Clandestine Inequality

by Benjamin Studebaker

The other week, I wrote a post in which I observed a connection in the United States between the rate of federal income tax on the wealthy and the rate of economic growth. As the rate of tax on the rich fell, the pace of economic growth appears to slow. However, it was pointed out to me by readers that despite changes in the tax rate, effective tax rates remained more or less the same. In 1979, the formal tax rate, the rate the baseline rate mandated by the tax code, on the rich was 70%, and in 1996, it was 40%, yet the effective tax rates, the rates people actually pay after taking into account deductions and other loopholes, according to the CBO, were only 1 percentage point apart–37% in 79′, 36% in 96′. Surprisingly, according to a Berkeley study, the effective rate of individual income tax on the rich in 1970 was actually lower–32%. Yet despite this, we still have lower growth rates and more inequality. This is bizarre. What on earth is going on?

It gets weirder. Despite there being seemingly no connection at all between the rate at which the rich are taxed and the rate of tax which the rich actually pay, the rich’s share of income rises as tax rates fall, and not merely in the United States, but across all developed countries:

How is it possible that lowering the tax rate can increase inequality when lowering the tax rate does not actually lower the tax rate?

This is a mystery. The conclusion I came to the other week seems true–over time, the rich have gotten richer, and their excess investment has produced bubbles leading to inefficient and ephemeral growth. The question is, how have they gotten richer? They can’t be paying less taxes, because the effective tax rate data shows stagnant rates. Changes in the tax rates cannot matter, because they do not produce differences in effective rates, yet our graph shows that they must be connected with something that does matter. While the rich aren’t paying less to the government, they must somehow be earning more.

Whatever our mysterious redistributive force is, it’s still in action. Pew data shows that the rich have done better even in comparison with the masses over the course of Obama’s presidency:

The Pew data leaves a clue, however:

That’s right, the rich have recovered from the recession primarily in the form of financial assets, and there’s a much bigger gap between the rich and poor in financial assets than there is in conventional stuff. Edward Wolff did a study that sheds some light on precisely how big the difference is. Here’s the spread on financial assets, as of 2010:


Compare that to the shares when it comes to conventional stuff:

The debt category is quite striking–the bottom 90% seem to owe a lot of money to other people. That money is on their balance sheets as “debt”, but it’s on the balance sheets of the their creditors as “financial assets”. We have lots of evidence that the rich have a dominant role in the investment of nation’s wealth, far more than they once did. The low growth rates seem to indicate that this is, in the long-run, economically harmful. But what policy changes allowed this to happen? How did the rich get this dominant role? If it wasn’t lowering the tax rates themselves, what was it?

It may not be one simple, easy to point to policy, but a combination of several things. Here are the few that stick out to me.

The rich make the largest gains not in conventional assets, but in financial assets–does this mean more of their income comes from capital gains? If it does, the top rate of capital gains tax has fallen a lot, though I can’t find reliable data on effective rates:

Another potential contributor is Ben Bernanke‘s theory–that over the last 30 years or so, highly educated workers have become more valuable such that wages for the rich have grown faster than they have for everyone else. As he put it:

It’s creating two societies. And it’s based very much, I think, on educational differences. The unemployment rate we’ve been talking about. If you’re a college graduate, unemployment is 5 percent. If you’re a high school graduate, it’s 10 percent or more. It’s a very big difference.

If Bernanke’s right, the problem may be self-correcting. Earnings for young college graduates have been in decline for some years now, dating back even to before the recession:

These forces could in turn be assisted by financial deregulation. The UK and the US saw the largest changes in wealth equality since the 80’s, and they have also seen very large amounts of financial deregulation during the same period, which has allowed financial institutions to invest larger portions of their wealth than before, and to open up non-conventional banks that are not subject to the traditional regulations. Sub-prime lending, derivatives, all of these things are to some degree the result of various deregulatory policies. They may have allowed the rich to make more money off of their investments, regardless of the tax rates, which the rich go on to re-invest to further maximize returns. In this way, deregulation is a vicious cycle that constantly increases the share of the investment controlled by the biggest investors, the wealthy.

As for how the rich could be paying the same effective individual tax rates they paid before rates were lowered? The tax reforms of the 80’s also engaged in a great deal of base-broadening–they eliminated ways that people could avoid tax. In this way, the rates could fall while the amount paid could remain more or less consistent, and seemingly big drops in the individual tax rate on the rich would produce relatively small raw effects on their own. The association of lower rates with more inequality is not a product of the rich actually paying less tax, but of other changes in the law and the wider economy that tended to happen around the same time as tax reform.

Wherever you identify the causes of the increase in the ability of the rich to control the flow of investment, the conclusion I reached last week seems to hold up–as the rich have gained more control, they have operated the economy less efficiently than it operated when that portion of the investment was distributed either by consumers or by the state.