Inequality Disaster Prevention

NEW HAVEN – Thomas Piketty’s impressive and much-discussed book Capital in the Twenty-First Century has brought considerable attention to the problem of rising economic inequality. But it is not strong on solutions. As Piketty admits, his proposal – a progressive global tax on capital (or wealth) – “would require a very high and no doubt unrealistic level of international cooperation.”

We should not be focusing on quick solutions. The really important concern for policymakers everywhere is to prevent disasters – that is, the outlier events that matter the most. And, because inequality tends to change slowly, any disaster probably lies decades in the future.

That disaster – a return to levels of inequality not seen since the late nineteenth to early twentieth century – is amply described in Piketty’s book. In this scenario, a tiny minority becomes super-rich – not, for the most part, because they are smarter or work harder than everyone else, but because fundamental economic forces capriciously redistribute incomes.

In The New Financial Order: Risk in the 21st Century, I proposed “inequality insurance” as a way to avert disaster. Despite the similarity of their titles, my book is very different from Piketty’s. Mine openly advocates innovative scientific finance and insurance, both private and public, to reduce inequality, by quantitatively managing all of the risks that contribute to it. And I am more optimistic about my plan to prevent disastrous inequality than Piketty is about his.

Inequality insurance would require governments to establish very long-term plans to make income-tax rates automatically higher for high-income people in the future if inequality worsens significantly, with no change in taxes otherwise. I called it inequality insurance because, like any insurance policy, it addresses risks beforehand. Just as one must buy fire insurance before, not after, one’s house burns down, we have to deal with the risk of inequality before it becomes much worse and creates a powerful new class of entitled rich people who use their power to consolidate their gains.

In 2006, I co-authored a draft paper with Leonard Burman and Jeffrey Rohaly of the Urban Institute and Brookings Institution’s Tax Policy Center that analyzed variations on such a plan. In 2011, Ian Ayres and Aaron Edlin proposed a similar idea.

Underlying such plans is the assumption that some substantial degree of inequality is economically healthy. The prospect of becoming rich clearly drives many people to work hard. But massive inequality is intolerable.

Of course, there is no guarantee that an inequality-insurance plan will actually be carried out by governments. But they are more likely to follow such plans if they are already legislated and take effect gradually, according to a formula known in advance, rather than suddenly in some revolutionary departure from past practice.

To be truly effective, increases in wealth taxes – which fall more on highly mobile retired or other affluent people – would have to include a global component; otherwise, the rich would simply emigrate to whichever country has the lowest tax rates. And the unpopularity of wealth taxes has impeded global cooperation. Finland had a wealth tax but dropped it. So did Austria, Denmark, Germany, Sweden, and Spain.

Increasing wealth taxes now, as Piketty proposes, would strike many people as unfair, because it would amount to imposing a retroactive levy on the work carried out to accumulate that wealth in the past – a change to the rules of the game, and its outcome, after the game is over. Older people who worked hard to accumulate wealth over the course of their lifetime would be taxed on their frugality to benefit people who didn’t even try to save. If they had been told that the tax was coming, maybe they would not have saved so much; maybe they would have paid the income tax and consumed the rest, like everybody else.

Moreover, once the reality of a Piketty-type wealth tax was understood, the rich might procreate more, because wealth in the form of children cannot be taxed away – which is why it would probably be better to tax income and maintain a deduction for philanthropic contributions outside of the family. And, if there are to be wealth taxes, instituting them now to take effect only in the future – and only if inequality becomes much worse – would preempt the perception that the rules had been changed after the game had ended.

The advantage of income-tax increases is that they could be based not just on current income, but on some average of income over the course of years, and could allow deductions for investments, thus sharing some features with wealth taxes without penalizing those who saved more to accumulate more wealth. Moreover, a long-term plan legislated by one or a few countries today, before any substantial impact on actual tax payments occurs, could help to promote an international dialogue about appropriate future policy toward inequality. That would create room for a more uniform tax response among countries, thus reducing the ability of the super-rich to evade taxation by switching location.

Piketty’s book makes an invaluable contribution to our understanding of the dynamics of contemporary inequality. He has identified a serious risk to our society. Policymakers have a responsibility to implement a workable way to insure against it.

Copyright: Project Syndicate, 2014.
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