Reducing the income tax rate and increasing the inheritance tax rate could induce a huge increase in UK GDP, according to research by Professors Alberto Alesina and Guido Cozzi and Dr Noemi Mantovan, published in the December 2012 issue of the Economic Journal.
Based on an analysis of how social beliefs about fairness have evolved over time as well as how redistribution affects incentives, they conclude that taxing inherited wealth rather than incomes would redistribute wealth from those who are born ‘lucky’ to the ‘unlucky’. This would not only reduce perceptions of unfairness in society but also encourage people to be more productive, thereby boosting the economy.
The study begins by asking why Europeans are typically more averse to inequality than Americans and more willing to tax the rich to give to the poor? One answer is that centuries of feudalism, privilege by birth and lack of social mobility have entrenched in many Europeans the idea that wealth is largely undeserved, while the poor are poor because they grew up in the wrong families. Tax and transfers therefore serve to redistribute income from the ‘lucky’ to the ‘unlucky’ in society.
But high income tax rates also discourage work and effort, leaving little space for those willing and able to create new wealth. Thus, concerns about fairness motivate voters to support high taxes on income. In turn, high income taxes discourage individual initiative and paradoxically create a situation in which inequality becomes more entrenched. If hard work is discouraged by high tax rates, individual success is more dependent on family connections, clientele and corruption.
Traditionally, in the United States, the rich were viewed as winners, who earned high incomes because they contributed a lot to society and poorer people were viewed as losers, lazy and unproductive. This justified lower income tax rates, which encouraged hard work and social mobility. Thus, wealth was correctly seen as the result of effort, at least more than in Europe, and therefore inequality was accepted as less unfair.
This study traces the convergence of the US and European paths to two very different ‘equilibria’. One has low taxation, high social mobility and higher GDP; the other has high taxation, low effort, less social mobility and lower income.
The analysis can help to understand political and ideological evolution within a single country. For example, in the United States, after the highly egalitarian ‘hippie’ generation of the 1960s and 1970s, a substantially more meritocratic generation voted for the Reagan administrations of the 1980s. They were dissatisfied with the relaxed work ethic that preceded them and wanted lower income tax rates, not only to stimulate GDP growth but also to reward those who produce more wealth in society.
While income tax discourages work and exacerbates the importance of ‘luck’ in individual success, tax on inherited wealth has the potential to reduce unfairness. Taxing inherited wealth instead of the income generated by individuals redistributes wealth from those who are born ‘lucky’ to the ‘unlucky’, thereby reducing the perception of unfairness in society.
In a numerical simulation with UK data, the researchers find that reducing the income tax rate and increasing the inheritance tax rate could easily induce a huge increase in GDP – of the order of 12% – thereby strongly raising government tax collection.
The design of such a reform in direct taxation should guarantee that only non-income generated wealth is taxed. In the scenario that these researchers describe, while individuals would have to pay 24% on each £1 of their wealth, they would be entitled to subtract 23% on each pound generated by their income.
Hence, the study concludes, a positive wealth tax should be coupled with a negative income tax, which would spur individuals to be productive and to declare their incomes to the tax authorities. This would strongly encourage effort, while correcting the intergenerational transmission of ‘luck’ and privilege.
Properly designed, the inheritance redistribution could be used to correct the current effects of cumulative past unfairness. These benefits should be evaluated against the standard costs of inheritance taxation (such as its effects on savings, tax avoidance, tax evasion, etc.), but these are not the direct focus of this study.
The Evolution of Ideology, Fairness and Redistribution by Alberto Alesina, Guido Cozzi and Noemi Mantovan is published in the December 2012 issue of the Economic Journal.