Income inequality matters less than wealth inequality, so why is everyone still talking about taxing your salary?
- By Daniel AltmanDaniel Altman is senior editor, economics at Foreign Policy and is an adjunct professor at New York University's Stern School of Business. Follow him on Twitter: @altmandaniel.
For the first time in decades, economies around the world are having serious debates about inequality. The recent wave of opportunity created by globalization and technological change has reduced inequality between countries, but it has also increased inequality within many of them. This can have serious costs for society, so it’s a shame that most of the debate is focused on the wrong kind of disparity.
Here’s a little game. When I say the word "inequality," what sort of inequality do you think of? If you said "income inequality," you’re like most people. Now ask yourself why you said that.
Income alone says very little about economic opportunities. Someone with a low income but enormous wealth may be much more powerful than someone with a high income who’s heavily in debt. Consider, for example, a community of retired executives who live off their lifetime earnings while taking huge tax deductions. And then consider young lawyers and doctors receiving their first big paychecks after taking on years of student debt.
Income measures a flow, like the rate at which water goes through a faucet and into a bathtub. Filling the tub up quickly is great, of course, but anyone who has taken a bath knows that what matters is the water level. That’s what economists call a stock. If income is the flow of money, then wealth is its stock.
The stock is what matters, because the flow is ephemeral. You never really hold on to income. Every dollar you earn instantly becomes part of your wealth, just like every drop of water that goes through the faucet adds to the water level in the bath. When you spend money, you decrease your wealth, just like letting water out through the drain. You drain your wealth by buying things and paying taxes; the rest is saving. Your income is just the change in your wealth before you decide what to do with it. (Debt is like having to fill someone else’s bathtub instead of your own.)
If inequality is a problem, then it’s probably because of the things people can do with their money rather than simple envy at the rate they are earning it. In fact, people who complain about inequality are almost certainly complaining about the differences in wealth that result from variation in incomes. They might not care about incomes at all if wealth inequality were somehow constrained.
But clearly, the stock and the flow are linked. So, in purely practical terms, which one should be the target for policy?
To answer this question, imagine two people using income to add to their wealth. One has $100,000 in wealth — all the assets in their bathtub, from bank accounts to baseball-card collections — earns $50,000 a year, and saves $10,000. The other has $1 million in wealth, earns $500,000 a year, and saves $100,000. The gaps in income and wealth are both a factor of 10.
Let’s say the government is worried about inequality and decides to tax the second person’s income at 50 percent. Putting behavioral effects aside, the gap in after-tax income has now been cut in half, accomplishing the government’s goal. The second person will only save $50,000 each year instead of $100,000. But how much will this change the gap in wealth?
Without the tax, the second person will still have 10 times as much wealth as the first person at every point in time. With the tax, it will take a decade for this multiple to narrow from 10 to 7.5. In other words, even after 10 years, the tax will have only half as big an effect on the distribution of wealth as it had overnight on the distribution of income. Wealth responds less quickly than income because the stock, at least for the second person, is much bigger than the flow affecting it. In bathtub terms, there’s so much more water in the second person’s tub that even turning the tap way down makes little difference to the relative water levels between the two tubs.
What about further into the future? The gap in wealth will continue to close, but it will never be halved like the gap in incomes. This is just math; the gap for wealth always approaches a factor of 5 but never reaches it.
The point is that a huge change in the income-tax system — and the distribution of income — can take ages to affect the distribution of wealth to the same degree. By going after the flow, you make much smaller dents in the stock.
So why is everyone obsessed with the flow? I think there are three reasons that income inequality has stolen the spotlight from wealth inequality:
1. It’s easier to get data on income. Most governments in advanced economies collect huge amounts of information on income: how much, what kind, and from where. Because income is usually paid out in cash, often through channels that can be traced electronically, it’s fairly straightforward to track. Wealth is much more difficult to measure. For instance, you can’t know exactly how much your house is worth until you sell it, and the value of your house is changing every day. Moreover, where income is objectively measurable in most cases, wealth can be a subjective assessment. But it’s not an impossible one, as economist Thomas Piketty and others have shown. Governments charge property taxes based on notional values, and some (as in the United States) periodically collect data on financial assets as well. For securities traded in markets, like stocks and bonds, measurement is a snap. Income still wins among most economists, however, because it has been measured more consistently and for longer. Economists love long time series.
2. Income is easier to tax. What would happen if the government wanted to tax wealth? In some countries, it might be against the constitution. Even if it were legal, taxing wealth might be much harder in practice than taxing income. People’s sources of income are usually fixed in place, so the government always knows where to find them; most folks can’t force their employers or the companies they invest in to move overseas just to reduce their own personal income taxes. Wealth is another story. Faced with a new tax, the wealthiest people might simply pull up stakes and move their domiciles to lower-tax countries or try to put their savings in secret accounts abroad (though this is supposed to get harder eventually). Many would still be able to get their income from the same sources, but their wealth would have disappeared from the tax base.
3. Income is a less sensitive topic. People are used to seeing their income taxed. Income taxes in advanced economies go up and down with regularity, depending on deficits and the political wind. But wealth is something people take more personally; it’s their retirement savings, or the inheritance they’re going to leave to their children, or just the sum total of a lifetime of hard work. Asking how much wealth someone has can be a touchy subject, so much so that even members of Congress don’t have to report exact figures. In addition, making the transition to a tax on wealth might feel unfair, since most wealth was already taxed when it was just a flow called income. And there’s no label for the income tax with quite the same resonance as "the death tax" — opponents’ nickname for the estate and gift levy.
These are all legitimate concerns, but they also serve to distract attention from the main issue of wealth inequality. Income alone has no power. Only wealth opens the door to economic opportunity, and wealth inequality is even more acute. Until the inequality debate shifts from income to wealth, the underlying costs to society are unlikely to change.
The way to change the debate is through measurement and awareness. The U.S. Federal Reserve already collects some data on wealth through its Survey of Consumer Finances, which is being compiled this year. Municipalities have information on property values. Tracking wealth comprehensively would be a first step toward understanding how broad wealth inequality really is and bringing it further into the public eye. YouTube videos and commentaries have already started to do this, but a shift among the researchers and politicians who shape the debate is long overdue.