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How do the rich get richer? Tax rates and the top 1 percent

Posted by Ricardo Fuentes Nieva Previously the Head of Research

5th Sep 2013

Tax image used courtesy of 401kcalculator.org
In the week before we launch our new paper on austerity, Ricardo Fuentes Nieva reveals that the richest in the US and the UK have paid a lower marginal tax rate over the last three decades and that their ability to influence tax rates is growing.

How do the rich get richer? The magic formula to wealth and status divides people along ideological lines: some say it's through hard work; others, through luck. Balzac even argued that behind every large fortune without apparent causes there is a crime.

Ben Bernanke, the current chairman of the Federal Reserve system of the United States, recently gave a speech in which he talked about merit and responsibility. The message was just as important as the audience - he was the key note speaker during the commencement ceremony of Princeton University, one of the most exclusive universities in the world both by cost and difficulty to be admitted. 

Bernanke said:

"The concept of success leads me to consider so-called meritocracies and their implications. We have been taught that meritocratic institutions and societies are fair. Putting aside the reality that no system, including our own, is really entirely meritocratic, meritocracies may be fairer and more efficient than some alternatives. But fair in an absolute sense? Think about it. A meritocracy is a system in which the people who are the luckiest in their health and genetic endowment; luckiest in terms of family support, encouragement, and, probably, income; luckiest in their educational and career opportunities; and luckiest in so many other ways difficult to enumerate-these are the folks who reap the largest rewards."

Bernanke's argument is a challenge to the economic and political elite everywhere...

Bernanke's argument is a challenge to the economic and political elite everywhere, not only in the US. He is arguing against two hard held beliefs: that if you're rich it is because you deserve it; and that in a fair society every person is responsible only for him or herself.

The speech was very well received. All in all, it was gratifying to see such an influential figure make the case for a more equitable society. Yet the warm, fuzzy feeling stops there. 

Bernanke makes a case for more responsibility by the privileged few. Yet the evidence in many countries shows that, in fact, the tax rate for the rich has been falling. 

In a new paper (recently published in the latest issue focusing on concentration of income of the Journal of Economic Perspectives), Alvaredo, Atkinson, Picketty and Saez analyze the long term trends of average tax rates for the top 1 percent for  the US, UK, Germany and France. Look at the graph.

Top Marginal Income Tax Rates 1900-2011

Top Marginal Income Tax Rates 1900-2011

Over the last three decades, the richest members of society in the US and the UK have been paying a lower marginal tax rate. In France, on the other hand, the decline is much smaller.

Over the last three decades, the richest members of society in the US and the UK have been paying a lower marginal tax rate.

Why has the average marginal tax rate dropped substantially in some countries? There are several factors, according to the authors, who say: "[t]he political factors that led to top tax rate cuts - such as those by Reagan and Thatcher in the 1980s in the United States and the United Kingdom - were accompanied by other legislative changes, such as deregulation, which may have caused top incomes to rise, not least on account of the impetus they gave to the growth of the financial services… and legal services sectors"

One remarkable development is that the fall in top tax rates is accompanied with a sharp increase in the pre-tax share of income of the top 1 percent (see graph). In other words, in some countries like the US, the UK and Ireland, the rich got a larger share of the economic pie and paid less taxes on it. How did this happen? There are several plausible reasons explored in the paper:

  • Those with high incomes decided to reveal their true income with the lower rates, as they didn't need to avoid paying higher tax rates anymore.
  • Lower tax rates promote economic activity and entrepreneurship and more work.
  • The preferred explanation of the authors: a change in bargaining power by the super rich.
    As they explain "[w]hen top marginal tax rates were very high, the net reward to a highly paid executive for bargaining for more compensation was modest. When top marginal tax rates fell, high earners started bargaining more aggressively to increase their compensation"

Changes in top income shares and top marginal tax rates since 1960

Changes in top income shares and top marginal tax rates since 1960

By now, it is a well known fact that the share of income for the top 1 percent has increased steadily since the early 1980s. In the US, this trend resisted the massive economic shock of 2008-2009 and returned with a vengeance: between 2009 and 2011 the top 1 percent has accrued 121 percent of the total income gains compared to a decline of 0.4 percent for the rest. The rich are getting richer when the rest are getting poorer.

The relevant policy question is: what comes first, the concentration of income or the decline in the tax rates? We do not know for sure, but what's happening is that once the rich get richer, they get more resources to influence even more on how the tax code is written, how the tax code is modified, and thus lock the gains and protect the trend that mostly benefits them.

It is a good time to seriously ask if this is a trend that cannot be reversed. Paul Krugman, commenting on Bernanke's speech, highlighted the case for a high income tax rate for the top of the distribution. There are several studies by top tax academics that indicate this would be economically optimal. But how do we counterbalance the influence that the rich have on tax legislation?

Main image 

 used courtesy of 401kcalculator.org

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Blog post written by Ricardo Fuentes Nieva

Previously the Head of Research

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