Tax, redistribution and economic performance: the micro and the macro

Alexandria Ocasio-Cortez, the youngest woman ever to be elected to the US Congress, has made headlines recently with her arguments for much greater marginal rates of tax on the highest earners. Oxford University’s Simon Wren-Lewis yesterday posted this helpful piece on some of the economics and politics of such a policy. He is broadly in favour, and makes a good case for it.

Wren-Lewis is something of a New Keynesian, coming from the centre-left of mainstream thinking. The post covers plenty of ground, but tends to only focus on the microeconomics, while neglecting the macroeconomics, of higher taxes and redistribution.

Microeconomics focuses on the behaviour of individuals, firms and households, while macroeconomics focuses on the overall economy, whether for a region, a single country, or the world as a whole.

The macro

There has long been an argument made by leftist economists, particularly those influenced by Keynes, that higher earners consume a smaller share of their income than poorer ones. Therefore, levying higher taxes on the former and redistributing the proceeds to the latter is likely to boost consumption and reduce savings.

The effect this has on the overall economy depends on whether investment is constrained by inadequate consumption or by inadequate savings. If it is constrained by inadequate consumption, then a government policy of tax and spending which favours the poorer members of society, by boosting consumption, will increase the demand for consumer goods and, if sustained, will give firms producing goods for consumption greater incentives to invest in new capacity in order to meet the greater demand for their output. In this way, reducing income inequality can boost economic growth.

On the other hand, if investment is constrained by savings, then reducing income inequality to boost consumption is likely to have the opposite effect. By reducing savings, it will reduce the resources necessary to fund investment, weakening economic growth. In this context, a policy that increases savings will lead to increased investment and output.

Inadequate saving is more likely to be a problem for the poorest developing countries rather than rich nations, especially if the former are unable to borrow sufficiently from abroad to fund necessary investment. In richer countries with more developed financial systems this should be less of a problem.

Of course, using higher tax revenues from higher rates levied on the richest individuals to boost the incomes of the poor either through reducing taxes levied on the latter or by increasing transfers is not the only way that redistribution and faster growth can go together.

In countries where growth is constrained by inadequate infrastructure, higher taxes on the wealthiest can fund public investment to improve it. Where it is needed, improved infrastructure in areas such as transport and energy can crowd in private investment by lowering the cost of doing business. In the case of the US, this would have been a much more productive use of public funds than Trump’s tax cut, and would have led to faster and more sustained growth.

Much of the political conversation about higher or lower taxes focuses only on microeconomic incentives, and worries about the ‘burden’ of tax. Incentives are of course important, but in his post Wren-Lewis shows that there are perfectly good arguments in favour of higher marginal rates on the wealthiest, which take into account both microeconomics and politics.

At the same time, it is also vital to consider the macro or systemic effects of such policies, particularly in countries whose politics has become divisive, corrupt and even unstable in the face of high levels of inequality, alongside weak economic performance. Greater social justice can be achieved alongside an improving economy, but not in every case.

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