Economics, Politics

You’re Doing Taxes Wrong: Consumptive vs. Wealth Inequality

When you worry about rising inequality, what are you thinking about?

I now know of two competing models for inequality, each of which has vastly different implications for political economy.

In the first, called consumptive inequality, inequality is embodied in differential consumption. Under this model, there is a huge gap between Oracle CEO Larry Ellison (net worth: $60 billion), with his private islands, his yacht, etc. and myself, with my cheap rented apartment, ten-year-old bike, and modest savings. In fact, under this model, there’s even a huge gap between Larry Ellison with all of his luxury goods and Berkshire Hathaway CEO Warren Buffett (net worth: $90.6 billion), with his relatively cheap house and restrained tastes.

Pictured: Warren Buffett’s house vs. Larry Ellison’s yacht. The yacht is many, many times larger than the house. Image credits: TEDizen and reivax.

Under the second model, inequality in new worth or salary is all that matters. This is the classic model that gives us the GINI coefficient and “the 1%”. Under this model, Warren Buffett is the very best off, with Larry Ellison close behind. I’m not even in contention.

I’ve been thinking a lot about inequality because of the recent increase in the minimum wage in Ontario. The reasons behind the wage hike – and similar economic justice proposals (like capping CEO pay at some double-digit multiple of worker pay) – seem to show a concern for consumptive inequality.

That is to say, the prevailing narrative around inequality is that it is bad because:

  1. Rich people are able to consume in a way that is frankly bananas and often destructive either to the environment or norms of good governance
  2. Workers cannot afford all basic necessities, or must choose between basic necessities and thinking long term (e.g. by saving for their children’s education or their own retirement)

Despite this focus on consumptive inequality in public rhetoric, our tax system seems to be focused primarily on wealth inequality.

Now, it is true that wealth inequality can often lead to consumptive inequality. Larry Ellison is able to consume to such an obscene degree only because he is so obscenely wealthy. But it is also true that wealth inequality doesn’t necessarily lead to consumptive inequality (there are upper middle-class people who have larger houses than Warren Buffett) and that it might be useful to structure our tax policy and other instruments of political economy such that there was a serious incentive for wealth inequality not to lead to consumptive inequality.

What I mean is: it’s unlikely that we’re going to reach a widely held consensus that wealth is immoral (or at what level it becomes immoral). But I think we already have a widely held consensus that given the existence of wealth, it is better to wield it like Mr. Buffett than like Mr. Ellison.

To a certain extent, we already acknowledge this. In Canada, there are substantial tax advantages to investing up 18% of your yearly earnings (below a certain point) and giving up to 75% of your income to charity. That said, we continue to bafflingly tax many productive uses of wealth (like investing), while refusing to adequately tax many frivolous or actively destructive uses of wealth (large cars, private jets, private yachts, influencing the political process, etc.).

Many people, myself included, find the idea of large amounts of wealth fundamentally immoral. Still, I’d rather tax the conspicuous and pointless use of wealth than wealth itself, because there are many people motivated to do great things (like curate all of the world’s information and put it at our fingertips) because of desire for wealth.

I’m enough of a post-modernist to worry that any attempt to create a metric of “social value” will further disenfranchise people who have already been subject to systemic discrimination and fail to reflect the tastes of anyone younger than 35 (I just can’t believe that a bunch of politicians would get together and agree that anyone creates social value or deserves compensation for e.g. cosplay, even though I know many people who find it immensely valuable and empowering).

That’s the motivation. Now for the practice. What would a tax plan optimized to punish spurious consumption while maintaining economic growth even look like? Luckily Scott Sumner has provided an outline, the cleverness of which I’d like to explain.

No income tax

When you take money from people as taxes, then give it back to them regardless of how hard they work, you discourage work. It turns out that this effect is rather large, such that the higher income taxes are, the more you discourage people from working. People working is a necessary prerequisite for economic growth and I view economic growth as largely positive (in that it is very good at engendering happiness and stability, as well as guaranteeing those of us currently working the possibility of retiring one day and generating revenues for a social safety net) and therefore think we should try and tax in a way that doesn’t discourage this.

No corporate tax

Another important component of economic growth is investment. We can imagine a hypothetical economy where absolutely everything that is produced is consumed, such that much is made, but nothing ever really changes. The products available this year will be the products available next year, at the same price and made in the same factory, with any worn-down equipment replaced, but no additional equipment purchased.

Obviously, this is a toy example. But if you’ve bought a product this year that didn’t exist last year, or noticed the cost of something you regularly buy fall, you’ve reaped the rewards of investment. We need people to deliberately set aside some of the production they’re entitled too via possession of money so that it can instead be used to improve the process of production.

Corporate taxes discourage this by making investment less attractive. In fact, they actively encourage consumptive inequality, by making consumption artificially cheaper than investment. This is the exact opposite of what we should be aiming for!

Interestingly, there have been a variety of report positive results of the recent cut in corporate tax rates in the US, from repatriation of money for US investment to bonuses for workers.

Now, I know that corporate taxes feel very satisfying. Corporations make a lot of money (although probably less than you think!) and it feels right and proper to divert some of that for public usage. But there are better ways of diverting that money (some of which I’ll talk about below) that manage to fill the public coffers without incentivizing behaviour even worse than profit seeking (like bloated executive pay; taxing corporate income makes paying the CEO a lot artificially cheap). Corporate taxes also hurt normal people in a variety of ways – like making saving for retirement harder.

No inheritance tax

This is another example of artificially making consumption more attractive. Look at it this way: you (a hypothetical you who is very wealthy) can buy a yacht now, use it for a while, loan it to your kids, them have them inherit it when it’s depreciated significantly, reducing the tax they have to pay on it. Or you can invest so that you can give your children a lot of money. Most rich people aren’t going to want to leave nothing behind for their children. Therefore, we shouldn’t penalize people who are going to use the money for non-frivolous things in the interim.

A VAT (with rebates or exemptions)

A VAT, or value added tax, is a tax on consumption; you pay it whenever you buy something from a store or online. A “value-added” tax differs from a simple sales tax in that it allows for tax paid to suppliers to be deducted from taxes owed. This is necessary so that complex, multi-step products (like computers) don’t artificially cost more than more simple products (like wood).

Scott Sumner suggests that a VAT can be easily made free for low-income folks by automatically refunding the VAT rate times the national poverty income to everyone each year. This is nice and simple and has low administrative overhead (another key concern for a taxation system; every dollar spent paying people to oversee the process of collecting taxes is a dollar that can’t be spent on social programs).

An alternative, currently favoured in Canada, is to avoid taxing essentials (like unprepared food). This means that people who spend a large portion of their money on food are taxed at a lower overall rate than people who spend more money on non-essential products.

A steeply progressive payroll tax

If income inequality is something you want to avoid, I’d argue that a progressive payroll tax is more effective than almost any other measure. This makes companies directly pay the government if they wish to have high wage workers and makes it more politically palatable to raise taxes on upper brackets, even to the point of multiples of the paid salary.

While this may seem identical to taxing income, the psychological effect is rather different, which is important when dealing with real people, not perfectly rational economics automata. Payroll taxes also make tax avoidance via incorporating impossible (as all corporate income, including dividends after subtracting investment would be subject to the payroll tax) and makes it easy to really punish companies for out of control executive compensation. Under a payroll tax system, you can quite easily impose a 1000% tax on executive compensation over $1,000,000. It’s pretty hard to justify a CEO salary of $10,000,000 when it’s costing investors more than a hundred million dollars!

Scott Sumner also suggests wage subsidies as an option to avoid the distortionary effect of a minimum wage [1], a concept I’ve previously explored in depth and found to be probably workable.

A progressive property tax

Property taxes tend to be flat, which makes them less effective at discouraging conspicuous consumption (e.g. 4,500 square foot suburban McMansions). If property taxes sharply ramped up with house value or size, families that chose more appropriately sized homes (or could only afford appropriately sized home) would be taxed at lower rates than their profligate neighbours. Given that developments with smaller houses are either higher density (which makes urban services cheaper and cars less necessary) or have more greenspace (which is good from an environmental perspective, especially in flood prone areas), it’s especially useful to convince people to live in smaller houses.

This would be best combined with laxer zoning. For example, minimum house sizes have long been a tool used in “nice” suburbs, to deliberately price out anyone who doesn’t have a high income. Zoning houses for single family use was also seized upon as a way to keep Asian immigrants out of white neighbourhoods (as a combination of culture and finances made them more likely to have more than just a single nuclear family in a dwelling). Lax zoning would allow for flexibility in housing size and punitive taxes on large houses would drive demand for more environmentally sustainable houses and higher density living.

A carbon tax

Carbon is what economists call a negative externality. It’s a thing we produce that negatively affects other people without a mechanism for us to naturally pay the cost of this inflicted disutility. When we tax a negative externality, we stop over-consumption [2] of things that produce that externality. In the specific case of taxing carbon, we can use this tax to very quickly bring emissions in line with the emissions necessary to avoid catastrophic warming.

I’d like to generalize this to Pigovian taxes beyond carbon. Alcohol (and other intoxicants), sugary drinks, and possibly tobacco should be taxed in line with their tendency to produce costs that (in countries with public risk pooling of health costs) are not borne by the individual over-consuming. I do think it’s important to avoid taking this too far – it’s reasonable to expect people to cover their negative externality, but not reasonable to punitively tax things just because a negative externality might exist or because we think it is wrong or “unhealthy” to do it. Not everything that is considered unhealthy leads to actual diseases, let alone increased healthcare costs.

A luxury goods tax

This comes from a separate post by Scott Sumner, but I think it’s a good enough idea to mention here. It should be possible to come up with a relatively small list of items that are mostly positional – that is to say that the vast majority of their cost is for the sake of being expensive (and therefore showing how wealthy and important the possessor is), not for providing increasing quality. To illustrate: there is a significant gap in functionality between a $3,000 beater car and a $30,000 new car, less of a gap between a $30,000 car and a $300,000 car and even less of a gap between the $300,000 car and a $3,000,000 car; the $300,000 car is largely positional, the $3,000,000 car almost wholly so. To these we could add items that are almost purely for luxury, like 100+ foot yachts.

It’s necessary to keep this list small and focus on truly grotesque expenditures, lest we turn into a society of petty moralizers. There’s certainly a perspective (normally held by people rather older than the participants) in which spending money on cosplay or anime merchandise is frivolous, but if it is, it’s the sort of harmless frivolity equivalent to spending an extra dollar on coffee. I am in general in favour of letting people spend money on things I consider frivolous, because I know many of the things I spend money on (and enjoy) are in turn viewed as frivolous by others [3]. However, I think there comes a point when it’s hard to accuse anyone of petty moralizing and I think that point is probably around enough money to prevent dozens of deaths from malaria (i.e. $100,000+) [4].

Besides, there’s the fact that making positional goods more expensive via taxation just makes them more exclusive. If anything, a strong levy on luxury goods may make them more desirable to some.


As I’ve read more economics, my positions on many economics issues have shifted in a way that many people parse as “more conservative”. I reject this. There are a great many “liberal” positions that sound good on paper, but when you actually do the math, hurt the poor and benefit the rich. Free trade makes things cheaper for all of us and has created new jobs and industries. A lot of regulation allows monopolies and large companies to crush any upstart rivals, or shifts jobs from blue collar workers making things to white collar workers ensuring compliance.

It is true that I care about the economy in a way that I never cared about it before. I care that we have sustainable growth that enriches us all. I care about the stock market making gains, because I’ve realized just how much of the stock market is people’s pensions. I care about start-ups forming to meet brand new needs, even when the previous generation views them as frivolous. I care about human flourishing and I now believe that requires us to have a functioning economic system.

A lot of how we do tax policy is bad. It’s based on making us feel good, not on encouraging good behaviour and avoiding weird economic distortions. It encourages the worst excesses of wealth and it’s too easy to avoid.

What I’ve outlined here is a series of small taxes, small enough to make each not worth the effort to avoid, that together can easily collect enough revenue to ensure a redistributive state. They have the advantage of cutting particularly hard against conspicuous consumption and protecting the planet from unchecked global warming. I sincerely believe that if more people gave them honest consideration, they would advocate for them too and together we could build a fairer, more effective taxation system.

Footnotes:

[1] A minimum wage can make it impossible to have Pareto optimal distributions – distributions where you cannot make anyone better off without making someone else worse off. Here’s a trivial example: imagine a company with two overworked employees, each of whom make $15/hour. The employees are working more than they particularly want to, because there’s too much work for the two of them to complete. Unfortunately, the company can only afford to pay an additional $7/hour and the minimum wage is $14/hour. If the company could hire someone without much work experience for $7/hour everyone would be better off.

The existing employees would be less overworked and happier. The new employee would be making money. The company could probably do slightly more business.

Wage subsidies would allow for the Pareto optimal distribution to exist while also paying the third worker a living wage. ^

[2] Over-consumption here means: “using more of it than you would if you have to properly compensate people for their disutility”, not the more commonly used definition that merely means “consuming more than is sustainable”.

An illustration of the difference: In a world with very expensive carbon capture systems that mitigate global warming and are paid for via flat taxes, it would be possible to be over-consuming gasoline in the economics sense, in that if you were paying a share of the carbon capture costs commensurate with your use, you’d use less carbon, while not consuming an amount of gasoline liable to lead to environmental catastrophe, even if everyone consumed a similar amount. ^

[3] For example, I spent six times as much as the median Canadian on books last year, despite the fact that there’s a perfectly good library less than five minutes from my house. I’m not particularly proud of this, but it made me happy. ^

[4] I am aware of the common rejoinder to this sort of thinking, which is basically summed up as “sure, a sports car doesn’t directly feed anyone, but it does feed the workers who made it”. It is certainly true that heavily taxing luxury items will probably put some people out of work in the industries that make them. But as Scott Sumner points out, it is impossible to meaningfully fix consumptive inequality without hurting jobs that produce things for rich people. If you aren’t hurting these industries, you have not meaningfully changed consumptive inequality!

Note also that if we’re properly redistributing money from taxes that affect rich people, we’re not going to destroy jobs, just shift them to sectors that don’t primarily serve rich people. ^

Data Science, Politics

Thoughts (and Data) on Charity & Taxes

The other day, I posed a question to my friends on Facebook:

Do you think countries with higher taxes see more charitable donations or fewer charitable donations? What sort of correlation would you expect between the two (weak positive? weak negative? strong positive? strong negative?).

I just crunched some numbers and I’ll post them later. First I want to give people a chance to guess and test their calibration.

I was doing research for a future blog post on libertarianism and wanted to check one of the fundamental assumptions that many libertarians make: in the absence of a government, private charity would provide many of the same social services that are currently provided by the government.

I honestly wasn’t sure what I’d find. But I was curious to see what people would suggest. Answer fell into four main camps:

  1. Charitable giving and support for a welfare state might be caused by the same thing, so there will be a weak positive correlation.
  2. Tax incentives for charitable donations shift the utility of donating, such that people in higher tax countries will donate more, as they get more utility per dollar spent (they get the same good feelings from charity, but also receive a bigger rebate come tax time). People who thought up this mechanism predicted a weak positive correlation.
  3. This whole thing will be hopeless confounded by other variables and no conclusion would survive proper controls.
  4. Libertarians are right. Taxes drain money that would go to private charity, so we should see a strong(ish) negative correlation.

I was surprised (but probably shouldn’t have been) to find that these tracked people’s political views. The more libertarian I thought someone was, the more likely they were to believe in a negative correlation. Meanwhile, people who were really into the welfare state tended to assume that charitable donations and taxes would be correlated.

In order to figure out who was right, I grabbed the most recent World Giving Index and correlated it with data about personal income tax levels (and sales tax levels, just to see what happened).

There are a number of flaws with this analysis. I’m not looking for confounding variables. Like at all. When it comes to things as tied to national character as charity and taxes (and how they interact!), this is a serious error in the analysis. I’m also using pretty poor metrics. It would be best to compare something like average tax rate with charitable donation amount per capita. Unfortunately, I couldn’t find any good repositories of this data and didn’t want to spend the hours it would take to build a really solid database of my own.

I decided to restrict my analysis to OECD countries (minus Turkey, which I was missing data on). You’ll have to take my word that I made this decision before I saw any of the data (it turns out that there is essentially no correlation between income tax rate and percent of people who donate to charity when looking at all countries where I have data for both).

Caveats aside, what did I see?

There was a weak correlation (I’m using a simple Pearson correlation, as implemented by Google sheets here, nothing fancy) between the percentage of a population that engaged in charitable giving and the highest income tax bracket in a country. There was a weaker, negative correlation between sales tax and the percent of a population that engaged in charitable giving, but more than 60% of this came from the anchoring effect of the USA, with its relatively high charitable giving and lack of Federal sales tax. The correlation with income tax rates wasn’t similarly vulnerable to removing the United States (in fact, it jumped up by about 12% when they were removed).

Here’s the graphs. I’ve deliberately omitted trend lines because I’m a strong believer in the constellation test.

 

All the data available is in a publicly viewable Google Sheet.

I don’t think these data give a particularly clear answer about the likelihood of private charity replacing government sponsored welfare programs in a hypothetical libertarian state. But they do suggest to me that the burden of proof should probably rest on libertarians. These results should make you view any claims that charitable giving is held back by the government with skepticism, but it should by no means prevent you from being convinced by good evidence.

I am happy to see that my results largely line up with better academic studies (as reported by the WSJ). It seems that if we look at the past few decades, decreasing the tax rates in the highest income brackets have been associated with decreasing charitable giving, at least in the United States. Whether this represents a correlated increase in selfishness, or fewer individuals donating as the utility of donating decreases is difficult to know.

The WSJ article also mentions that government grants to a charity reduce private donation by about 75% of the grant amount. I don’t know if this represents donations that are lost entirely, or merely substituted for other (presumably needier) charities. If it’s the first, then this would be strong evidence for the libertarian perspective. If it’s the latter, then it means that many people intuitively understand and accept the key effective altruism concept of “room for more funding“, at least as far as the government is concerned.

Conclusions

Finding good answers to the question of whether private charity would replace government welfare turned out to be harder than I thought. The main problem was the quality of data that is easily available. While it was easy to find statistics good enough for a simple, limited analysis, I wasn’t able to find a convenient table with all of the data I needed. This is where actual researchers have a huge advantage over random people on the internet. They have access to cheap labour in the volumes necessary to find and tabulate high quality data.

I’m very glad I posed the question to my friends before figuring out the answer. It never occurred to me to consider the effect of tax incentives on charitable giving. I’m now of the weakly held opinion that the main way taxes affect charitable donations is by offsetting the costs with rebates. I’m also fascinated by the extent to which people’s guesses tracked their political leanings. This shows that (on my Facebook wall, at least) people hold opinions that are motivated by a genuine desire to see the most effective possible government. Differing axioms and exposure to different data lead to differing conceptions of what this would be, but everyone is ultimately on the same team.

I will try and remember this next time I think someone’s preferred government policy is a terrible idea. It’s probably much more productive to try and figure out why they believe their policy objectives will lead to the best outcomes and arguing about that, rather than slipping into clichéd insults.

I was also reminded that it’s fun and rewarding to spend a few hours doing data analysis (especially when you get the same results as studies that get reported on in the WSJ).