Tuesday, August 5, 2014

The Robin Hood method of tax and redistribution

Source: Spark Studio via Getty Images
Robin Hood famously took from the rich to give (back) to the poor, to the despair of the Sheriff of Nottingham. But could taxing high-earners actually increase economic well-being and decrease income inequality simultaneously? Could Robin Hood have been right? 

Economic theory tells us that our appetite is satiable. The first slice of pizza when you’re hungry is delicious but the fourth just gives you a stomach ache. And so it is with money. The marginal utility of money – the additional “happiness” we feel from an extra $1 in our pockets – falls as the total amount of money we have rises. $1 to the richest person means much less than $1 to the poorest. In fact, a 2010 study by Daniel Kahneman and Angus Deaton estimated that the average person requires around $75,000 to be happy. Additional income does not add to their emotional well-being.

Economic theory also tells us that those on lower incomes spend more of every $1 they earn than the rich. Their marginal propensity to consume is higher. All families need to meet basic needs. But for the poor, this takes up a higher fraction (if not all) of their income. This drives demand for goods and services. The rich, meanwhile, have a higher propensity to save.

Combining these two observations implies that taxing those on the higher incomes – say above $75,000 – and redistributing to those on the lowest could actually improve overall well-being. If the evidence is to be believed, those on high incomes would not be made worse-off.  And those on the lowest incomes would be made better-off.  

How might this redistribution occur, in a way that does not disincentive those on low incomes from working? One way is to make use of the negative income tax built into our system. Everyone who works has a tax-free allowance, the amount they can earn before they start paying income tax. But many people are unable to work sufficient hours or earn enough to meet their income tax threshold, so part of their benefit is unused. An income transfer could address this gap provided the person is working (the Earned Income Tax Credit effectively does this in the US on a smaller scale).

Opponents of higher taxes argue that those with a higher propensity to earn will have a lower incentive to work or invest in high-return activities because any income would be taxed away. As a result, economic growth would slow and we would all be worse-off. But a report by the Congressional Research Service, which provides unbiased research for the US Congress, found that there is little evidence of a relationship between income tax and hours, savings or investment. Furthermore, the IMF has demonstrated that lower inequality achieved through redistribution can in most cases produce more stable, durable growth rates. That is likely to be because it enables more of the population to participate fully in society. And neither Robin Hood nor the Sheriff could have argued that stable and durable growth was a bad thing.*

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