workers less.

And that's all because what is happening here is governed by two different economic effects. One of these is known as the income effect. As certain choices become cheaper, consumers respond by acting as though their income has increased and spending more on all products. While this is a rough analogy, this explains roughly why rich investors given tax cuts would be theoretically inclined to invest more. With more money freed up, they can afford to do so.

But there's another effect in economics as certain options become cheaper that is known as the substitution effect. As it becomes cheaper (relatively speaking) to give a raise to themselves, rich people are likely to do that. This isn't complicated. It's very basic theoretical economics.

And over the last 25 years, we've seen it happening. Ronald Reagan effectively lowered marginal rates for the rich through tax cuts and raised the marginal rates for the low-income (through payroll tax increases). Clinton managed to undo some of the damage by increasing the top rate, but Bush Jr. is setting about undoing that.

The response is exactly what textbook economics would predict, when it is cheaper for rich people to give themselves more money, they do precisely that. The result is growing inequality.

Progressive taxation need not be redistributive to have a real impact on wage inequality in this country. Real progressive taxation just creates an incentive scheme that is more likely to result in higher wages on the lower end of the spectrum. That alone is a good reason to support it.

--Matt Singer

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