The idea that we should tax the rich to fund public services and transfers to the poor seems obvious from an egalitarian perspective, at least as long as we are in a society with significantly unequal incomes. But it has been challenged recently by some advocates of Modern Monetary Theory.
[note: The meaning of ‘rich’ is rarely spelt out, and isn’t very helpful. Hardly anyone is willing to admit to being rich, so the discussion tends to focus on a handful of cases like Bill Gates, rather than on people in the top 1 per cent or 10 per cent of the income distribution. So, from now on, I’m going to use the term ‘high-income’ and refer to proposals raising taxes on some subset of the top 10 per cent.]
Over the fold, an extract from my book-in-progress, The Economic Consequences of the Pandemic
The argument that we don’t need to tax people on high incomes works in two stages.
First, following the functional finance arguments made by Abba Lerner in the 1940s, MMT advocates argue that taxes aren’t needed to ‘fund’ public expenditure. Rather, for a given level of public expenditure, taxes should be set to ensure that aggregate private and public demand is equal to the total productive capacity of the economy.
That’s one way of presenting the standard Keynesian model and useful in a lot of ways. But it doesn’t do as much work as many MMT advocates would like. Suppose the government balanced aggregate demand and supply, and now wants to introduce a new spending
problem program. To maintain balance, private spending (consumption and investment) needs to be reduced by an equal amount. That requires tax revenue roughly equal to the amount of the new spending.
The second part of the argument is that, if taxes are meant to reduce consumption, there’s no point in taxing high income earners because they won’t change their consumption in response to changes in their income. (By contrast, the poor will spend their entire income).
The claim that high incomes won’t change their consumption in response to changes in their income has some merit when we are talking about short-run stabilization, for example an economic stimulus during the pandemic. People who can manage their financial assets and liabilities won’t change their spending much in response to a once-off payment or tax increase. Rather they will reduce their savings to absorb a tax increase and use once-off payments to increase savings or pay down debt. By contrast, people on low incomes are typically ‘credit constrained’, meaning that they can’t borrow (at least at reasonable rates of interest) to meet current needs. So, they are more likely to spend any windfall gain, which makes them more responsive to short term stimulus payments (and also more likely to reduce spending when the payments stop)
Permanent changes in spending and taxation raise quite different issues. Unlike the case of temporary changes, households at all levels will respond to these changes. The only question is whether the responses of high-income and low-income households differ enough to matter. One way to answer this question is to ask whether, in the long run, high income households save a large share of their income than low income households. This question turns out to be surprisingly difficult to answer.
For our purposes, the most interesting approach is to look at the way changes in income distribution affect aggregate savings. If high income households save much more, a redistribution of income that reduces their share will increase aggregate consumption. In this case, the claim made by Kelton and others, that taxing the rich does not provide extra resources
In reality, however, studies at the aggregate level find no such effect. Changing the distribution of income does little or nothing to affect aggregate savings. Studies at the household level find some effect, but not enough to matter. To quote an influential recent study
“policies that redistribute across income groups can have real effects on saving [BUT] the differential saving effects of typical government transfer programs are not so large as to make a measurable dent in aggregate saving” Dynan et al, Do the Rich Save More? DOI 10.1086/381475
This claim that high income earners don’t spend their (permanent) income is commonly associated with MMT. However, it isn’t inherent in any of the intellectual strands of thought that go into MMT – functional finance, Minsky crisis theory, post-Keynesian macro. Rather it’s been added on by MMT supporters who want to avoid the need for tax increases, either because it seems politically too difficult, or because they don’t want to alienate potential allies in the financial sector.
To restate, the current debate about pandemic stimulus. Here the need is to hand out lots of money on a temporary basis to people who will spend it now. That implies an expenditure program targeted at low income earners. Once the economy has recovered, it will be time to look at permanent new spending programs and raise taxes to provide the necessary resources.
—– Taxing to level down —-
Some opponents of taxing high income earners to fund (or resource) government programs say that they nevertheless support progressive taxes to reduce the excessive incomes of ‘the rich’. On the arguments above, that doesn’t provide any extra spending capacity, so the only purpose of the tax is to reduce inequality by levelling down.
This position is, whether its proponents realise it or not, a rhetorical dodge. The implied policy program now is one in which permanent spending programs are introduced now, without any increased tax on high income earners. The inequality-reducing tax, which is a much harder program to sell politically in the absence of any plan to spend the proceeds, will be deferred indefinitely.
The problem is that, one way or another, the need for real resources to support public programs will become evident. Either access to programs will be delayed and rationed, or charges of one kind or another will be imposed, or inflation will be allowed to erode the value of benefits. Real public programs require real resources and that means taxing the people who have the resources to pay (the apocryphal words attributed to Willie Sutton, when asked why he robbed banks, are apposite here).