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Taxes & Inequality: Shiller’s Plan to Fix Tax Code

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Yale economist Robert Shiller says he and a colleague have studied “inequality indexation” with the objective of showing how more complex systems of tax rates might work. Though the concept could irritate some, it aims to “help achieve a better society,” the expert says in an excerpt from his new book, “Finance and the Good Society,” posted Tuesday on Bloomberg.

“Rising inequality is certainly a valid concern, and one that must be addressed,” writes Shiller, who–in the end–doesn’t stridently come down in favor or the inequality-indexation scheme he describes. Instead, he shares it as another option to put on the policymaking table.

It’s not that financial capitalism produces unjust wealth distribution, it is that some wealthy families “annoy others by ‘showing off’–by spending extravagantly and wastefully on themselves.”  That leads to resentment.

In ancient times, Shiller notes, Greece forbade women from wearing extravagant clothing or jewelry.

“Neither a sumptuary tax nor a progressive consumption tax is an easy and obvious solution to the problem of wasteful and resentment-inducing consumption that announces wealth or social position,” he writes.

“Ideally, estate taxes should be set at some intermediate level, so that they neither confiscate people’s wealth at death nor allow it to pass entirely to the next generation,” explains Shiller.

Taxes and Inequality

While one of “society’s most important weapons against economic inequality is the progressive income tax … ,” according to Shiller, “the income-tax system has never been designed with the express objective of managing inequality.”

In his view, countries like the United States “would be wise to index their tax systems to inequality. Under such a system, the government would not legislate fixed income-tax rates for each tax bracket, but would instead prescribe a formula that tied tax rates to statistical measures of pretax inequality.”

This means that if income inequality rose, tax rates would automatically become more progressive. “Inequality indexation could be considered a kind of insurance–against worsening inequality,” Shiller writes.

Historic Analysis

Shiller worked with Leonard Burman, a tax policy expert at Syracuse University, to look at the possible effects of inequality indexation over time.

“We found that if one had been legislated in 1979, freezing after-tax income inequality at the then-current level, the marginal tax rate on high-income individuals would have increased to an extraordinarily high level, more than 75%, ”he notes. “This indicates how much economic inequality has worsened since 1979.”

Shiller concedes that societies have great trouble dealing with the issue of inequality in a systematic manner: “The principle has never been articulated that some degree of inequality is a good thing, that there should be some who are richly rewarded for their business success (or their parents’ success), but that society should put some limits on this inequality.”

Since such a principle has never been established and the impact of tax laws aren’t looked at systematically, the wealthy “instinctively oppose any increase in their taxes, fearing that acquiescing even to a limited extent might leave them open to a haphazard series of tax increases that, in combination, could amount to confiscatory taxation,” according to Shiller.

“The inequality indexation scheme may not ultimately prove to be the right course, but it at least illustrates how more complex systems of tax rates grounded in risk-management theory and behavioral economics could work,” he concludes. “We could introduce more responsiveness and nuance into the tax system to help achieve a better society–one in which people feel that basic economic fairness is assured.”

See AdvisorOne’s Special Report, 22 Days of Tax Planning Advice for 2012, throughout the month of March.