Sunday, June 25, 2006

On Inequality

A student asks a broad question:
I was wondering if you could offer your views on income inequality.
Let me offer a few observations as broad as the question:

1. There is little doubt that U.S. income inequality has been increasing for the past three decades. (The trend in world inequality is very different.) Most economists who study the topic attribute the trend primarily to changes in technology that reward skilled workers relative to unskilled workers. Education and other skills are more valuable now than they were in the past.

2. Reasonable people can disagree about how much the government should redistribute income. Part of the disagreement is economic: for example, how large are the elasticities that determine tax distortions? Part of the disagreement is philosophical: for example, is taking money from high-wage individuals to give it to low-wage individuals a way to ameliorate the injustices inherent in a market economy or a form of government-sanctioned theft? Economists can help with the economic part of the disagreement, but we have no comparative advantage to help with the philosophical part.

3. However much redistribution we choose, the best way to accomplish it is by a progressive system of taxes and transfers. Economists sometimes call this a negative income tax, because low-income individuals pay a "negative" tax. The current progressive income tax together with the Earned Income Tax Credit is close to being an example (although the EITC has a variety of conditions that a pure negative income tax would not have). Wikipedia reports the following about the history of the EITC: "Enacted in 1975, the then very small EITC was expanded in 1986, 1990, 1993, and 2001 with each major tax bill, regardless of whether the tax bill in general raised taxes (1990), lowered taxes (2001), or eliminated other deductions and credits (1986). Today, the EITC is one of the largest anti-poverty tools in the United States, and enjoys broad bipartisan support."

4. Ideally, I would use consumption, rather than income, as the tax base for purposes of raising revenue and redistribution. The benefit of consumption taxes over income taxes is that they do not distort the intertemporal allocation of consumption. A variety of economists have proposed ways to implement a progressive consumption tax. For example, the Hall and Rabushka flat tax is progressive in average tax rates; the Bradford X-tax is similar but even more progressive.

5. Having achieved the desired degree of redistribution with a system of taxes and transfers, policymakers should focus on economic efficiency when setting most other policies. That is, policy regarding international trade, rent control, minimum wages, health care, housing and so on should, in my view, aim to make the economic pie as large as possible. Although these other policies affect the size of different slices, they are inefficient and poorly targeted instruments for purposes of redistribution. To the extent that we choose to redistribute income, we should use the best tools we have for that purpose (see points 3 and 4).