Unit 4 Macro: Tax Changes to Boost Growth

Reducing the income tax rate and increasing the inheritance tax rate could induce a huge increase in UK GDP, according to research by Professors Alberto Alesina and Guido Cozzi and Dr Noemi Mantovan, published in the latest Economic Journal (December 2012)

Based on an analysis of how social beliefs about fairness have evolved over time as well as how redistribution affects incentives, they conclude that taxing inherited wealth rather than incomes would redistribute wealth from those who are born ‘lucky’ to the ‘unlucky’.

This would not only reduce perceptions of unfairness in society but also encourage people to be more productive, thereby boosting the economy.

The study begins by asking why Europeans are typically more averse to inequality than Americans and more willing to tax the rich to give to the poor? One answer is that centuries of feudalism, privilege by birth and lack of social mobility have entrenched in many Europeans the idea that wealth is largely undeserved, while the poor are poor because they grew up in the wrong families. Tax and transfers therefore serve to redistribute income from the ‘lucky’ to the ‘unlucky’ in society.

But high income tax rates also discourage work and effort, leaving little space for those willing and able to create new wealth. Thus, concerns about fairness motivate voters to support high taxes on income. In turn, high income taxes discourage individual initiative and paradoxically create a situation in which inequality becomes more entrenched. If hard work is discouraged by high tax rates, individual success is more dependent on family connections, clientele and corruption.

Traditionally, in the United States, the rich were viewed as winners, who earned high incomes because they contributed a lot to society and poorer people were viewed as losers, lazy and unproductive. This justified lower income tax rates, which encouraged hard work and social mobility. Thus, wealth was correctly seen as the result of effort, at least more than in Europe, and therefore inequality was accepted as less unfair.

This study traces the convergence of the US and European paths to two very different ‘equilibria’. One has low taxation, high social mobility and higher GDP; the other has high taxation, low effort, less social mobility and lower income.