Tax the rich, Part 3: Gross inequity hurts GDP

My two previous articles addressed the normative issues associated with increasing taxes on the wealthy. I answered the question of whether such taxes are just, considering the ethical consequences as more important than the positivistic economic consequences. Now, in my next two articles, I will discuss the reasonably predictable economic consequences of allowing gross economic inequality. I will make the case that raising taxes on the wealthy would actually have desirable economic consequences.

But what is a “desirable” economic consequence? For our purposes, there are three standards we can use to evaluate the desirability of various economic systems. First, a desirable system should be efficient. This means that the prices of various assets accurately reflect their value. In an efficient market, the price of a house would be predictable and stable, rather than volatile. Efficient markets tend to grow more slowly in the short-term, but they avoid the asset bubbles that characterize inefficient markets.

Second, increases in aggregate GDP should be accompanied by a corresponding increase in GDP-per-capita. If the total size of the economic pie is increasing, everyone should be able to enjoy that wealth.

Third, the power of money should be maximized. When a dollar is spent, it isn’t just spent once. When consumers buy goods and services, the providers of those goods and services spend the money they use again. This happens over and over again, and as money exchanges hands while moving through the economy. This phenomenon is known as the “multiplier effect.” The greater the multiplier effect, the more time the dollar is spent. The more a dollar is spent, the more it boosts aggregate demand.

When these economic conditions are established as desirable, the question then becomes how to implement policy that satisfies these conditions. First, let’s take a look at the status quo.

Income taxes on the wealthiest Americans are the lowest they’ve been since 1929. In terms of tax revenue as a percentage of GDP, the U.S. collects less in taxes than almost every other OECD country. In terms of economic inequality, the U.S. has greater income inequality than every OECD country. Moreover, income inequality today is greater today than at any other time in the last thirty years.

The bottom line: in both relative and absolute terms, the wealthy today are richer than ever. Now, if the wealthy were truly the “job creators,” then where are all the jobs? There are hundreds of billions of dollars just waiting to be invested in small businesses, so what’s happening?

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Well, it turns out that the wealthy aren’t “job creators” at all. It makes more sense for rich people to buy sports cars than to invest in small businesses. Why? Because the wealthy do the same thing with their money that everyone else does. They try to increase their well-being.

When a wealthy person wants to increase their well-being, they’re looking to increase their satisfaction in both absolute terms and relative terms. So if Gary is super wealthy, and lives in a neighborhood with other super wealthy people, he’s going to spend his money on things that increase his satisfaction relative to the people around him. So if Gary’s neighbor Sam owns an $80,000 sports car, then Gary will want to buy a $90,000 sports car to increase his relative satisfaction.

Some people seem to think that Gary wants to create jobs for everyone. This is nonsensical. Unless Gary expects a massive return on his investment in a small business, he’s going to buy a sports car.

This phenomenon is something economists call “relative deprivation.” It prominently occurs in economic systems with gross economic inequality. This is because as incomes skyrocket, the standard of living drastically changes. A chain of comparisons begins with the wealthiest earners, and then cascades down to the middle class.

Few middle-class people aspire to live in a 44,000 sq. ft. mansion like the one Bill Gates owns. But by building that mansion, Gates set a new standard, or benchmark, for other exceedingly wealthy people, some who subsequently built mansions just as big. These giant mansions ratcheted up the aspirations of people below them, who were just “rich,” as opposed to exceedingly wealthy, and who began building larger homes than they had before. The typical American home built in the United States in 1977 was 1,780 sq ft. The average size of a home built in 2007 was 2,500 sq. ft even though median incomes barely rose. The typical wedding in 1980 cost $11,213. In 2007, it cost $28,082. What’s most interesting, however, is that weddings first became more expensive for the wealthy, and then slowly for everyone else.

The only way middle class Americans can keep with the inflating cost of just about everything is to borrow more and rely on credit. As the middle class watches the rich get richer, they don’t want to feel left behind. Consequently, in an effort to increase their relative satisfaction, they rely more on credit to keep up with the rising standard of living.

Here’s the bottom line: the standard of living has certainly increased in the last thirty years. However, most people can’t afford the new, higher standard of living. So, are we genuinely living better lives by borrowing to keep up with bigger homes, more expensive weddings, nicer appliances, and more extravagant vacations? I’m not convinced.

Using credit to keep up with the rising standard of living isn’t people being irresponsible. This is simple behavioral economics. People make money so they can buy things that make them happy. When the things they buy make them less happy, then they have to buy more.

Allowing hedge fund managers to report their earnings as long term capital gains and make billions contributes to the problem. Lowering taxes on the wealthy so they can buy more sports cars contributes to the problem. Taxing the wealthy mitigates the problem, and empowers the middle class.

Unless we address ballooning economic inequality, our economy will continue to suffer. Increasing taxes on the wealthy is a powerful way to stabilize the economy, and fight against the economic harms of relative deprivation.