Tax, tax, tax, and redistribute!

Posted by on 16 March 2009

The current crisis is not merely financial but it also raises moral considerations, and sooner or later political consequences will become manifest. Since World War II, socio-economic cohesion in Continental Europe has been based on the containment of socio-economic inequalities. For this reason, we may not have fully understood the deepness of this crisis. Two aspects are currently being overlooked. One is the considerable rise in unemployment that so far affects mainly young workers, but which may soon attain a wider range of usually protected workers. The other aspect is that as a result of swings in real estate prices, millions of families over the world have lost significant parts of their wealth and life-time savings, and in some extreme cases underwent personal bankruptcies and land expropriation.

Historically, crises that deliver a severe impact on middle-classes also spark challenges to political cohesion. In such a context, paying huge dividends and high bonuses to top-level management stock owners can only add fuel to the fire. Once the implicit social contract is threatened, political radicalism is likely to emerge.

Some believe that solutions lie in more ethics. As usual, these are nice and necessary words. But, like in a Prisoner Dilemma situation, if 95% of economic decision-makers suddenly decided to be “ethical”, the remaining 5% would reap huge gains by engaging in unethical behaviour. Ethical solutions are inherently difficult. For example, it would be “ethical” for French banks to reduce mortgage rates to limit the drop in real estate investments. Alas, from October 2008 until present, the ECB “main refinancing operations” rate was cut by 2.75 percentage points but mortgage rates in France dropped by merely 0.7 percentage points, on average, according to statistics of the real estate sector. In short, two-thirds of the decrease in ECB rates went into the margins of banks.

There are better and more secure solutions than invoking ethics to limit inequalities and restore social cohesion. But they would require political courage. Indeed, the current crisis has shaken the foundations of proposals based on flexible wages and low taxation that were until recently sold as panacea for narrowing inequalities. Leading proponents of such social model like the US, the UK, Ireland, Estonia, and Czech Republic have been the hardest-hit countries in the current global recession. Their public opinions will ask for radical actions, as the scale of the US fiscal stimulus suggests. However, one can doubt of the effectiveness of asymmetric aggregate spending (Europeans are reluctant to follow the US paths) when the magnitude of Keneysian multipliers in closed economies is already controversial.

How then can inequalities be contained? In short, there are two alternative models.

A first proposal consists in targeting before-tax inequalities through rigid pay scales, effective collective wage agreements, and strong unions. This model, however, has been weakened as it is incompatible with a world characterized by competition for rare skills, biased technical change favouring top echelons of the income distribution, and competition from flexible wage countries in a world of increasing labour mobility.

The second model is to let wages -- and for that matter, stock-option bonuses -- be as flexible as the private sector requires, but making sure there is a sizeable amount of ex-post redistribution through highly progressive tax rates on labour and capital. This model had been put under considerable strain by the fiscal competition that accompanied the integration in good and capital markets during the past few decades, as well as by the surprising tolerance of fiscal heavens within Europe (e.g., Liechtenstein, Andorra, and others).

The recent agreement between Angela Merkel and Nicolas Sarkozy on bank secrecy rules, which followed strong US pressures on Swiss banks, brings tax havens into line and gives some hope of more concrete and microeconomically-oriented political reforms. There is indeed a symbolic connotation to this agreement that may help cool down the radical social pressures likely to emerge. Leaders may be tempted to further exploit the symbolic dimension through noisy and inefficient gestures such as forbidding stock options or putting ceilings to the earnings of CEO’s. However, concrete action is needed at this critical juncture.

Leaders need to move one strong step further and correct their tax systems so as to restore some fair amount of redistribution. Reform should tackle both non-progressive tax-bases (such as VAT), as well as taxes on highest incomes and capital. Additionally, coordinated tax policies would generate gains both along the fairness and the efficiency dimensions. In fact, leaders attending the G20 Summit in London should deliver concrete steps in this direction and propose an immediate and coordinated 10-percentage-point increase to the top marginal tax rates on both capital and labour. Other countries should commit to follow suit. Additionally, G20 leaders should discuss the creation of a new tax bracket above say 150 000 Euros per year, with a marginal tax rate around 66%. Finally, they should also commit to substantial increases in the taxation of stock exchange and real estate capital gains.

This is an ambitious agenda, and arguably one difficult to pass through legislatures. But political will and leadership can deliver global public goods. Was it really easy to coordinate reductions in tariffs and other barriers to trade by more than 110 countries? Certainly not! But much as the GATT and WTO were created to overcome the forces of conservative domestic lobbies, one can envisage at this critical juncture the establishment of a supra-national institution charged with delivering ambitious fiscal reforms.

In addition to political difficulties, another objection to these proposals is that a fiscal shock could amplify the recessionary trends throughout the world. Such concerns could be easily addressed if states were to immediately re-inject additional collected-resources into their national economies. This could be achieved through three means: decreasing marginal tax rates for low incomes, issuing checks for the poorest segments, and though temporary increases in welfare and unemployment benefits. Countries that already implement automatic stabilizers should immediately increase other categories of public spending (e.g., health, education, public infrastructure).

Finally, the above proposals could also help many sovereigns attain more sustainable fiscal situations over the long-term. This would results from the fact that the rise in the tax base at the top of the income distribution and the tax on capital would be a permanent one, while transfers to the poor would only last through the current recession. Higher fiscal revenues for government would considerably improve expectations on the sustainability of public debts, lowering financial markets risk-premia on sovereign debts and relaxing long-term rates.

My propositions may have sounded absurd just a few weeks ago given the credo on optimal taxation of factors. But the inability of European leaders to undertake coordinated action on the one hand, and the sudden collapse of the perceived of superiority of laissez-faire models on the other hand, give a unique window of opportunity to build a new post-crisis social consensus. Financing long-term investments in health and education by taxing more those who have immensely benefited from three decades of deregulation and globalization should be the main concern of G20 leaders. A triple dividend could result from such a coordinated fiscal harmonization: heightened perceptions of fairness, greater equality and political cohesion, and more efficiency by restoring the fiscal health of national governments.