How To Fix Income Inequality
Abba P. Lerner an American economist theorized that aggregated utility would be maximized by taking wealth from the rich and giving it to the poor. He believed the state of optimized happiness would be perfect economic equality. As Lerner explains it, “If it is desired to maximize the total satisfaction of a society, the rational procedure is to divide income on an equalitarian basis”.
Now Lerner’s theory runs into one major problem in a real life setting; it removes incentives and accountability. A capitalist society thrives on continued innovation through the use of motivation by incentives. The importance of Lerner’s work in term of the current economic situation is it highlights the connection between a society’s income disparity and its total happiness. As income disparity grows, total happiness within a society declines.
The last economic depression was righted partially through an increase to the top marginal tax rate. A current bump to this rate would rebalance the economy and get money to the people who need and use it. Personal savings would increase leading to higher consumer confidence. Spending on goods and services would then rise with consumer confidence and becomes the catalyst for new job creation.
The key is raising top marginal taxes high enough to be successful in reenergizing the economy without removing financial incentives and motivation in the society.
The Law of Diminishing Marginal Utility in Taxes
A solution to satisfying both sides of this spectrum is by using the Law of diminishing marginal utility of money to create a progressive tax rate. Earlier this year Sarah B. Lawsky, the acting professor of law at the University of California, wrote an article titled On the Edge: Declining Marginal Utility and Tax Policy”. This shows a very thorough review of the different thought processes surrounding this type of policy.
The Law of diminishing marginal utility explains that the more money a person possesses the less each additional dollar increases their total utility. As an example, if you gave a million dollars to a person in poverty it would change their life forever, but if you gave that same million to a multibillionaire there’s a high probability it would have a much smaller effect on their happiness.
Each additional dollar a person acquires means less and less the further they move up in wealth. As this happens money becomes a smaller percentage of motivation. This explains why someone like Warren Buffet is still working while simultaneously campaigning to be taxed higher. Adding additional wealth is no longer the primary factor that keeps him working. This dismisses the theory if you tax the super wealthy it will demotivate the job makers.
Capital Gains and the Friedman-Savage Curve
The capital gains tax rate should run on a parallel utility curve to income tax. The capital gains rate needs to be increased but remain lower than the income tax rate. This will assure that individuals who have a locally increasing marginal utility based on a Friedman-Savage curve always have an opportunity to decrease their tax rate through risk-preferring behavior.
The Broad Definition of Capital Gains
“Almost everything you own and use for personal or investment purposes is a capital asset. Examples include a home, household furnishings, and stocks or bonds held in a personal account. When a capital asset is sold, the difference between the basis in the asset and the amount it is sold for is a capital gain or a capital loss.” (Source)
This broad IRS definition of capital gains needs to be revised. Large hedge funds and market leaders capitalizing on their ability to manipulate stock prices is very different than someone investing in a startup company.
Clarification needs to be made so reduced capital gains tax rates are only rewarded for:
- Investments into startups
- Investments that directly contribute to company expansions
- Investments in specifically allocated retirement funds
A tax structure that incorporates the diminishing marginal utility of money would optimize the total amount of utility in a society without decreasing the total amount of motivation. This would then begin to shrink the wealth distribution to a stabilized level and increase economic production.
Table of Contents & Page Links
1) Income Inequality Influences the US Personal Savings Rate
2) Income Disparity Sparked by Low Top Marginal Tax Rates
3) Unequal Distribution of Wealth
4) Tax Breaks and Tax Loopholes for the Rich
5) Low Capital Gains Tax Rates Cause Investment Bubbles
6) Great Depression VS Great Recession
7) The Job Creators Myth Debunked
8) Government Spending and the National Debt
1) How To Fix Income Inequality
2) Restructuring is Needed to Stop Government Overspending
3) Use Taxes for Economic Recovery
This is a working paper and will be updated and expanded upon as time permits. All comments, questions, and alternative opinions are greatly appreciated.
Brian Rogel isn’t a household name but his analysis of wealth inequality could become household reading.