Nova workboard

a blog from young economists at Nova SBE

A rising tide does not lift all boats

Growing inequality is something that must be taken seriously. While some inequality may have some benefits, as motivation and stimulation, the amount is the poison. Worldwide protests as the American “Occupy Wall Street”, the Spanish “Los indignados” or the Portuguese “Geração à rasca” are obviously signs that rising inequality is a problem that must be addressed.

Besides the social outrage regarding the unfair allocation of resources, according to the World Bank economist Branko Milanovic extreme inequality encourages poor people to demand disproportionally high tax rates on the rich (which populist governments tend to comply with), this reduces investments and growth rates. Thus the social instability it generates (when on the one hand there are very high rates of unemployment and on the other huge incomes) reduces investments and discourages economic activity. Toursten Persson and Guido Tabellini found evidences that “a rise of 0.07 in the income share of the top 20% lowers the average annual growth rate half a percentage point”.

Another reason why we must take inequality in consideration is because it is strongly related with poverty. The concept of relative poverty aims at incorporating one’s perception about life standards in the society where one lives. A poor, in relative terms, is thus usually defined as someone with an income below 60% of the median national income. One immediately sees that inequality increases poverty mechanically. In absolute terms a person is poor if he/she cannot afford a considered basic consumption basket, so, since negative economic performance may increase the number of those who may not be able to buy that basic basket, then, due to the factors explained above, the negative economic effects of inequality increases poverty also in absolute terms.

The following graph shows for the EU-27 member countries, the positive relation between the percentage of people at risk of poverty or social exclusion (which is a hybrid measure that combines absolute with relative poverty indicators) and inequality (using the Gini coefficient):

                                                   Source: Eurostat

In this post I would like to propose a way of bouncing back this issue through an inequality indexation tax.

Our progressive income taxes, that tax the rich more heavily, are vehicles of managing inequality. Actually, our personal income tax is “fair par excellence”. However, there is nothing in the tax code expressly designed to fight inequality. For that reason, the proposal is to index our tax system to inequality, that is, the government would bind the tax rates to statistical measures of inequity (as the Gini coefficient). Therefore, if income inequality gets worse, the tax system will become automatically more progressive.

This is Robert Shiller’s idea, professor of Economics at Yale University. He calls it “inequality insurance” because it must be placed before we know inequality will worsen and before we know who will become more highly taxed. That is why he named it insurance, because it is dealing with the rising inequality risk.  According to Leonard Burman of Syracuse University, if the US had implemented Shiller’s indexation scheme in 1979, the marginal tax rate on high income people in 2002 would have increased from 34.7% to 77%! This shows how inequality has worsened since then.

This policy reduces inequality directly, so, besides that being good already, it will have indirect positive effects reducing poverty. Although this policy’s extra revenues could be earmarked to fund strategies to fight poverty (which ones work? That is another story, but certainly involves money directly or indirectly). This setting violates the non consignment principle of the Budget Law (“Lei de Enquadramento Orçamental”), however this law allows exceptions (eg. Social security) if it is considered an essential expenditure… I think it is, if we want the rising tide to lift all boats.

Diogo Silva Pereira Teles Machado

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Author: studentnovasbe

Master student in Nova Sbe

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