Cutting taxes doesn’t always make inequality worse

Why did the incomes of top earners rise so much after 1980? One reason was the boom in asset markets, which increased capital income from stocks and housing. But much of the gain was because the rich earned a lot more in salaries, bonuses and other labor income.
To cite a well-known example, chief executive officers in the late 1970s got paid a little more than 20 times what the average worker did; since the mid-1990s, it’s been more like 200. Here, from a paper by several economists who study inequality, is a graph of the income share going to the top 1 percent in the U.S.
Why are top earners getting paid so much more than they used to? It could be the result of natural shifts in demand. As technology and globalization have made markets more complex and strategic decisions more important, companies may simply be much more in need of skilled executives and managers. That demand, in turn, might drive up salaries in professions that compete for high-skilled labor, such as law, medicine and finance.
But another possibility is that the rich are making more because of government policy changes. It’s widely believed that U.S. policy became much friendlier to rich people starting with the Ronald Reagan administration. And just as one would expect, developed nations in Europe and Asia haven’t seen a comparable rise in rich people’s incomes. That makes policy a prime suspect.
But what did Reagan and his successors do to boost rich people’s incomes? The biggest policy change was to cut taxes — a process that began after World War II, when top marginal income tax rates were extremely high:
And in fact, a number of people are now claiming that Reagan’s tax cuts caused the rise in top incomes. That is the conclusion of a new paper by economists Thomas Piketty, Emmanuel Saez and Stefanie Stancheva.
At first glance, that seems like the opposite of what should have happened. If sales taxes vanished tomorrow, you would almost certainly pay less for a washing machine, not more. In the labor market, a company is the buyer of labor. So if workers are like washing machines, you would expect income taxes to work like sales taxes — an income tax cut would cause people’s take-home income to go up, but it would allow employers to reduce gross salaries.
From the end of World War II through the late 1970s, that simple, Econ 101 story looks like it fits the U.S. data. Top tax rates came down, and so did the income share of the top 1 percent. It’s also broadly consistent with what happened after 1990 — tax rates rose from their low of 28 percent in the late ’80s, dipped again after the George W. Bush tax cuts, and then went back to about 40 percent. At the same time, top incomes rose. The only time that top incomes rose while top tax rates were falling in the U.S. was in the 1980s.
But Piketty et al. look across a bunch of different countries, and they find a negative correlation between tax rates and salaries for the rich since 1960, meaning that when tax rates go down, the rich get paid more. Part of this is because rich people started working more, and part is because they stopped trying as hard to avoid taxes. But a large part of the correlation remains unexplained.
Piketty et al. have a hypothesis to account for why lower taxes might cause higher prices for top-end labor. They say it’s all about wage bargaining. When tax rates are high, a CEO might not expend the energy to bargain hard for an eye-popping compensation package. But lower the tax rate, and suddenly it makes sense to spend a lot more effort squeezing companies for more. This is also called the “grasping hand” effect.
That’s the theory, anyway. I’m unconvinced. Besides the fact that the U.S. correlation doesn’t seem to fit the model, Piketty et al.’s whole story relies on effort being very costly. But how hard is it to ask for more money or stock options? I don’t have data on how much of their time executives and managers spend on salary negotiations, and I’m not sure such data exists — but I doubt the change has been that dramatic.
Whenever economists invoke models based on effort, I tend to be skeptical. I think that most people are trying as hard as they can, most of the time. That includes executives pushing hard to get paid more money.
So why do lower taxes correlate with higher salaries in most countries? It’s still a mystery. If economists want to sell us on the “grasping hand” effect, I think they’re going to have to bring empirical evidence that demonstrates this directly.
—Bloomberg

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion