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Stefan Karlsson

Why the increase in inequality is probably exaggerated

As the top tax rate rises and falls, so do tax avoidance techniques – both legal and illegal. Changes in reported income, therefore, might not reflect changes in actual income.

By Guest blogger / October 2, 2010

The apparently rising imbalance between rich and poor may be exaggerated by the fact that lower tax rates have encouraged the rich to report their wealth more honestly. Increasing tax rates also increases tax sheltering.

Illustration / Aristidis Tsinaroglou / www.smartmagna / Newscom

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John Stossel has an interesting column showing how upper income tax increases in New York State and some other American states have generated a lot less revenue than expected.

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It could be argued that this is misleading in a discussion about federal tax increases, since some of this effect reflects people moving across state lines, and people are probably more reluctant to move away from the United States (especially since the IRS tries to tax American expatriates), than they are moving from say, New York State to New Jersey or Connectitut.

However, upper income tax increases will nevertheless generate less revenue than suggested by a static analysis (where it is assumed that behavior won't be affected) because first of all it will reduce productive activities, and secondly because it will increase both legal and illegal tax avoidance activities.

This point also has implications for the discussions about increased income inequality. As I have noted before, higher upper income tax increases won't just decrease after-tax income inequality, but because it will for the above mentioned reasons reduce the tax base it will also reduce apparent pre-tax income inequality.

However, this reduction in apparent pre-tax income inequality is not something which will benefit the poor and the middle class. To the extent this reflects lower productive activities, this will reduce GDP and in fact reduce income for the poor and the middle class as well. And to the extent it reflects increased ytax avoidance, the apparent decrease in inequality is an illusion.

Remember that income inequality statistics are based on tax returns. If upper income earners manage to use legal or illegal tax avoidance techniques to reduce their reported, but not their real, income than official statistics will show a reduction in inequality even as there has been no real decrease.

This also suggests that much of the apparent increase in inequality since 1979 that leftists complain about is probably an illusion. Because just as higher income tax rates will increase tax avoidance, lower income tax rates will decrease it. And as the top federal income tax rates has fallen from 70% in 1979 to 35% now, the degree of tax avoidance has probably decreased a lot, meaning that the actual increase in income for the rich has been smaller than the real increase in income.

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