Dealing with inequality, part I: The bottom 99 per cent

I’ve made the point before that the debate about income inequality is something that occurs at more than one level, and I’ve also made the following distinction:

1. First-order inequality is visible in standard measures such the gini coefficient, and shows up as an increase in the gap between average and median incomes. If income growth is concentrated in the top half of the income distribution, average incomes will increase, but median incomes will remain unchanged.
2. Top-end inequality refers to the share of income that goes to those whose income puts them above the 99th percentile and beyond.

In this post, I’m going to talk about what we can do about first-order inequality. I’m going to ignore the top one per cent, because their numbers are too few to make any material difference in what follows.

The first thing is to deal with the question of why first-order inequality is a problem in the first place, and to make the distinction between levels of inequality and changes in inequality. I don’t have a lot to say about what the level of inequality should be, except that it should be greater than zero. Certain jobs require specialized training and skills, and we need some way of rewarding those who make the effort to acquire them.

Even so, we should be concerned when first-order inequality widens. Let me explain. There are a certain number of policy proposals that have the potential of increasing economic growth and the collective total income of all Canadians. But if it is widely believed that the gains will only go to a privileged minority, then we shouldn’t be surprised if those policies don’t receive broad support. As UBC’s Kevin Milligan noted, the British Columbia HST referendum is a good example of this: people voted against a policy that they believed would benefit BC as a whole, but not them personally. If inequality were stable, then, it would be more widely believed that everyone would benefit from policies that increase total income.

So how can we ensure that inequality remains steady? The best example here is that of the Nordic countries of Finland, Sweden, Norway and Denmark.

When one looks at market incomes—that is, before government redistribution in the forms of taxes and transfers—these countries look remarkably similar to other industrialised nations (including Canada, which, in the 2005 ranking below, falls somewhere in the middle of the northern European countries). Just take a look at this graph from a paper by Lane Kenworthy:

That’s because the Nordic countries don’t deal with inequality by trying to engineer more equal market outcomes, they do so by redistributing market incomes so that disposable incomes are more equal.

This redistribution can take two forms: taxes and transfers. But it may surprise many to learn that the tax systems of the Nordic social democracies aren’t particularly progressive: inequality in Nordic after-tax incomes is comparable to after-tax inequality in Canada and the U.S.

In the Nordic countries, the heavy lifting of reducing inequality is done by direct income transfers, not by taxes. Still, the tax system plays a crucial role in all this: those income transfers, after all, have to be financed somehow. But the primary goal of their tax system is not to reduce inequality, it is to generate the largest amount of revenue with the least reduction in economic growth. (Peter Lindert’s Growing Public provides a good summary of how the Nordic countries’ go about doing this; for some further reading see here.)

Taxes on income—corporate taxes in particular—are most harmful to economic growth, while consumption taxes like the GST/HST are less bad. So the high-growth, high-revenue tax strategy is to rely more on consumption taxes and less on taxes on capital income. For example, Sweden’s VAT rate is 25 per cent, and its corporate tax rate is 26.3 per cent. To put these numbers in perspective, the combined HST/GST rate in Quebec is now just under 15 per cent and the combined federal-provincial corporate tax rate after the last round of cuts is 26.9 per cent. The Nordic countries’ tax structures also rely more heavily on payroll taxes, which hit low-wage earners harder than high earners. (I’ll talk about personal income taxes when I cover top-end inequality. For now, I’ll just mention that taxing the top one per cent to finance these transfers is one of those great-sounding ideas that fall apart when you do the math.)

This is an important lesson that Canadian progressives have yet to fully absorb. Every time I point out the advantages of the GST/HST as a way to generate tax revenues to finance income transfers, someone will inform me that since the GST/HST is regressive, increasing the GST/HST is a bad idea. (I have this conversation so often that I have a special name for it.)

As far as the economics goes, dealing with first-order inequality is easy enough: increase taxes—the GST/HST is probably the best choice—and use the extra revenues to strengthen our system of income transfers. Too bad no party seems to think that this policy mix is likely to win votes.