Inequality (Part 2) - The Pathological Focus on Income and Wealth Gaps

In our last piece on inequality^[1], we focused on claims from the World Economic Forum (WEF) and other progressive organizations about the growth in inequality over time in income and wealth and how those measures have been grossly exaggerated particularly when looking at post-tax and transfer income redistribution measures.^[2] In this piece we consider the impacts of such redistributive policies. How do higher taxes on those at the top of the income distribution alter their behavior? What are the effects of increasing transfer income for those at the bottom of the income distribution? The evidence shows that myopically focusing on gaps under the guise of avoiding runaway inequality has actually had a severe, negative impact on potential economic growth, standards of living and opportunities across the income distribution.

Social Mobility and its Relationship with Inequality Trends

In 2020, the WEF published its “Global Social Mobility Index”, which sought to show which countries in the world could most improve economic mobility by “fixing inequality”^[3]. Its recommended tools include “improving tax progressivity on personal income”, “address[ing] wealth concentration”, and “most importantly, [changing] the mix of public spending and policy incentives” so that there is a “greater emphasis on factors of social spending”.^[4]

Researchers who study inequality have relatedly argued that higher levels of inequality contribute to relatively lower levels of mobility. In a 2015 essay admonishing Republicans for blindness to this asserted reality, New Yorker columnist George Packer cites the research of the late accomplished Princeton economist Alan Krueger’s research:

Alan Krueger has demonstrated that societies with higher levels of income inequality are societies with lower levels of social mobility. As America has grown less economically equal, a citizen’s ability to move upward has fallen behind that of citizens in other Western democracies. We are no longer the country where anyone can become anything.^[5]

Is this statement accurate? Harvard economics professor Raj Chetty has done comprehensive studies on mobility in the United States (U.S.) and has found that mobility has fallen significantly over the last 50 years. However, a confounding fact emerges from his research: during the period in which many economists claim that there was rising inequality – the period between the early 1970s and early 1990s – Chetty’s data show that relative mobility (i.e., the likelihood children can change their rank in the income distribution relative to their parents) did not fall but rather remained completely flat over this period of time.^[6]

What Chetty’s data show is that absolute mobility (i.e., the likelihood children from one generation achieve a higher income status than their parents) has fallen precipitously since 1970.^[7] While this may initially seem compelling, the question is whether this decline in absolute mobility is a result of an increase in inequality.

In fact, the time patterns do not match up. With the steep decline in absolute mobility beginning in 1970, this trend began well before inequality supposedly began to explode in the 1980s according to the series of economists Thomas Piketty and Emmanuel Saez in their 2003 paper (See Figure 1).^[8] Thus, even taking at face value the dubious Piketty-Saez claim of soaring inequality, it would be highly questionable to claim that the fall in absolute mobility that occurred after 1970 could be directly attributed to that phenomenon.

Chetty’s findings related to mobility are by no means unreasonable. Economic growth has slowed and thus if incomes are no longer rising at the same rates as they once did, it stands to reason that past generations had a better chance of outperforming their parents in terms of income than they do today. But this is a perfectly natural consequence of economic growth.

As Scott Winship of the American Enterprise Institute notes in a recent report on economic mobility for the Archbridge Institute, absolute mobility is much higher in countries that are poorer and thus are growing much more rapidly.^[9] However, while absolute mobility peaked around 1933^[10] in the U.S. would any reasonable person prefer to live in the U.S. during the Great Depression rather than today? Or would anyone prefer to live today in a poorer but rapidly growing country like China rather than the U.S.?

Contrasting Visions For Improving Citizens’ Opportunities and Welfare

Many economists have argued that due to the growing complexity of skill sets required for the 21^st century labor force, even an increase in economic growth would be unlikely to yield increases to wages for lower-skilled workers that keep pace with those for higher-skilled workers. These arguments have added to the paranoia around any policy agenda that aims to cut taxes to any degree for wealthier taxpayers with the goal of stimulating economic growth, since this would theoretically only exacerbate current trends around income inequality.

For example, during the period preceding the Trump tax cuts, many were sounding the alarm about the almost-certain calamitous impact that the new tax bill would have on income inequality. Dylan Scott and Alvin Chang of Vox confidently asserted, “The Republican tax bill will exacerbate income inequality in America.”^[11] The progressive think tank Center for American Progress ran a piece with a headline with a similar theme, “How Middle-Class and Working Families Could Lose Under the Trump Tax Plan.”^[12]

Yet, two years later the Council of Economic Advisers looked at the growth rates in earnings during President Trump’s time in office between managers and workers, those with bachelor’s degrees and those without, those in the bottom 10 percent and those in the top 10 percent, and finally between black and white workers, finding the inverse to be true. Workers’ earnings outpaced managers’ earnings, those without a bachelor’s degree saw faster rates of growth in their earnings than those with bachelor’s degrees, the bottom 10 percent’s earnings significantly outpaced those in the top 10 percent, and the growth in black Americans’ earnings outpaced those of white Americans.^[13]

A similar situation took place in the aftermath of President John F. Kennedy’s tax cuts, which reduced the highest marginal tax rate from 91 percent in 1962 to 70 percent by 1965. At the time, critics viewed the change as irresponsible, fearing that this would almost certainly increase the Federal deficit.^[14] Yet, despite this concern, government revenues actually increased by 33 percent in real terms between 1961 and 1968 - from $94 billion to $153 billion.^[15]

This often happens to be the case as relates to policies allegedly aimed at benefiting the poor or middle class at the expense of the rich. A key example was the passage of a large increase in state tax rates for households in California in 2012 under Proposition 30. Touted as a ballot measure that would provide $8.5 billion in additional tax revenues to fund education systems in California including public school systems, voters decisively passed the tax increase.^[16] Three new tax brackets were established for high earners with the highest rate reaching 13.3 percent.

In recent research, Rauh and Shyu (2023), we have studied the impact of the measure on tax revenues using detailed administrative tax data. This work finds that the reactions of high earners to the tax increase - either expressed through moving out of the state or through reporting less income - eroded 55.6 percent of the windfall tax revenues over the first 3 tax years and over 80 percent by the final year.^[17] A persistent high-income earner (i.e., one in the top bracket for all years studied) would have generated about 11 percent more in taxable income if that taxpayer had faced the original marginal tax rate that existed prior to the passage of the proposition as opposed to the new rate established in the aftermath of its passage.

The top 1 percent of California earners pay around 50 percent of all state taxes according to the nonpartisan California Legislative Analyst’s Office, and much has been made of ever-rising California taxes potentially pushing wealthy earners out of California.^[18] This has proven to be a relevant concern as high earners’ rates of departure are the highest among all income earners^[19] in California. Still, of the behavioral impact on revenues, Rauh and Shyu find that an overwhelming 90 percent of the erosion in tax revenues came from high income earners reporting less income rather than through them leaving the state entirely. In other words, California is both losing large numbers of wealthy earners and those that have decided to stay are reporting significantly less income through working less, engaging in less private business investment, or hiring tax accountants to reclassify income and avoid taxation.^[20],[21]

While the highest earners have the highest rates of departure, lower and middle income earners area also leaving at high rates as well^[22]; however, these taxpayers' reasons for leaving are less related to the tax regime and are more so due to other policy commitments from progressive groups like the WEF toward issues like climate change drastically increasing the cost of living. Harvard economics professor Ed Glaeser who has studied housing changes in cities across America notes that policymakers in California starting in the 1960s began to make construction much harder in large part because of environmental concerns. Ironically, he and his co-author Matthew Kahn of the University of Southern California found that building in more temperate coastal California relative to areas like Houston or Phoenix would result in less carbon emitted overall due to differences in air conditioning usage. Nevertheless, the state tightened restrictions and prices soared.^[23]

Implications of Progressive Policies

These policies ultimately have serious implications for long-term job prospects for lower-income workers. In a 2018 Brookings paper studying labor trends across the country, Harvard economists Benjamin Austen, Ed Glaeser, and Lawrence Summers found that domestic migration rates have fallen significantly and are less directed toward high-income areas relative to past years. While moving to these areas still often results in significant wage gains, housing costs in these areas have risen dramatically. In Boston and San Francisco for example, real housing prices have increased by 200 percent and 300 percent between 1978 and 2017, respectively.^[24]

In the past when fewer restrictions were placed on housing construction, migrating to high-income areas provided massive gains for lower-income workers. For example, between 1940 and 1960 almost 3.5 million black Americans left the south for northern and western cities. During this same period, the poverty rate among black Americans fell a staggering 40 percentage points from 87 percent to 47 percent.^[25] It is worth mentioning that this drop occurred well before the passage of the expansive “War on Poverty” social programs of the 1960s and 1970s that were advertised as aimed at completely eradicating poverty.^[26]

Another significant variable placing downward pressure on cross-state migration is the lack of transferability of public benefits across state lines. As Yale Law School’s David Schleicher finds, lower income Americans are often stuck in their respective states due to public benefits like housing vouchers. Federal programs like Medicaid insofar as one is able to move would require new applications that may not ultimately be approved.^[27] While it is hard to isolate any change to just one or two variables, Austen, Glaeser, and Summers note that the growth of the aforementioned geographic barriers has coincided with a large increase in the share of prime aged men (aged 25-54) who are not in the labor force, as that number has grown from under 4 percent during the 1950s to over 10 percent today.^[28]

Conclusion

Policymakers’ pathological focus on income and wealth gaps over the last several decades has proven to be gravely misguided. While in our last piece, we showed that much of the rhetoric around the growth in inequality has been grossly exaggerated or even completely misestimated, what has changed is that there is a growing consensus particularly among progressive elites that the proper way by which you improve citizens’ general welfare is through aggressive progressive taxation and increased spending on cash-transfers or other government programs.

California has been a place of emphasis for us in this piece precisely because it has pursued much of the economic policy agenda of the progressive left while also having the distinct advantages of temperate climate and natural beauty that might make citizens more willing to tolerate the state’s higher cost of living.^[29] Yet even with these embedded advantages, over the last decade people of all income brackets have begun leaving en masse for states like Texas, with much lighter tax burdens and a lower overall cost of living.^[30]

Even with this record of failure in California and elsewhere, any discussion about potentially cutting taxes to generate economic activity or altering government programs due to concerns about their inherent economic disincentives is almost always batted away as irresponsible or having no evidentiary basis. Of course, what are seldom acknowledged are moments in economic history wherein anticipated growth trends in income or government revenues based on progressive notions about taxation prove incorrect like in the case of income growth trends in the aftermath of the Trump tax cuts or in the case of government revenues in the aftermath of President John F. Kennedy’s tax cuts.

What is ultimately required is a re-examination of economic first principles that prioritizes economic growth and citizen mobility over elaborate tax and social program schemes that are based on assumptions with questionable levels of evidence. Typically, those who have argued against progressive tax and redistribution policies have been accused of quietly desiring to benefit the rich at the expense of the poor, despite the inverse appearing to be true based on the historical record discussed above.

As J.A. Schumpeter once famously said, “We fight for and against not men and things as they are, but for and against the caricatures we make of them.”^[31] Hoover Institution economist Thomas Sowell cited this phrase in 2012 in particular to characterize discussions of tax and spending policy. Over a decade later, we may be even farther away from a dialogue that assesses government reforms on their merit, as politicians increasingly weaponize wealth gaps and ignore the actual evidence of the negative effects of tax and spending policy on overall economic prosperity. What is important is not the static income effects of a policy on the differences between segments of the income distribution, but rather the long-term dynamic effects on economic growth and citizens’ economic opportunities and well-being.

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[1] https://libertylensecon.substack.com/p/taking-the-political-spin-out-of

[2] Government policy redistributes income in two ways: through progressive taxation (taxing higher incomes at higher rates than lower incomes) and through spending and welfare programs. Inequality estimates before and after taxes are paid and government spending is redistributed can vary.

[3] https://www.weforum.org/reports/global-social-mobility-index-2020-why-economies-benefit-from-fixing-inequality/#:~:text=Denmark%20tops%20the%20rankings%20with,)%20and%20Iceland%20(82.7).

[4] https://www.weforum.org/press/2020/01/revealed-why-economies-benefit-from-fixing-inequality/

[5] https://www.newyorker.com/magazine/2015/11/09/the-republican-class-war

[6] https://www.brookings.edu/articles/the-great-gatsby-curve-all-heat-no-light/

[7] https://www.brookings.edu/articles/raj-chetty-in-14-charts-big-findings-on-opportunity-and-mobility-we-should-know/

[8] https://eml.berkeley.edu/~saez/pikettyqje.pdf

[9] https://www.archbridgeinstitute.org/wp-content/uploads/2022/02/Economic-Mobility-in-America_Part-3_Scott-Winship-1.pdf

[10] https://www.gc.cuny.edu/sites/default/files/2021-07/SCWP04_-The-Long-Run-Evolution-of-Absolute-Intergenerational-Mobility.pdf, pg. 35.

[11] https://www.vox.com/policy-and-politics/2017/12/2/16720952/senate-tax-bill-inequality

[12] https://www.americanprogress.org/article/middle-class-working-families-lose-trump-tax-plan/

[13] https://trumpwhitehouse.archives.gov/articles/blue-collar-labor-boom-reduces-inequality/

[14] https://www.nytimes.com/1963/07/18/archives/63-deficit-under-estimate-kennedy-presses-tax-cut-26billion-drop.html, pgs. 1 and 9.

[15] https://taxfoundation.org/happy-birthday-kennedy-tax-cuts/

[16] https://calbudgetcenter.org/app/uploads/120911_Proposition_30_BB.pdf

[17] https://www.aeaweb.org/articles?id=10.1257/pol.20200500

[18] https://calmatters.org/commentary/2022/08/california-is-leaking-vital-high-income-taxpayers/

[19] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4037764

[20] https://www.ppic.org/blog/where-are-californians-going-when-they-leave-the-golden-state/

[21] Ultimately, Rauh and Shyu’s findings imply an elasticity of taxable income with respect to marginal net of tax rates for high earners of 2.6-3.0.

[22] https://www.bubbleinfo.com/2023/05/03/california-migration-2/

[23] https://www.city-journal.org/article/free-to-build

[24] https://www.brookings.edu/wp-content/uploads/2018/03/AustinEtAl_Text.pdf, pg. 158.

[25] https://www.aei.org/carpe-diem/thomas-sowell-on-the-legacy-of-slavery-vs-the-legacy-of-liberalism/

[26] https://millercenter.org/president/lbjohnson/domestic-affairs

[27] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2896309

[28] https://www.brookings.edu/wp-content/uploads/2018/03/AustinEtAl_Text.pdf, pg. 161.

[29] https://news.usc.edu/76714/whats-the-real-california-dream-its-all-about-the-weather/

[30] https://nypost.com/2023/02/18/over-500000-people-left-california-in-two-years-report/

[31] https://www.hoover.org/sites/default/files/uploads/documents/Sowell_TrickleDown_FINAL.pdf