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Taxing the Rich: A History of Fiscal Fairness in the United States and Europe

Author(s):Scheve, Kenneth
Stasavage, David
Reviewer(s):Poulson, Barry W.

Published by EH.Net (December 2016)

Kenneth Scheve and David Stasavage, Taxing the Rich: A History of Fiscal Fairness in the United States and Europe. Princeton: Princeton University Press, 2016.  xv + 266 pp. $30 (hardcover), ISBN: 978-0-691-16545-5.

Reviewed for EH.Net by Barry W. Poulson, Department of Economics, University of Colorado.

In this study Kenneth Scheve (Professor of Political Science at Stanford University) and David Stasavage (Professor of Politics at New York University) address an important question:  given evidence of increasing inequality in recent years, why is there not greater effort to tax the rich? To answer this question they survey the history of progressive taxation in twenty countries over the past two centuries, and the literature on taxation and the distribution of income and wealth.

Their evidence reveals an inverted-U curve for the average top marginal rates of income taxation in these countries in the twentieth century. Using evidence for the income share going to the top 0.01 percent of the income distribution, their evidence suggests an inverse relationship between the top rate of income taxation and the share of income received by the top income group.  They also find evidence of an inverted-U for average top rates of inheritance taxation in the twentieth century. Using evidence for the share of wealth owned by the top 1 percent of wealth holders, their evidence suggests an inverse relationship between the top rate of inheritance taxes and the share of wealth held by this wealthy group.

The authors maintain that higher tax rates on the rich were a form of compensatory taxation. Mass conscription during World War I and World War II imposed a heavy burden on citizens. The rich, as owners of most of the capital, captured extraordinary profits during these war years. Higher marginal tax rates on the rich compensated for this privileged position they enjoyed during the war, and the differential burdens imposed on citizens by mass conscription.

Their explanation for declining tax rates on the rich in the post-World War II period is the converse of this argument. Technological changes eliminated the requirement for massive conscription of citizens into the military. As countries relied on a voluntary army, this argument for compensatory taxation of the rich no longer held. Further, they find that other arguments for compensatory taxation of the rich based upon privilege or rent seeking are not persuasive. The authors conclude that current economic and political conditions are such that the compensatory compensation argument for taxing the rich is no longer valid.   The authors agree with Thomas Piketty that taxation of the rich and income inequality in the twentieth century were linked to war; but, they do not agree that this was a random process (Piketty 2014, Piketty and Saez 2007). They argue that taxation of the rich and trends in income inequality were driven by long-run trends involving international rivalries and technologies available for waging war.

My major concern with this study is that their analysis ignores fundamental issues in this debate, especially as it relates to tax and fiscal policy in the U.S. Their analysis is based on the ‘public interest theory’ of government; the assumption is that progressive taxation satisfies a norm of fairness or equality. The public choice literature provides an alternative explanation for the differential tax burdens imposed on the rich relative to the non-rich. If the preferences of elected officials differ from those of their constituents, self-interested politicians will attempt to minimize the political costs associated with raising a given budget or revenue, where political costs result from opposition to taxes by taxpayer interest groups. Politicians can minimize these costs by shifting the tax burden to citizen groups that are less sensitive or effective in influencing tax policy. The use of a specific tax or marginal tax rate will then depend upon this tax price defined in terms of political costs. Allan Meltzer and Scott Richard use this model to show why preferences of voters for taxes are ranked by income, and how extension of the franchise could lead to higher taxation and redistribution of income from rich to poor (Meltzer and Richard 1981). (Scheve and Stasavage refer to this literature in a footnote on page 220, but argue that there is no general theory supporting the argument.)

The public choice literature reveals a systematic bias toward increased spending and deficits. From this perspective, the challenge in democratic societies is to design fiscal rules and institutions to constrain the growth of government, and to allow the preferences of citizens to dominate those of their elected representatives. Progressive tax systems are analyzed within the context of these fiscal rules and institutions (Merrifield and Poulson 2016b).

After World War II, under the leadership of the U.S., industrialized countries successfully removed barriers to international trade and capital flows. This so called “Pax Americana” set the stage for rapid growth in international trade and the global economy. To compete in this new global economy countries significantly reduced tax burdens.

As Chris Edwards and Daniel Mitchell document, the tax reforms enacted in major competitors have left the U.S. behind (Edwards and Mitchell 2008). While the U.S. retains certain tax advantages, there are a growing number of disadvantages. Its top individual income tax rate is now about average compared to other OECD countries, although it kicks in at a higher income level than most countries, and thus penalizes fewer people. However, U.S. businesses are increasingly at a competitive disadvantage with respect to tax burdens when compared to businesses in other OECD countries. The U.S. now has the second highest corporate income tax rate, at 40 percent when calculating federal and state corporate income taxes. U.S. businesses face high business tax and compliance costs. American businesses face a tax penalty when they repatriate profits earned by their foreign subsidiaries. The U.S. has the eighth highest dividend tax rate, and the highest estate and inheritance tax rate among OECD countries. Finally, the U.S. has one of the highest tax rates in the world on corporate capital gains. Much of this tax burden on business is borne by workers in the form of lower wages and employment opportunities.

In contrast, the most successful OECD countries have enacted new fiscal rules to constrain the growth in government spending. John Merrifield and I document how new fiscal rules have enabled these countries to reduce taxes and borrowing. By the end of the twentieth century Switzerland and the Scandinavian countries imposed the lowest top income tax rates compared to other OECD countries; and these countries are successfully addressing unfunded liabilities in their entitlement programs (Merrifield and Poulson 2016a).

Fiscal rules in the U.S. have been relatively ineffective in constraining the growth in federal spending. For half a century rapid growth in federal spending has been accompanied by deficits and debt accumulation. With total debt now in excess of 20 trillion dollars, the U.S. is one of the most indebted countries in the OECD. The total debt burden as a share of GDP exceeds 100 percent, and is projected to grow even higher in coming decades under current law. Growing unfunded liabilities threaten the viability of federal entitlement programs. These flaws in tax and fiscal policy are causing a massive redistribution of income and wealth in the U.S (Merrifield and Poulson 2016b).

References:

Chris Edwards and Daniel Mitchell. 2008. Global Tax Revolution: The Rise of Tax Competition and the Battle to Defend It. Cato Institute, Washington D.C.

Allan H. Meltzer and Scott F. Richard. 1981. “A Rational Theory of the Size of Government,” Journal of Political Economy 81: 914-927.

John Merrifield and Barry Poulson. 2016a. “Swedish and Swiss Fiscal Rule Outcomes Contain Key Lessons for the United States,” The Independent Review 21: 251-74.

John Merrifield and Barry Poulson. 2016b. Can the Debt Growth be Stopped? Rules Based Policy Options for Addressing the Federal Fiscal Crisis. New York, Lexington Books.

Thomas Piketty. 2014. Capital in the Twenty-First Century. Cambridge: Harvard University Press.

Thomas Piketty and Emmanuel Saez. 2007. “How Progressive is the U.S. Federal Tax System? A Historical and International Perspective,” Journal of Economic Perspectives 21: 3-24.

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Subject(s):Government, Law and Regulation, Public Finance
Geographic Area(s):Europe
North America
Time Period(s):19th Century
20th Century: Pre WWII
20th Century: WWII and post-WWII