Tax Wealth Rather Than Income or How to Accomplish (Relatively More) Efficiency and Equality

     The short story is that if you tax something you get less of it and if you subsidize something you get more of it. So taxing income isn’t a good thing economically, it’s more so done out of necessity. Taxing wealth more would enable us to lower the marginal tax rate on income (the amount of tax paid on an additional dollar of income), meaning less distortionary effects on incentives and higher growth.

     But here’s the long story of it:

     In the 1800s Vilfredo Pareto came up with the basis of the First and Second Fundamental Theorems of Welfare Economics. This is back when economists were first formulating mathematical macro models of the economy. Here’s Pareto’s at its simplest: imagine a two person economy where the first person is randomly given some of the economy’s resources and the second gets the rest. The two will make any mutually beneficial trades. They continue to trade until there are no more mutually beneficial trades. This is a market equilibrium. So The First Theorem is that competitive market equilibrium is “Pareto Efficient” (hereafter referred to simply as “efficiency”).

     The Second Fundamental Theorem is that given any initial resource endowment, there is an efficient outcome that can be reached. Basically, the Second is the First in reverse. Sounds simple now but the point is that a market equilibrium must be a point at which no person can be made better off without another being made worse off (that’s the First), and for any initial starting point, or resource endowment, market exchange will result in equilibrium (the Second). Or, equilibrium is the most efficient allocation of resources and free markets tend towards equilibrium. A key fact of this model is that efficiency is not equality, and equality is not something free markets in equilibrium will achieve per se.

     In the mid-1900s Kenneth Arrow, having lived through the Great Depression, tried to come up with a way to accomplish both equality and efficiency. His answer was a one-time lump-sum tax on individuals proportional to their earnings potential (pretend it’s possible to know someone’s earnings potential for the moment). Such a tax results in a 0% marginal income tax rate. There is no disincentive for people to try to make as much as they possibly can, so no distortions of market incentives. The tax basically alters the resource endowments, or starting points, of people in the economy. The Second Fundamental Theorem says that given any initial resource endowment, equilibrium can and will be accomplished. Together this means equality and efficiency can be accomplished by redistributing resources and letting market exchange do the rest.

     Also in the 1900s, Abba Lerner[1] showed that such an equilibrium, with both equality and efficiency, is the only aggregate utility maximizing point, assuming money “buys” utility, which economics does[2]. Going back to Pareto’s two person model, if the first person is richer than the second, and marginal utility per dollar decreases as you get richer (is one dollar “worth” less to Bill Gates than a homeless person? I think so), you can increase the sum of both people’s utility by taking a dollar away from the richer person and giving it to the poorer person. Aggregate utility grows until there is equality. While Lerner’s simple mathematical model ignores incentives and growth over time, Arrow showed that such an equilibrium point is theoretically achievable accounting for individual incentives.

     But this is all in theory. In addition to requiring assumptions that can’t all hold in the real world (see post from 2012), like every econ model, there is no way to know a person’s earnings potential in advance. However, you can know someone’s earnings potential after the fact. You look at how much wealth they accrued over their lives and you subject it to a one-time lump-sum tax, as Arrow said. This is essentially the Estate Tax. Even with the complications of the real world vs models, taxing wealth is is more economically efficient than taxing income because it involves fewer distortions of incentives to produce[3], reduces inequality, and increases aggregate utility, which is the whole point of economics.





1. Abba Lerner was a very interesting economist. In large part because he was a socialist, but one who was fluent in economics and mathematical models. Despite never winning the Nobel Prize, he obviously deserved one. Perhaps being a socialist contributed to not getting one, but other socialist economists such as Gunnar Myrdal have won the prize. Lerner came up with or significantly improved upon many indispensable economic theories and models, such as the aforementioned Distributive Efficiency Condition, the Lange-Lerner-Taylor Theorem, Market Socialism, the Lerner Symmetry Theorem, the Lerner Index, the Marshall-Lerner Condition, and the concept of Full Employment or NAIRU. While there are things I disagree with Lerner on, I wish there were still well-known socialists who can make arguments with coherent economic theory (which applies to all economic systems not just capitalism), models, and math.

4. To be clear, money does not have to be the only way to get utility, but just a way to get utility for this to be true.

3. In fact, not taxing inherited wealth reduces incentives for economic production by creating a class of people who obtain great wealth for no work and therefore have no incentive to produce for a living.