Wednesday, October 22, 2008

Comment on the Claim that Increasing Income Tax Will Improve Average Earnings and Reduce Income Inequality

Those who claim that increasing income taxes will improve real hourly earnings have to explain the fact that prior to 1913 there was no income tax but real hourly earnings were increasing as much as 20 times faster than they have increased since 1971, when a significant income tax was in place. I tabulate some rough estimates of average real wage growth pre 1913 and post 1971. Between 1860 and 1890 real wages were growing at a 1-2% clip or so. Post 1971 they have been growing at about 0.1% per year. But there was no income tax for most of the 1860 to 1913 period. In contrast, under the income tax, real wages have been stagnant.

See comparison here.

Differences this big have been ignored in the popular debate about wage inequality. Something is seriously amiss here. Comments, anyone?


Marc Fox said...

Prof. Langbert makes some interesting points. Nevertheless, I am forced to disagree with his conclusion.

The economic environment was very different in the late 19th Century than it is now. in particular, there was a large pool of land and resources that were just beginning (e.g. the U.S. was a net oil EXPORTER until the 1950's) to get developed.

Moreover, the U.S. was just beginning to get industrialized, and higher growth rates are possible if the initial starting point is low. Indeed, in 2008 China can grow very fast in part because it began from such a low level of economic activity. Indeed, it is highly likely that China's growth rates will taper off in the next few decades.

I'd like to make one more point in this regard. The U.S. had very high marginal tax rates after WWII and these rates were reduced during the Kennedy Administration and later during the Reagan Administration. Yet GDP growth fell. So there does not appear to be strong evidence that high marginal tax rates reduce growth.

Marc Fox
Brooklyn College

Cortes said...

There are, of course, an almost infinite number of factors that might have influenced the rate of growth in wages during any period that the analyst may wish to choose. In all events, however, adding an additional cost to the price of any goods or services (labor included), such as an income tax, will reduce the consumption or availability of those goods or services.

For a reductio ad absurdam, assuming a confiscatory, flat income tax of 100%, it is immediately apparent that no one would work for wages (they may work for other reasons) as they would take home no pay. Lower taxes will reduce this effect and zero taxes on wages would eliminate it entirely.

I suggest that to worry as to whether or not an income tax improves average earnings and/or reduces income inequality (and at what rates of taxation) is to miss a larger and more important point, i.e., what is the fairest and most efficient way to raise the revenue for government to perform its necessary services. At the same time, tax policy should attempt to leave the largest amount of workers' wages in their hands while distorting the labor market as little as possible.

Many countries have reverted to a consumption tax (VAT) in an effort to achieve this goal and I have long preferred a head tax. This tax is no longer on the table for discussion as it has become accepted wisdom that the tax code is designed not just to raise revenue for the government but is also a key tool in the effort to achieve various social goals.

Perhaps a discussion on this as a matter of principle would be interesting.