Are Taxes the Best Way of Dealing With Inequality?

Just because firms and rich people play by the rules of the markets, this does not lead to the conclusion that the results are just. (And, of course, they often don't play by the rules!) (Photo: Ars Electronica / Flickr)

Are Taxes the Best Way of Dealing With Inequality?

Taxes can redistribute income, but relying on taxes means we are accepting the way the system works—the way markets operate—to create inequality in the first place.

Higher taxes on the rich would be a good start. During the mid-20th century, we had much less inequality (though still too much), and this was partly due to higher taxes on the rich. Today, the very rich pay lower tax rates than any other group. (There is, by the way, no evidence that those higher tax rates of earlier years harmed economic growth.)

Yet, there is a problem with relying on taxes to reduce economic inequality. Taxes can redistribute income, but relying on taxes means we are accepting the way the system works--the way markets operate--to create inequality in the first place. So instead of only focusing on taxes to redistribute income, we should also focus on reconstructing markets to predistribute income. As the saying goes, "An ounce of prevention is worth a pound of cure."

Not Natural, Not God-Given

There is a pernicious myth that affects the way we think about markets. According to this myth, markets are natural phenomena, there for us to work within and carry out our economic lives. The rules of markets are viewed as though fixed in stone, as though God-given. This leads to the view that, as long as we play by the rules, there is a certain justice in the outcomes, however unequal. In fact, markets are created by people, sometimes through the long development of decisions and practices by many people, but often directly by legislative action.

A few examples make the point:

The labor market and the role of unions. Before the 1930s, laws greatly constrained the unified action of workers. The National Labor Relations Act of 1935 established a new set of rules, facilitating a burgeoning of unions. Even after things moved in the other direction with the Taft-Hartley Act of 1947, which restricted the activities and power of unions, the labor movement remained relatively powerful in the post-World War II years--and the period from World War II to the 1970s was an era of less economic inequality as compared to later and earlier periods.

From the 1980s to the present, government actions (particularly via the National Labor Relations Board) have restricted union formation by, for example, ignoring illegal actions by employers during workers' efforts to unionize. Other factors have also weakened unions, including the nature of international trade agreements, which give employers relatively unfettered opportunities to close shop at home and employ low-wage workers abroad. This reconstruction of the labor market has directly and indirectly weakened unions and contributed to rising inequality.

The market for intellectual property and the role of patent and copyright laws. The U.S. system of intellectual property rights contributes to inflated profit rates and outsized executive salaries, especially in pharmaceutical and software firms. Patent and copyright laws protect the monopoly positions of these firms. Supporters of these laws argue that they encourage innovation, but the laws can also be used to prevent innovation, as large firms can stifle the operations of small competitors by claiming patent or copyright infringement. Also, even if the protections provided by these laws were useful for innovation, there is no reason that the protections need to last as long as they do in the United States.

There are, moreover, other ways to induce innovation. Indeed, much innovation is already based on research supported by the government through the National Institutes of Health, the National Science Foundation, the Defense Department, and other government agencies. In any case, regardless of whether one sees existing protections of intellectual property rights as good or bad, there is no disputing the point that the market in intellectual property is a constructed market, not "natural."

Financial markets. The operation of banks and other financial institutions doesn't simply "exist," but is organized with many regulations. Banks have to be chartered and follow various rules regarding reserves, reporting requirements, purchase and sale of assets, etc. Also, they operate under certain practices widely recognized and accepted by financial institutions, as well as the government. A particularly important example is the "too big to fail" principle, which gives investors confidence that the federal government will step in to support large firms if they run into serious trouble. This practice provides an implicit subsidy to big banks, because investors are willing to provide funds to them on favorable terms, knowing that if things go wrong the government will step in and save the banks.

Fossil-fuel markets. Current regulations and subsidies in the oil and gas industry (including policies to encourage fracking) inflate the profits of energy companies, keep fuel prices low, encourage the overuse of fossil fuels, and harm the environment. A May 2019 working paper from the International Monetary Fund estimates fossil fuel subsidies for 2015:

This paper updates estimates of fossil fuel subsidies, defined as fuel consumption times the gap between existing and efficient prices (i.e., prices warranted by supply costs, environmental costs, and revenue considerations), for 191 countries. Globally, subsidies remained large at $4.7 trillion (6.3% of global GDP) in 2015 and are projected at $5.2 trillion (6.5% of GDP) in 2017. The largest subsidizers in 2015 were China ($1.4 trillion), United States ($649 billion), Russia ($551 billion), European Union ($289 billion), and India ($209 billion).

These subsidies are a fundamental part of the construction of the fossil-fuel market, having negative impacts on both economic equality and the climate.

Schooling and the labor market. Schooling, from pre-K through college, shapes the labor market. The U.S. school system is a multi-tiered system, preparing people for different levels in the workforce. Certain areas of education receive attention--which means funds--according to the needs of employers, as demonstrated by the emphasis in recent years on STEM (science, technology, engineering, and math) education. The structure of the school system, good or bad, is not a "natural" phenomenon, but it greatly affects the operation of the labor market and the distribution of income.

Playing by the Rules They Set

These examples involve conscious action by groups with direct interests in the structure of these markets. Financial institutions, fossil fuel firms, pharmaceutical companies, software giants, and many others use their wealth and power to see that markets are constructed in ways that work for them. (An extreme example: seats on the regional boards of the Federal Reserve Bank, which plays a major role in regulating banks, are reserved for bank representatives.) They get the rules made the way they want, play by the rules, and then claim they deserve what they get because they played by the rules. Nonsense, yes, but effective nonetheless.

Of course, it is difficult to fight these powerful firms and the individuals who reap their fortunes through these firms. They are quite powerful. But there is no reason to think it is more difficult than raising their taxes.

A first step is to establish a wide understanding of the fact that markets are social constructs and that they can be constructed differently. They have been structured differently in the past, and they can be structured differently in the future. For example, the medical care system could be removed from market relations by the creation of "Medicare for All." This would not only alter the provision of medical care, but would reconstruct various related markets (e.g., the market for pharmaceuticals). Even if little change comes in the short run, it is important to send the message that just because firms and rich people play by the rules of the markets, this does not lead to the conclusion that the results are just. (And, of course, they often don't play by the rules!)

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