Economic Inequality: Facts, Theory and Significance

Policy Reports | Economy | Government | Social

No. 312
Tuesday, June 10, 2008
by David R. Henderson

Potential Pitfalls of Redistribution

Interestingly, because of the way incomes are often measured, many of the policies that various redistribution advocates propose would, in fact, increase measured inequality.  These policies include: 1) increasing marginal tax rates on high incomes and/or 2) increasing the Earned Income Tax Credit.

The first policy — increasing marginal tax rates — would increase measured inequality as long as the supply curve of high income earning labor is even slightly upward-sloping.  The reason is that an increase in the marginal tax rate would discourage work.  This reduction in the supply of labor would drive up the before-tax pay of the highest earners.  All other things equal, their after-tax pay would decrease and after-tax inequality would fall — but measured inequality would rise.  One can easily imagine advocates of such a policy promoting even higher marginal tax rates on high earners on the grounds of “we didn’t increase taxes enough to have an effect.”  Of course, the ironic result would be a further increase in measured inequality.

The second policy, increasing the Earned Income Tax Credit (EITC) by raising the upper end of the income range over which people qualify, could have a similar effect to increasing marginal tax rates.  Those at the new upper end would likely cut their work hours — and, therefore, their pay — to get the marginal subsidy for not working.  Assuming this effect were not enough to cause a noticeable effect on wage rates, before-tax incomes of the newly qualifying EITC recipients would fall.  Of course, they would be better off in income terms, but if the measure of income does not include the tax credit, measured inequality would increase.  Just as in the case of increases in marginal tax rates, one can imagine advocates of an EITC increase calling for further increases on the grounds that the previous increases were not large enough.

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