The Cost of Equality

A brief analysis of macroeconomic data reveals that there is growing income inequality in the United States. Income inequality has many undesirable outcomes such as political division, unemployment, and large public and private debt (the former is now more than 100% of GDP and the latter is just over 200%).

The progressive tax in the United States exists specifically to mitigate income inequality by redistributing wealth from higher earners to lower earners via taxes and subsidies, respectively. I came across some good research and summarized the pros and cons of such a system.

Benefits:

Economic Justice

We can crudely define economic justice to be something along the lines of: those who have more should pay more and those who have less should pay less. If we accept this definition, then the first two panels of the figure above should partially satisfy our idea of justice. Those who have received a greater portion of the pie also pay a greater portion of tax receipts. The converse is also true.

Reduced Inequality

The far-right panel in the figure above verifies that a progressive tax code reallocated wealth effectively. Inequality would be much higher without the taxes and benefits we currently have on the books. This goes a long way to avoiding the damaging effects of inequality.

Costs:

Volatility

There are merits to a robin hood-style taxing system, but equality does have costs, such as revenue volatility. In NY, CT, NJ, and CA, the top 1% of earners paid 40% or more of state income taxes in 2008. Clearly, state tax revenue is highly dependent on the wealthy. This wouldn’t be as problematic if the top 1% was not the most volatile income bracket.

Between 2007 and 2008, the income of the 1% fell 16%, compared to a decline of 4% for total U.S. earners. Today’s highest salaries are usually linked to financial markets – through stock-based pay or investments – they are more prone to sudden shocks.

Inability to Forecast Revenue

This volatility and link to the financial markets is problematic for government economists who seeks to forecast budgets. In states where over 40% of the revenue is drawn from the top 1%, who in turn draw that revenue from the financial markets, good revenue forecasts involve forecasting the stock market, an impossible task.

Debt

If any of the states mentioned above seem familiar to you, it’s probably because they are also one of the most indebted states to date. States with high dependence on top earners profit wildly during economic booms but suffer revenue shortfalls when the economy turns sour. For reasons outlined in the section above, these turning points cannot be identified so spending is almost never curtailed in time. With spending held constant and revenues falling, debt piles up.