Here’s a story:

There’s a country divided into two classes, the payers and the paid. The payers are the small but wealthy, privileged, and influential group – CEOs, Boards of directors, various managers – that decides both how much the payers get paid and how much the paid get paid; the paid are “the rest,” the vast majority who work for however much the payers decide to pay them. Often times the paid will try to increase their leverage by ganging up and bargaining collectively, but not always.

A key fact of this story is that, when it starts, taxes are very, very high. In fact, they rise with income almost asymptotically, so that as your income rose the rate grew increasingly until such point that it was over 90% after some (very healthy) sum.

In such a world, I’d imagine, very few of the payers would elect to pay themselves much more than that amount. Obviously there will be some variation, but very few payers will elect to pay anyone, even other payers, much more than that amount when the actual payer receives but a tenth or less of that increase and the government pockets the rest. In essence, a tax of this level of progressivity creates a maximum income.

So when the payers are done paying themselves, what do they do with the rest of the money? Well, they still want to compete, so they invest it in places that guarantee their future income – competing over investments in capital and labor. New factories, more workers, better workers, new technologies – hopefully by accumulating more of these resources the firm that generates the profits will continue to do so, thus allowing the payers to continue to be payers and get paid. This means that much of the wealth organically goes to the paid class, either in greater competition for their services that drive up wages or in increasing a capitol stock that requires more labor to build and maintain. Thus, the mechanism of the progressive tax doesn’t “re-distribute” wealth from the payers to the paid primarily by taking it from one and giving it to the other through cash and services, though that does happen; the primary mechanism is to prevent the payer class from paying itself a vast fortune in the first place, and instead having them invest that money through their firms in ways that benefit labor in order to lock in their future wealth.

Now imagine we drastically reduce the progressivity of the tax burden – let’s say the top bracket’s rate plummets from 90% to 50%. What happens then?

Well, naturally, the payer class elects to pay itself more – the “half to us, half to the government” deal is a far better one than the “one to me, nine to the government” deal of the past – and begins to accumulate more and more of the profits. Competition between the payers increases rapidly as it becomes possible to acquire new luxury goods as well as the social good of prestige from being well-paid or employing an elite CEO, for example, and more of the revenue generated by firms goes from long-term investment in the health of the firm to guarantee future payoffs to the immediate payoffs now possible – why wait? Demand for labor slackens as firms invest less, and despite the possibility of collective bargaining there reality of supply and demand means that the paid class loses a fundamental pillar of their leverage against the payers. The payer class gains more leverage and the paid class is willing to accept less because the alternative starts to become “no work” rather than “better-paid work.”

Yet the payer class has a conundrum – before they essentially “saved” by investing in their own firms to guarantee future payoffs around the maximum level, and they have traded that by taking the money now and risking less payoff later. Yet they still need to find investment, and luxury goods start to have steep diminishing returns (1 yacht awesome, 2 yacht boring). So there is now a bulk of liquid assets accumulated by the payers looking for somewhere to sit making a return. At the same time the paid class is seeing less and less reliable increases in pay and a weaker guarantee of future employment even as prices rise and they feel the need to continue to increase their standard of living.

The solution? The payer class lends to the paid class. The paid class supplements their stagnant incomes with credit, the payer class invests in consumer debt.

So how is this world different than the one that preceded it? Certainly the payer class has more luxury – more of them are able to buy vast mansions, expensive cars. But the vast majority of their newfound wealth has been invested. And the paid class continues to see increases in their standard of living, however rather than be financed by increasing wages it is being financed by debt.

So the world, materially, is largely similar – what changes are prices, some shifts in supply and demand, but primarily, society-wide debt. Rather than a mandatory tax that through various mechanisms moves wealth from the payers to the paid, what we have instead is an “optional” credit society that has the same effect. So we’ve created a vast paper imbalance to substitute for the progressive tax. And vast paper imbalances are a fragile thing – even small real shocks can tear through an economy increasingly dependent on a paper flow based largely on widespread indebtedness.

Does this story explain where we are? Maybe. A lot of things have happened in the United States over the past half-century, and things like free trade, the rise of international competition, technological disruptions, increasing weakness in organized labor, and social/cultural changes have all played a role in what Timothy Noah memorably titled “The Great Divergence.” But I think the simple, fundamental factor of how society is taxed has played a far more important role than most people realize. I’m not sure this is the whole story, but it may very well be the primary driver of the story.

Of course, the zen question is “if the sharp decrease in the progressivity of the tax rate caused The Great Divergence, what caused the sharp decrease in the progressivity of the tax rate?”

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