Thomas Piketty's best-selling “Capital in the Twenty-First Century” has given policy makers and pundits a renewed excuse to call for the redistribution of wealth and higher taxes.
But it is time for the French economist to move out of the limelight. Two eminent economics professors, Carnegie Mellon's Allan Meltzer and the Wharton School's Scott Richard, are challenging his conclusions with a new model and different data. Contrary to popular wisdom, they find that government redistribution increases inequality rather than reducing it.
In their July 4 working paper, titled “ A Rational Theory of the Growth of Government and the Distribution of Income ,” Meltzer and Richard show that using redistribution to ameliorate income inequality is not only ineffective, but worsens the problem that policy makers seek to cure.
Central to the Meltzer-Richard model is the assumption that technological progress happens through “learning by doing.” Since workers' productivity levels increase with the more they produce, and because higher taxes create disincentives to working, taxes lead to lower economic growth.
Meltzer and Richard assume that people act to maximize their lifetime utility and that the “median-voter theorem” holds. That means the median-income earner chooses the tax rate, so the tax rate selected will likely be higher than the rate chosen by those with income above the median.
Higher tax rates that fund transfer payments hamper economic growth. That's because they increase the number of people who depend on these payments and find it preferable not to work. There also is less learning-by-doing among those who work. This has been extensively documented by University of Chicago professor Casey Mulligan in his award-winning book, “The Redistribution Recession.” As taxes and transfers rise, hours of work and acquired skills decline, reducing economic growth.
Meltzer and Richard are the first to show formally that it is this decline in hours worked for low-productivity workers that leads to more economic inequality — not the growth of technology nor the rent-seeking privileges of the rich, two causes cited by Piketty. Reduced effort by the rich in reaction to higher taxes comes at the expense of economic growth, which has the potential to raise everyone's living standards and increase economic opportunity.
For developing economies, such as India and China, the rate of economic growth increases quickly, because they can copy technology from mature economies. The result is a high rate of economic growth that slows over time, as promising technologies are integrated. As the growth rate of the economy slows, the rate of government growth increases due to a slowing of the “learning by doing” mechanism. This larger government, as measured by a higher tax rate, leads to more income inequality.
Picketty sees the subsequent income inequality as the result of an economy increasingly rewarding the wealthy. But Meltzer and Richard show that the growth of government is the true driver behind inequality.
In a mature economy, what drives the rate of economic growth is the business cycle, not the catch-up effect of copying existing technology from other countries. When computers were invented, the productivity of office workers increased relative to agricultural workers. More unequal levels of productivity mean more unequal wages, making it more likely that the median voter will choose to increase tax rates, leading to more income inequality.
A similar outcome can result from immigration of low-skill workers. If more low-productivity workers migrate to the United States, the distribution of relative productivity will become less equal, also resulting in the median voter being more likely to choose a higher tax rate.
Meltzer and Richard use data from the Census Bureau and the St. Louis Federal Reserve bank to test their predictions for the U.S. Taking advantage of a data series that begins in 1967 and ends in 2011, they track changes in tax rates, average hours worked, mean and median household incomes, and productivity, among other variables. Their model predicts that the rate of productivity growth (the “learning by doing” mechanism) grew over time, until declining post-2007. Comparing their estimates of productivity, tax rates and income inequality, they find their estimates closely match what actually happened.
In the discussions of income inequality that have become so popular today, the government's power to redistribute tax revenue is frequently touted as being a tool to narrow the income gap between the rich and the poor. Meltzer and Richard show that even though higher taxation may lead to less inequality in terms of consumption, it eventually leads to higher levels of inequality in terms of income. That is an important result that cannot be ignored.
Original Source: http://www.marketwatch.com/story/pikettys-cure-for-income-inequality-hurts-the-poor-2014-07-10