I have been thinking about income inequality. I've been thinking about it because if the final version of the finance reform bill now awaiting reconciliation does not effectively rein in speculation and unfettered and seemingly unbounded short-term individual self interest (aka greed), income inequality in the US (which is already quite high) is likely to become even greater.
If finance reform does not dampen unfettered and seemingly unbounded short-term individual self-interest we can look forward to even more financial capital being siphoned off to feed the casino that passes for finance these days. It will not recycle back into the economy where it could fuel innovation, competition, and the day-to-day provision of goods and services that creates jobs and from which we all benefit. In addition, continuing periodic crisis will almost certainly necessitate additional future transfers of taxpayer money to support the financial sector's addiction to gambling. The crises and the transfers widen the income gap. Depending on how resolution is ultimately structured and financed, taxpayers could still remain unwilling enablers to a highly dysfunctional financial system.
So I got to thinking. Are there additional ways to rein in unfettered, seemingly unbounded short-term individual self-interest?
What if there are two kinds of people in the world? One experiences diminishing marginal utility of income just as we are all taught in Econ 101. The other, let's call him Gyges, experiences constant or even rising marginal utility of income. Because each additional dollar of income yields the same or more utility, the second type of person is drawn to high-risk, high-payoff "games." In the extreme and particularly as the downside diminishes because someone else underwrites the losses or because the speculation is with someone else's money, Gyges over time is enabled to behave like an addict in the advanced stages of addiction, seeking higher and higher highs (payoffs), taking on higher and higher risks with other people's money.
If this were Uncle Ned, the guy who started out going to Atlantic City every weekend and ended up losing the house, his wife, Aunt Shirley, the cousins, his job, and his self-respect, we might be willing to pay for his rehab, but we sure wouldn't give him more money to take to Atlantic City. In fact, we might try to figure out how to reduce the payoffs of any of his bets. After all, if we're paying for his rehab, wouldn't it make sense to rake back some of his gains when he sneaks to the Jersey shore? The ultimate goal would be to shrink the actual increment in Uncle Ned's utility from that $1200 win at black jack to something like, say, $120, with us using the balance to pay the still outstanding bill from his rehab.
Remember when the marginal tax rate on the top income bracket in the US was 90%? Many of you won't. It outraged my businessman father although I'm pretty sure it never affected him. It used to outrage me, but now I find myself wondering. What if it dampened unfettered, seemingly unbounded, short-term individual self interest? What if the Gyges of the world are unable to resist the temptation to go for broke? What if they are drawn to jobs where payoffs are high (because of their non-diminishing marginal utility of income)? What if the majority of the people who populate the top income brackets are of the Gyges type, addicted to high payoffs, high risk; obscured by complex financial instruments; and enabled by an uncritical national narrative in which high income signals high productivity, high innovation, high contribution to the common wealth?
If this were the case, then progressively higher marginal tax rates serve more purpose than simply allowing those who have benefited most from the laws, markets, and other benefits of residing in the US to contribute equally in utility terms to the infrastructure and country that enabled their success. It serves to dampen the siphoning of financial capital away from productive enterprise and into non-productive unfettered, seemingly unbounded, short-term individual self-interest. It dampens the incentives to take high risks with other peoples' money for high payoffs to oneself. It internalizes the negative externalities associated with unproductive financial "innovation," thereby discouraging it.
Am I advocating a return to a 90% top marginal tax rate? I'm not sure. For one thing, my father will never speak to me again if I do. For another, some of the people in that bracket are not Gyges. The non-Gyges contribute to the economy. They are not vampire squids and should not be penalized.
The optimal tax rate for the top income bracket(s) will depend on at least two things: the proportion of Gyges-like people (or people engaged in Gyges-like activities) relative to productive people and the relative responsiveness of both groups to changes in the marginal tax rates.
Evidence suggests that increasing the top rates does not curtail productive activity as measured by growth in GDP. This would be expected if the non-Gyges of the world have diminishing marginal utility of income and progressively higher tax rates approximately reflect the utility they derive from the marginal dollar. The higher rates tax rates do not affect their productive output.
Unfortunately, the fact that there appears to have been less casino-like finance during the time that the top marginal tax rates were high does not prove that they acted as a restraint on casino-like finance. There were many other forces in place post-WW II that may also have served to constrain such behavior.
That such a tax structure appears not to affect productive output or growth and also appears to reduce income inequality seems to argue in its favor. That reductions in income inequality will tend to raise individual incentives among the less advantaged to invest in health and human capital, seems wholly consistent with the objectives of those who favor "personal accountability" as a means of achieving better population health, lower rates of growth in health costs, and higher educational attainment. Increases in such investment would also tend to narrow income inequalities over time by increasing the inter-generational transmission of better health and human capital.
Whatever the optimal top marginal tax rates are, I'm guessing that a top rate in the 30-40% range is probably too low, both as a brake on Gyges and as a utility-neutral way of financing a capitalist economy and the government that must provide, maintain, and update the infrastructure for it, that must regulate it and that must govern it in ways that encourage and enable all its citizens to flourish.
It's time to disable greed and to enable individual productivity, commercial competition and innovation, and long-term investment in commercial enterprise and in the health and human capital that supports it. This is how markets and economic growth benefit both current and future generations.
(This one's for you, Obey. ;-) )