March 2010 Quadrant article
Economics
Taxing the Rich and Spreading the Wealth
Peter Smith
A tale of two villages
There was once a particularly industrious and skilful man in a coastal village near the mouth of a river. He caught more fish than he could eat, while his fellow villagers just barely managed to feed themselves. The problem was that without refrigeration his spare fish spoiled. He had an idea of giving his spare fish to some of his fellow villagers in return for them forgoing their own foraging for food and building him a bigger hut. When his bigger hut was built he had an even better idea. In return for his spare fish, he commissioned the building of a bigger fishing boat for himself and something he had dreamt up in his spare time, which he called a fishing net. Now, with his bigger boat and net, he had many spare fish, and had the best idea of all. He employed some villagers to help him catch even more fish and sail upriver to neighbouring villages and towns, where fish were scarcer; to trade his fish for other goods and something called money. That was only the start; that village is now called “metropolis”.
There was another coastal village, equally endowed, in another place. A man in that village caught more fish than he could eat and it was decided that he would share his surplus with the others, so that they would have a little more to eat and would not have to work so hard. That village is now called “village”.
As a point of view, taxing the rich and spreading the wealth is guaranteed to win plaudits among the faithful on the Left: union or party members, intellectuals, anti-globalisation demonstrators, or Greens. When famously talking to Joe the plumber in the lead-up to the last US presidential election, Barack Obama said: “I think when you spread the wealth around it’s good for everyone.” Now President Obama intends to tax high-income earners as part of paying for an expansion of medical insurance in the USA. In the UK, Gordon Brown intends to raise the top income tax rate from 40 to 50 per cent. In Australia, Sharan Burrow talks about a “fairer distribution of wealth”, and the ACTU recommended a “wealth tax” to the Henry tax review. It seems unlikely that the “rich” (“those materially better off than most” will do as a loose definition) will escape unscathed from whatever is implemented out of this review. Taxing the rich to pay for improved and additional government services seems so easy and so palatable. After all, who will suffer? Only the rich and they can afford it.
Politicians on the Left are in thrall of taxing the rich because most people are not rich, and they have a suspicion that not too many of the rich will vote for them even if they don’t tax them heavily. It’s a win-win. But let us not be too party-political about this; there are plenty of examples of right-of-centre parties following the same course. It is to one extent or other a beguiling proposition across the political spectrum. For example, it wasn’t Keating that introduced the superannuation surcharge on the “rich” in the 1990s; it was Costello and Howard. Sinclair Davidson points out that at the end of the Howard years, the top 25 per cent income earners were paying a higher proportion of tax than they were at the start. The Carbon Pollution Reduction Scheme Bill, voted down in the Senate, had a complementary household assistance component for the purpose of compensating “low and middle-income families”. In rejecting the bill, I don’t believe the Liberals or Nationals made particular objection to the fact that the well-off were not to be compensated.
All political parties, at times, see electoral advantage in redistributing income from the relative few who are well-off, to the many who are less well-off, by imposing much heavier taxation on the few.
In that supposed epitome of individual self-reliance, the USA, which has had more Republican than Democrat presidents, the Internal Revenue Service recently reported that, in 2007, the top 10 per cent of federal taxpayers (that is, those who paid any federal income tax at all) paid over 70 per cent of income taxes.
Taxing the rich, and taxing them more, is apparently costless to an overwhelming proportion of the population. For example, the expansion of medical insurance in the USA is seemingly a “free” good, if you believe only the rich will be paying for it. Everyone knows the rich will remain rich so, in practical terms, it is costless. What has been discovered is an almost bottomless pot of gold. It’s a form of magic; the gift that keeps on giving. But we know there is no such thing as magic; only conjuring tricks. So, it isn’t true. Why isn’t it true? That is the question. The answer isn’t of the kind usually trotted out. Adam Smith had the real answer; but first to the meretricious.
If we tax the rich too much, they will simply work less or stop working. There was a survey of motor vehicle workers in the UK in the 1960s. They were asked whether they thought their colleagues would work less overtime if the government were to increase tax rates. Over 90 per cent said they thought their colleagues would work less. They were also asked whether they would work less. Over 90 per cent said they wouldn’t. The rich will keep on working because that is what they do.
If we tax the rich too much, they will take their bat and ball and go and live elsewhere. No, they won’t, or at least not so many that it will matter. You have to be where your business or employment is located. It’s not easy to simply pack up and move. Anyway, most places that are pleasant to live in are much the same; the rich are taxed heavily. Quite simply there is nowhere for the rich to go. No, the rich will stay around; they will work just as hard and will simply pay more of what they earn into the public purse, to the extent that they can’t wriggle out of it.
What about the moral argument? Is it unfair to tax one section of population heavily, and won’t this cause disenchantment among the heavily taxed? Strictly speaking, it may be hard to justify on moral grounds; notwithstanding the reverse argument that the rich are morally bound to assist the poor. Why should those who are especially talented or who work especially hard pay a much larger amount and, under progressive taxation, a much larger proportion of their earnings into the community pot, than those who are less talented or who work less hard?
There is biblical support for taxing the well-off. Several times in both Old and New Testaments the Bible mentions tithing to support priests and the less well-off. Tithing is 10 per cent of income. It can add up to a larger proportion once you have separately supported the priests and the poor and so on; nevertheless it is still a flat proportion. There is nothing about progressive taxation, or some such similar concept, in the Bible; that has to be put down as a secular invention.
While it is hard to be definitive about the moral argument, the movie The Edge has something useful to say. In the movie Anthony Hopkins plays a very rich businessman married to a much younger and glamorous wife (played by Elle Macpherson), with all the pressures this brings. Alec Baldwin, playing none too savoury a character, at one point expresses faux sympathy for Hopkins while accompanying him in Hopkins’s private jet. Hopkins replies: “Never feel sorry for the man that owns the plane.” And nor should we. The rich will manage, and put up with things resignedly, and it is best we lose no sleep over their plight of paying abundant taxes. It is a tyranny, of the Alexis de Tocqueville kind, of the relatively poor majority over the relatively rich minority, but it is, perhaps, the least worst of all such possible tyrannies.
This brings us to Adam Smith. It is salutary and levelling that the eighteenth century provided the answer which eludes many current politicians and political and economic commentators, who don’t seem to understand, and certainly don’t acknowledge, that taxing the rich costs us all, rich and poor alike. It is not a free good for anyone.
Economic commentators have perhaps less excuse than others in failing to appreciate and bring into account Adam Smith’s insights. Economics did not begin with Keynes.
In The Theory of Moral Sentiments Smith writes of the landlord:
that the eye is larger than the belly, never was more fully verified than with regard to him. The capacity of his stomach bears no proportion to the immensity of his desires, and will receive no more than that of the meanest peasant. The rest he is obliged to distribute among those who prepare in the nicest manner, that little which he himself makes use of, among those who fit up the palace in which this little is to be consumed, among those who provide and keep in order all the different baubles and trinkets which are employed in the economy of greatness; all of whom derive from his luxury and caprice that share of all of the necessaries of life which they would in vain expected from his humanity and justice.
And he goes on:
The rich only select from the heap what is most precious and agreeable. They consume little more than the poor, and in spite of their natural selfishness and rapacity … they divide with the poor the produce of all their improvements. They are led by an invisible hand to make nearly the same distribution of the necessaries of life, which would have been made, had the earth been divided into equal portions among all its inhabitants, and … advance the interest of society, and afford means to the multiplication of the species.
It is clear that Smith held little brief for the rich but he recognised that they did little damage and, if inadvertently (in his view), much good in spreading the wealth. Why they did little damage was because they saved rather than consumed most of their income. That is what the rich do. His observations told him that private frugality was the common inclination of those whose earnings allowed them the luxury of saving.
Brought up to date: with the most profligate will in the world, even the super rich usually have no more than a few wardrobes of clothes, ten cars, five houses, a luxury yacht and a private plane. You might say this is excessive (some might say it is obscene) and so it might be, but it adds up to very little in terms of soaking up the world’s resources; it is insignificant in fact.
The rich consume little more than the poor. What an insight of Smith’s that was and how it has been lost sight of. The rich save and only the rich have capacity to save very much. Consistent with this, Keynes, no less, pointed out that “a poorer community will be prone to consume by far the greater part of its output”.
Savings on one side represent investment on the other; and it is investment, particularly private investment, that produces growing prosperity. Smith understood that too:
In the midst of all the exactions of government, capital has been silently and gradually accumulated by the private frugality and good conduct of individuals, by their universal, continual, and uninterrupted effort to better their own condition. It is this effort, protected by law and allowed by liberty to exert itself in the manner that is most advantageous, which has maintained the progress of England towards opulence and improvement …
(The Wealth of Nations)
Taxing the income of the rich effectively requisitions private savings and investment for public purposes. It is not costless because it reduces private investment which otherwise produces increased prosperity for us all. While Smith had a somewhat jaundiced view of government spending—“Great nations are never impoverished by private, though they sometimes are by public prodigality and misconduct”—the worth or otherwise of such spending is not the point. The point is that it is not costless when it is paid for by the rich. The cost is the product and benefit of the private investment forgone.
In fact, calls for “taxing the rich and spreading the wealth” are for the most part no more than empty sloganeering suited to Tammany Hall-style meetings. This is not because taxing the rich more than the poor is a bad idea per se; in fact who else are you going to tax, if the poor have very little. It is because the costs and consequences of taxing the rich, and of taxing the rich more, are neither acknowledged nor seemingly understood. This fools people into thinking that something can be gained without cost, and so inevitably leads to the implementation of misguided and damaging economic policy.
None of this is saying that the rich shouldn’t be taxed as highly as they are or even more than they are. Nor is it saying that governments will waste the taxes raised—though they undoubtedly waste a good deal. It is saying that there is a cost of taxing the rich and that this must taken explicitly into account. Moreover, it is saying that this cost is private investment forgone which, a priori, we are entitled to think would have been of significant benefit because it would have been guided by market forces into satisfying real wants.
Contributing to the lack of understanding about the costs of taxing the rich is a very fuzzy idea about wealth. When you hear those on the Left talk about taxing the rich and spreading the wealth it is as though they were contemplating taking money that would otherwise be under a mattress. Apart from anything else, this thinking is a species of money illusion. It mistakes financial assets for real wealth.
The only consumable tangible manmade wealth we have, as of today, is already almost completely spread. For example, my immediate neighbours, though not very rich, are I suppose quite a bit richer than average yet they each possess only one house, one washing machine and one refrigerator; though admittedly two cars and maybe two televisions and the odd small boat here and there. The whole population of these possessions cannot be spread much more thinly to count for very much. My neighbours tend to eat only reasonable portions, as Adam Smith suggested they would so many years ago. Leaving aside houses, and household and personal possessions, all of the other tangible manmade wealth in the world is in the form of physical capital: infrastructure, commercial property, mines, plant and equipment. For the most part, this is fully employed making more physical capital or those familiar houses, and household and personal possessions. There is little or nothing left to spread. It is important to understand this. Spreading real wealth can only mean building more and bigger houses, making more and more expensive cars, making more boats, making more household goods of all kinds, and distributing them to those who cannot now afford them. How is it to be done? The answer is that it can’t; at least it can’t without redirecting resources and retooling factories to produce goods for immediate use and, in so doing, lessening future growth.
Financial assets, as distinct from physical assets, are concentrated. There are various estimates of this concentration but they are all broadly consistent. For example, Professor Edward Wolff has estimated that the top 20 per cent of households in the USA hold 92 per cent of non-occupied housing wealth. Australian ABS figures for 2005–06 show that the top 20 per cent of households held 60 per cent of wealth but this would be much higher if owner-occupied housing were removed from the figures.
The concentration of financial assets is used often to “demonstrate” how the system—capitalism—is unfair and defective: the rich have too much; the poor too little. Look at what good the rich could do if they gave their money away to the poor, you might hear it said. It is obscene that a relative few have so much when there is so much poverty. These are all understandable reactions, but that makes them no less superficial and misguided.
First, the concentration of financial assets is an inevitable consequence of the fact that only the rich save very much. Second, such saving provides the wherewithal to finance the building of physical capital; thereby increasing productivity and future growth. Without future growth, the availability of goods for those who are now deprived would be so much less. It is no accident that the developed world is more prosperous than it was and generally grows more prosperous each year. It all comes down to savings and the way those savings are used to build innovative and increasingly productive physical capital.
Financial wealth—the accumulation of past savings—has its counterpart in the stock of physical capital. This stock would not disappear overnight if financial wealth were spread much more thinly; but we could expect significantly more demand for houses and bigger houses, for cars and more expensive cars, for consumer durables and consumer services of various kinds, and so on. After all, stripped of money illusion, that is the purpose and effect of spreading the wealth. This would mean less future investment in physical capital and, potentially, a reduction in the stock and quality of such capital, depending on how much financial wealth was spread.
Without at all taking away from the benefits of philanthropy or government safety nets and even progressive taxation there is, in the end result, nothing of any materiality that can be done to relieve poverty without economic growth. Economic growth depends on investment. Investment depends on saving.
Of course, Keynesians would object to putting saving in the driving seat. For them, the virtue of saving was a pre-twentieth-century phenomenon; in a time of scarcity—in a time when the classical economists like Ricardo and Say were writing, when perhaps supply did create its own demand and there could be no long-lasting insufficiency of demand—but not now. They would say that the relative abundance we have now in developed economies means that saving is predominantly a curse rather than a virtue, and that we need to encourage consumer spending to maintain full employment. Simple observation suggests this is not true. The facts get in the way.
Leaving aside the fact that poverty is still with us to an appreciable extent, only few among us would say that all their material wants were satisfied. If you doubt that, have a look at credit card debt. Keynesians follow their master in endemically underestimating and understating the appetite of human beings for continual improvement in their material circumstances, and the concomitant ability of entrepreneurs and businesses to develop new goods and services that become the essentials of tomorrow. Only savings can fuel that process.
At our stage of civilisation only the comparatively rich save in quantities. Unequal income and wealth are therefore essential to combating poverty and improving everyone’s material circumstances; however much the Left or Keynesians have difficulty in understanding that. Policies of taxing the rich more and spreading the wealth more are not necessarily ruled out by this, once the consequences of reduced investment are understood. The point is that those consequences should be taken into account when such policies are espoused, to make sure there are offsetting benefits of at least equal value. Taxing the rich and spreading the wealth is not a free ticket to a more equal world.
Peter Smith is a former CEO of the Australian Payments Clearing Association. He wrote “Economics and Socialism Don’t Mix” in the December issue.
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