Good Economics for Hard Times

by Abhijit V. Banerjee

  THE PANAMA PAPERS

  The other way the rich will surely try to react to a tax rise, however, is by finding ways to not pay taxes.

  One thing the absence of caps in European soccer and the resulting astronomical salaries does is encourage players to evade taxes. In 2016, Lionel Messi (who made more than €100 million in 2017) was found guilty on three counts of defrauding tax authorities of €4.1 million and given a suspended jail sentence. In July 2018, the Spanish government and Cristiano Ronaldo signed a deal in which he agreed to pay a fine of €19 million and receive a suspended prison sentence. He was accused of four counts of tax fraud worth €14.7 million, resulting from the use of shell companies outside Spain to hide income made from image rights from 2011 to 2014. Moreover, many of those who do not actually cheat shop around for lower taxes. Comparing countries in Europe that raised or lowered taxes at different points in time, a study found that when the tax rate in a country increases by 10 percent, the number of foreign players goes down by 10 percent.65 In 2018, Ronaldo left Spain for Italy to lower his tax bill.

  The exposé of the so-called Panama papers, which revealed the efforts of Panamanian law firm Mossack Fonseca on behalf of the global plutocracy in setting up hundreds of thousands of shell companies for them to evade taxes, showed just how pervasive tax evasion had become. The list of names included former prime ministers of Iceland, Pakistan, and the UK. Even in famously honest Scandinavia, only 3 percent of personal taxes are evaded on average, but the very rich are much more serious offenders. A study estimated that those in the top 0.01 percent in the wealth distribution of Norway, Sweden, and Denmark evade 25–30 percent of personal taxes they owe.66

  If taxes go up a lot, so will tax evasion. The question is, by how much? In the short run, the response will surely be substantial. We already mentioned this in the context of the Reagan tax cuts. When taxes go up, we expect to see the reverse: a sharp drop in taxable income as those who can hide their incomes do so right away, but a smaller effect afterward.

  In part for this reason, a small number of politicians in the United States and some economists67 are pushing for a progressive wealth tax applicable on worldwide wealth (in 2019, Elizabeth Warren proposed a 2 percent wealth tax on Americans with assets above $50 million, and a 3 percent wealth tax on those who have more than $1 billion). The idea is not new. After all, most Americans who own a home already pay a tax on the value of their home: the real estate tax they pay to their municipal government. But this tax is regressive. Suppose you own a house worth $300,000 and pay 1 percent property tax ($3,000). Then you will effectively pay 10 percent of your net wealth if you have a mortgage of $270,000 (since your net wealth is then $30,000) but 0.1 percent of your net wealth if you have financial assets of $2.7 million and no mortgage (since your net wealth is then $3 million).

  The wealth tax would be progressive and apply to all forms of wealth, not just real estate. The advantage of a tax applied on very high wealth, from the point of view of fighting inequality, is that very wealthy people do not consume the vast majority of the income they derive from their wealth. Instead, they take a small fraction of the wealth income in the form of a dividend, and they plow the rest back into their family trust or whatever structure has allowed their wealth to accumulate. In the current tax codes in most countries, they do not pay any taxes on the amount that goes back into the trust.68 This is part of the reason why Warren Buffet, as he likes to remind us, pays very little in income taxes.69 It is difficult to have a redistributive income tax if most of the top incomes are effectively (and legally) shielded from taxation in this way. Moreover the tax advantage gets compounded. The new wealth generates new investment income, most of which is again untaxed for the same reasons, making the rich even richer. A wealth tax on very high fortunes solves this problem. The best way to think about it is not, as the economic press and the politicians try to explain it, as a way for the wealthy to make a special effort to “give back” (though if that makes them feel better maybe it’s okay). Instead, it is simply a convenient and administratively (relatively) simple way to ensure they pay a tax on all their income, regardless of what they chose to do with it: someone whose $50 million in wealth makes at least $2.5 million in investment income in the average year. A 2 percent tax on wealth ($1 million) amounts to a 40 percent tax on this income, which is not outrageous.

  Unlike estate tax, which got a bad rap after being called the “death tax,” the idea of wealth tax is very popular. In 2018, 61 percent of respondents to a poll conducted by the New York Times were in favor, including 50 percent of Republicans.70 So it even may be politically feasible. Yet in recent decades many countries got rid of their wealth tax if they had one, and few countries have put one in place (Colombia is an exception). In France, getting rid of the wealth tax was one of the first actions of the centrist Macron government after his election in 2017. As we saw, this was a very dangerous political move; the abolition of the wealth tax and the attempt to put in place a surcharge on fuel was the original motivation for the Yellow Vest protest movement. In an attempt to quell it, Macron promised a number of giveaways, but did not reinstate the wealth tax.

  There are two reasons why wealth taxes are so politically difficult. First, because of effective lobbying. High-net-worth individuals finance the campaigns of politicians on the left and on the right, and few are in favor of wealth taxation, even when they are otherwise quite liberal. Second, it is easy to avoid the taxes, legally or not, particularly in small European countries where people can move or park their wealth abroad. This gives rise to a race to the bottom on tax rates.

  We should not lose sight of the fact, however, that all of this happens in part because the world tolerates tax evasion: most tax codes have loopholes galore and the penalties for parking money abroad are ineffective. As we saw, countries with a simple tax code with few loopholes lose less from evasion when taxes go up than the United States.71 Gabriel Zucman has convincingly argued that there are many relatively straightforward things that would help a lot in limiting tax evasion and tax avoidance. Among his ideas are to create a global financial registry that would keep track of wealth no matter where it is (making it possible to tax wealth no matter where it is parked), to reform the corporate tax system such that the global profits of multinational firms are apportioned to where they make their sales, and to more strongly regulate banks and law firms that help people evade taxes through tax havens.72

  Identifying a set of steps is of course not sufficient. There needs to be the political will to implement them. The three steps Zucman recommends may be particularly tricky since they involve international cooperation, and the men (yes, almost always men) at the top right now do not seem to be all that able to join together to get things done. Without that, countries may be tempted to engage in a race to the bottom in taxation in the hope of attracting talent and capital. Preferential tax schemes for high-skilled foreign workers have been introduced in Belgium, Denmark, Finland, the Netherlands, Portugal, Spain, Sweden, and Switzerland. In Denmark, for example, high-earning foreigners pay only a 30 percent flat tax for three years (against a top rate of 62 percent for the Danish). This was very effective in attracting high-income foreigners to Denmark, which may be good for Denmark, but bad for other countries. Now they have the choice between taxing their top earners less or pushing them to leave.73 This tension between country welfare and global welfare in the design of individual income tax policy has loomed large in the debate about tax competition.

  But the point is that these are political problems, not economics impossibilities. The spirit of this book is to emphasize that there are no iron laws of economics keeping us from building a more humane world, but there are many people whose blind faith, self-interest, or simple lack of understanding of economics makes them claim this is the case.

  CITIZENS UNITED?

  From the strict point of view of economic efficiency, therefore, the evidence suggests that nothing stops a government from having a very
progressive tax schedule with extremely high top marginal rates. If Denmark can have high taxes on top incomes without all the capital decamping to some neighboring less-taxed country, and all its rich moving to Ireland (or Panama), then for a large and much less globally integrated economy like the United States, from a strictly economic point of view, there is nothing to prevent it from doing the same.

  The difficulty of raising top tax rates is a political one. Indeed, we seem to be in the midst of a vicious cycle of concentration of political and economic power. As the rich become richer, they have more interest and more resources to organize society to stay that way, including financing the campaigns of legislators willing to lower taxes at the top. The “Citizens United” decision of the US Supreme Court, which ruled as unconstitutional legislative limits on corporations’ ability to fund electoral campaigns, has formally legitimized the unlimited power of money in influencing elections.

  But it seems unlikely that this state of affairs can continue unfettered without generating a massive backlash. High tax rates on the top earners are already quite popular. Polling data suggest that 51 percent of voters support a marginal tax rate of 70 percent on income above $10 million.74 In our survey, more than two-thirds of respondents, who were otherwise not particularly liberal, thought entrepreneurs making more than $430,600 annually (which puts them in the top 1 percent) paid too little in taxes.75

  To some extent, the recent populist uprising in the United States is the beginning of this backlash. Behind it is a profound sense of disempowerment, a feeling, right or wrong, that the elites always decide, and in any case what they decide makes no difference for the average Joe or Jean. In the United States, Trump, for all his wealth and elite connections, was elected on his promise to undermine business as usual, but the Republicans lined up behind him because they were confident he was as pro-rich as any of them. Indeed he did deliver the tax cut. But it is not clear how long this game of bait and switch can continue without it all exploding. The rich may eventually see that it is in their self-interest to argue for a radical shift toward real sharing of prosperity, or it may end up being imposed on them in even less favorable ways. The reason is that the increase in inequality has been at the root of a deep increase in social anxiety and unhappiness.

  KEEPING UP WITH THE JONESES

  Social scientists have long suspected that people’s sense of self-worth is related to their position in the groups they see themselves as part of—their neighborhoods, their peers, their country. If this were true, inequality would of course directly affect well-being. Given how plausible this seems to us, it has been surprisingly difficult to prove beyond doubt. For example, evidence suggests that, at any given income level, people tend to be less happy when the average income in their locality is higher than their own.76 But it could be because they live in an expensive neighborhood where everything, from housing to cups of coffee, costs more. In other words, the facts can be explained without reference to inequality per se.

  A recent study from Norway shows that increased awareness about one’s place in the distribution of income increases the extent to which a person’s happiness depends on their income.77 In Norway, tax data has been publicly available many years, but the records were kept as hard copies and were therefore hard to access. This changed in 2001, when they were put online, and it became possible to snoop on your neighbors or your friends with just a few clicks of your mouse. This was very popular, to the point it was dubbed “tax porn,” and everyone seemed to know exactly where they stood. What we saw right after the data went online was that the poor were sadder and the rich happier. The awareness of one’s place on the totem pole does seem to affect well-being.

  In a way, we are all living in some version of the Norway experiment. Bombarded as we are by images of the lives of others on the internet and in the media, it is impossible for those who are stuck to not be aware that the rest of the world looks like it is moving ahead. The flip side of this is the impulse to show the world that we too are able to “keep up with the Joneses” and, if possible, do better than them. This is the logic behind “bling” purchases, designed to show off status. In a recent experiment, an Indonesian bank offered some of its higher-income customers (largely urban and upper middle class) a new platinum credit card.78 In the control group, customers received an offer upgrade of their existing credit card, with all the benefits of a platinum card except the platinum look. Customers understood the cards had exactly the same benefits, but that did not stop them from liking the platinum card more; 21 percent of those offered the platinum card went for it compared to 14 percent of those offered the nondescript alternative.

  Interestingly, the urge to show off is less strong when people feel good about themselves. The experimenters found that simply writing a short essay describing a moment when the person did something she or he was proud of reduced the demand for platinum cards. This creates a vicious cycle, with people who feel economically vulnerable being particularly eager to demonstrate their worth through useless purchases they can ill-afford, and an industry all too ready to provide these services for a handsome fee.

  THE AMERICAN NIGHTMARE

  Americans have another peculiar problem of their own. Fed a steady diet of the “American dream” along with their breakfast cereals, Americans tend to believe, in spite of everything, that although their society is unequal, it rewards industry and effort. In a recent study, researchers asked people in the United States and in several European countries their views of social mobility.79 When asked, “Out of 500 families divided in 5 groups of 100, how many of the children born of parents in the poorest group will stay in the poorest group, move one group up, two groups up, or make it to the richest group?” Americans are more optimistic than Europeans. They believe, for example, that out of one hundred poor children, twelve will make it to the richest quintile and only thirty-two will be stuck in poverty. In contrast, the French believe that out of one hundred, nine poor children will make it to the top, and thirty-five will be stuck in poverty.

  The rosy American view does not reflect reality today in the United States. Along with the general stagnation at the bottom, intergenerational mobility has declined sharply in the US. Mobility is now substantially lower in the United States than it is in Europe. Within the OECD, the child from the bottom quintile most likely to remain stuck in the bottom quintile is from the US (33.1 percent), while the least likely is from Sweden (26.7 percent). The average for continental Europe is below 30 percent. The probability of moving to the top quintile is 7.8 percent in the US, but close to 11 percent on average in Europe.80

  The places within the United States most likely to cling to the outdated notion of American social mobility, a.k.a. the dream, are actually those least likely to experience it. Americans also generally believe effort is rewarded (with the corollary that the poor must be in part responsible for their own plight), and probably for this reason, those who believe mobility is high also tend to be suspicious of any government effort to address the problems faced by the poor.81

  When overoptimistic perceptions of mobility clash with reality, there is a strong urge to avoid the awkward truth. The majority of Americans whose wages and income have stagnated, and who confront an ever-widening gap between the wealth they see around them and the financial woes they are experiencing, face a choice between blaming themselves for not benefitting from the opportunities they believe their society offers and finding someone to blame for stealing their jobs. That way lies despair and anger.

  By all measures, despair is on the rise in today’s America, and it has become deadly. There has been an unprecedented increase in mortality among less-educated whites in middle age and a decrease in life expectancy. Life expectancy declined in 2015, 2016, and 2017 for all Americans. This grim trend is specific to US whites, and in particular to US whites without college degrees: in all racial groups in the US except the whites, mortality is falling. Other English-speaking countries that have pursued a broadly simila
r social model to the US, namely the UK, Australia, Ireland, and Canada, are also going through a similar change, albeit in slow motion. In all the other wealthy countries, on the other hand, mortality is going down, and going down faster for the uneducated (who had higher mortality to start with) than for the educated. In other words, when the rest of the world saw convergence between mortality levels of the college educated and the rest, the United States went the other way. Anne Case and Angus Deaton have shown that the increase in mortality is due to a steady rise of “deaths of despair” (such as deaths from alcohol and drug poisoning, suicide, alcoholic liver disease, and cirrhosis) among white middle-aged men and women in America, combined with a slowdown in the progress against other causes of mortality (including heart disease). Self-reported health and mental health follow a similar pattern. Since the 1990s, middle-aged whites with low education are increasingly likely to report themselves in poor health, and they are more likely to complain of various pains and aches. They are also more likely to report symptoms of depression.82

  This is probably not so much a result of low (or unequal) incomes per se. After all, blacks did not fare any better economically over the period, and they are not affected by this trend. And there was no uptick of mortality in Western Europe, even after incomes stagnated during the Great Recession. On the other hand, Russia’s mortality exploded after the breakup of the Soviet Union in 1991, and like in the United States, most of the increase was due to changes in mortality from vascular disease and violent deaths (mainly suicides, homicides, unintentional poisoning, and traffic incidents) among young and middle-aged adults.83

  Case and Deaton also point out that although the increase in mortality in the United States started in the 1990s, it capped a trend that had begun long before that. After the cohort that entered the labor market in the late 1970s, each subsequent cohort fared worse than the preceding one in many different ways.84 At every age, among less-educated white Americans, each subsequent cohort was more likely to have difficulty socializing, to be overweight, to experience mental distress and symptoms of depression, and to have chronic pain. They were also more likely to kill themselves or die of a drug overdose. It is the accumulated weight of these deprivations that eventually led to the increase in mortality.