Rising inequality and capital accumulation at high-income households bring severe political and economic disadvantages. To tackle misdistribution of income without burdening middle-income households, this paper proposes to increase progressivity of capital income taxation (CaIT) .
After pillorying the inequal distribution of income and wealth by renown economists, such as Piketty, Saez, or Zucman, the discussion about the appropriate use of taxes to mitigate the harmful effects of inequality on human capital, innovation, and investment runs at full speed (Alvaredo, Chancel, Piketty, Saez, & Zucman, 2018). Despite various designs for taxation, the principle decision of a government is simple: it can either tax labour, capital or both. In the following, this paper focusses on income taxation for households and argues that income from capital should be more progressively taxed than labour income. This is to reduce income inequality and harmful wealth accumulation without stressing capital-reliant middle-class households.
Extensive literature has shown severe economic and societal effects of excessive income inequality and unbalanced wealth distribution. Among others, inequality lowers economic output as investments in (human) capital are not optimally distributed; low income households burden the public budgets twice as they do not only miss to contribute but receive public support; income inequality leads to less political and societal engagement, less trust, and more criminality (Coccia, 2018; Dabla-Norris et al., 2015; Solt, 2008).
To tackle inequality, governments can use taxes as means of redistribution. Yet, regardless of labour or capital being addressed, increased taxes deteriorate economic efficiency: Taxes on labour reduce labour supply as it shrinks the marginal rate of return for work; higher and especially more progressive tax rates disincentivise human capital investments; higher taxes on labour advantage capital income and increase wealth accumulation at the upper end (Alvaredo, Atkinson, Piketty, & Saez, 2013). On the other hand, higher taxes on capital income endanger retirement plans, burden self-employed and business-owners from the middle class, and discourage savings that fuel investments, finance innovation and foster economic growth (Artus, Bozio, & García-Penalosa, 2013).
Trying to optimize the efficiency trade-off between negative long-term effects of inequality and short-term deterioration of taxes, this paper proposes to tax capital income stronger – yet, not by raising the overall tax rate or increasing the tax base, but by increasing the marginal tax rate to incline the CaIT progressivity. To enter the discussion and understand the possible effects of higher progressivity, one must regard the mix of household income among different income levels: Economists have pointed out that the higher the income, the more of it is received through capital gains. In the US, for instance, the income of the bottom 90 percentiles of population derives by only 15 % from capital, whereas the top 10 percentile obtains 43 % through capital (Hungerford, 2011).
A more progressive CaIT allows for tackling this specific group as marginal rates of taxation rise if income from capital increases. Progressivity separates between high-income capital-rich and middle-income capital-reliant households, such as farmers generating income from their land, landlords with a limited number of houses, self-employed or business-owners that do not receive a salary but rely on their return on capital, as well as pensioners with private retirement plans. For the latter, the marginal rate of taxation stays low and the proposed change does not deprive them of their livelihood. But as income from capital increases, the marginal rate of taxation rises and charges high incomes from accumulated capital. The change in progressivity suffers smaller detriments: Higher taxes usually encourage tax avoidance. Also, higher top-income CaIT discourages savings and therefore favours present over future consumptions (Artus et al., 2013). In general, the benefits compensate the disadvantages: Foremost, progressive taxing reduces inequality and enables greater redistribution. This effect is lasting as more progressive CaIT limit the growth of capital for future income (Alvaredo et al., 2018). Thirdly, as a household’s (and not a company’s) income from capital is taxed, shareholders or business-owners are incentivised to reinvest profits into the company instead of declaring the dividends. This allows for increased innovation and growth, and less private consumption. Lastly, an increase in capital income taxes incentivises labour over capital income which encourages human capital investments instead of wealth accumulation.
Progressivity fell into disrepute as an inequality mitigating, yet economically deteriorating element of taxation (Alvaredo et al., 2018). This paper argues that increased progressivity of CaIT compensates its potential detriments as it reduces income inequality and wealth misdistribution by burdening high-income capital-rich households without stressing middle-income capital-reliant households or company investments.
 It is important to notice that we do not refer to taxes on capital for companies, yet household income from capital, such as landownership and rents, interest and dividends, as well as company-ownership (Artus et al., 2013)
- Alvaredo, F., Atkinson, A. B., Piketty, T., & Saez, E. (2013). The Top 1 Percent in International and Historical Perspective. Journal of Economic Perspectives, 27(3), 3–20. https://doi.org/10.1257/jep.27.3.3
- Alvaredo, F., Chancel, L., Piketty, T., Saez, E., & Zucman, G. (2018). World inequality report, 1–291. Retrieved from https://wir2018.wid.world/files/download/wir2018-full-report-english.pdf
- Artus, P., Bozio, A., & García-Penalosa, C. (2013). Taxation of Capital Income. French Council of Economic Analysis, 9.
- Coccia, M. (2018). Economic inequality can generate unhappiness that leads to violent crime in society. International Journal of Happiness and Development. https://doi.org/10.1504/IJHD.2018.10011589
- Dabla-Norris, E., Kochhar, K., Ricka, F., Suphaphiphat, N., & Tsounta, E. (2015). Causes and consequences of income inequality: a global perspective. IMF Staff Discussion Note.
- Hungerford, T. L. (2011). Changes in the Distribution of Income Among Tax Filers Between 1996 and 2006: The Role of Labor Income , Capital Income , and Tax Policy.
- Solt, F. (2008). Economic inequality and democratic political engagement. American Journal of Political Science. https://doi.org/10.1111/j.1540-5907.2007.00298.x
This OnePager is part of a six piece series written for the course "Advanced Economics: Economic Theory & Policy" at Hertie School of Governance, lectured by Prof Jean Pisani-Ferry, Chief Economist of the French President and Professor at Hertie School of Governance and SciencePo.