Income Inequality: A Progressive Tax System Isn't the Best Solution

Margaret Thatcher once famously chastised a critic from the opposition party for preferring that "the poor were poorer, provided that the rich were less rich." Such is the perverse result, she said, of focusing excessively on relative wealth while ignoring positive changes in absolute wealth.

As the issue of inequality becomes increasingly salient, we run a similar risk of missing the economic forest for the trees if not careful. When data is properly interpreted, we see that claims of growing inequality in the U.S. are vastly overstated. Moreover, proposed solutions such as a heavily progressive tax code are counter-productive.

There are valid reasons to consider the issue of income inequality. Inequality that results from genuine differences in ability, skill and work ethic shouldn't be of much concern from a policy perspective – in a free society, such differing results are not only expected, but are a necessary and desirable part of the competitive system – but when inequality is caused by institutional barriers that hold some groups down, or unfairly benefit others, it is of greater concern.

So is income inequality a problem in the U.S.? There is reason to be skeptical of claims that it is. Arguments that inequality is rising dangerously fast are common, but typically rest on the misinterpretation of economic measures. For instance, it's not unusual to see an argument resting primarily on some sort of chart showing gains made by different income levels – often divided into five quintiles – over the last several decades, with much more going to top earners than anyone else. Proof of growing inequality, right? Not so. Such data tell us nothing about who receives the gains because quintiles are not static. It is not the same people in the top quintile in 2013 as it was in 1980.

A person near the top in earnings today was most likely near the bottom 30 years ago when first entering the work force. Longitudinal studies which actually track the same people over time thus paint a very different picture than snapshots of economic quintiles, and show significant mobility and increases in wealth for all over time.

As the old poor move up the economic ladder, new poor, in the form of young workers and immigrants, enter the labor force. This continual process is not adequately reflected in static snapshots of the economy.

Median household incomes are also frequently cited as evidence of troublesome inequality, but households are unstable. Increases in divorce rates, growth in two income households, and changes in education and marriage patterns (the educated wealthy are more likely to prefer marrying within class than in previous generations) add considerable noise to household income data and further evidence that the appearance of growing inequality is really a statistical artifact.

Even the type of income measured can distort the inequality debate. Looking narrowly at cash wages might lead one to conclude that middle class earning has stagnated. But when total compensation is considered, earnings for poorer workers are actually growing faster than those at the top. Health care costs are simply taking up an ever greater share of earnings – a problem in its own right, but not one to be confused with income inequality.

Even accepting for the sake of argument that income inequality is a problem, redistribution through a progressive tax code is not a solution. For one, the U.S. already has one of the most progressive tax codes among OECD countries, including the much more redistributive European welfare states. Thus if progressive taxes were going to work, we should expect they would have done so already.

There are also considerable negative economic consequences to a highly progressive tax code. Excessive marginal tax rates – the rate levied on the next dollar earned – discourage work. While wage earners typically have no choice in when and how they work, upper income Americans have tremendous ability to decide the type and timing of their income. At a certain level of taxation, production is reduced in favor of other activities, such as more vacation time or retirement. The result of tax progressivity is thus reduced economic growth.

This might be judged an acceptable trade-off for those seeking egalitarian ends. Those are, after all, the sort of competing goals that must be weighed against any potential policy. But it's important to remember that economic growth in general is most beneficial to the least among us. A person whose wealth increases enough to finally be able to afford to put food on the table every day, or take a needed medicine, gets more marginal value from the next dollar earned than does a Bill Gates or Mark Zuckerburg. It is thus the poor who are most harmed by economically destructive progressive taxation – the very people for whom concern over income inequality is meant to benefit.