On Monday, Aaron Edlin and I published a cri de coeur op-ed in the New York Times calling for a Brandeis tax, an automatic tax that would put the brakes on income inequality. This is the second in a series of posts (the first post is here) explaining more about our rationale and providing more details on how a Brandeis tax might be implemented.
An Inequality Tax Trigger
By Ian Ayres and Aaron Edlin
A central idea behind our Brandeis tax proposal was to have a tax that is triggered by increases in inequality. Our Brandeis tax does not target excessive income per se; it only caps inequality. Billionaires could double their current income without the tax kicking in — as long as the median income also doubles. The sky is the limit for the rich as long as the “rising tide lifts all boats.” Indeed, the tax gives job creators an extra reason to make sure that corporate wealth does in fact trickle down.
But in crafting an inequality trigger we might have chosen a more traditional measure of income inequality – such as the Gini coefficient or the Herfindahl-Hirschman Index (HHI). Any standard of inequality would show a sharp increase over the last 25 years.
In part, we choose the Brandeis ratio because we think it is more transparent. We could try to explain that the Gini number represents the ratio of two areas, including crucially the area above the Lorenz curve. The Lorenz curve is the inequality measure that Robert Shiller and coauthors use in their 2006 paper on this topic of inequality of tax triggers; they account for behavioral responses to such changes and consider how to optimally balance the benefits of lower risk and higher economic growth with the traditional negative incentive effects. For those interested in the details, Shiller, one of the paper’s authors, has also written a compelling book on the costs of high risk finance and even proposed “inequality insurance.” Shiller should get credit for coming up before us with the general idea of an inequality-contingent tax system.
Or alternatively, we might explain that a slight modification of the HHI represents the probability that two randomly selected items come from the same source. For example, in antitrust analysis, if the modified HHI for the lawnmower market is equal to .43, that means there is a 43% chance that two randomly selected lawnmowers would have been produced by the same company. A market is more concentrated if this probability approaches 100%. As applied to income concentration, the modified HHI would tell you the probability that two random dollars of income would be received by the same person (or possibly the probability that the two randomly selected dollars would have been earned by people of the same economic class). But notwithstanding this nifty interpretation, it remains unclear why this probabilistic concentration measure is related to the Brandeis concern that excess inequality and democracy are incompatible.
In contrast, the Brandeis ratio as a measure of concentration is immediately graspable, and is more closely tied to the specific concern that a sliver of plutocrats with gargantuan wealth could distort the political process. It doesn’t take a Ph.D in economics to understand that something seismic has occurred when the average one percenter goes from earning 12.5 medians to 36 median incomes. It’s true that not all these measures of inequality are about income inequality; some might rightfully cite the Nobel Laureate Amartya Sen in arguing that income alone doesn’t capture human welfare, hence the multidimensional indices often used in global development. Indeed, part of Brandeis’s concern was not income equality for its own sake but rather the consequences of income inequality on democracy.
More subtly, the Brandeis ratio intentionally ignores what is happening to two other parts of the income distribution. Unlike the Gini coefficient, the Brandeis ratio does not take into account how many Americans are unemployed or living below the poverty line. This is not a weakness. The purpose of our inequality tax is not to respond to short- or even medium-term business cycle fluctuations. We want the tax to respond to long-term structural shifts in inequality. We consider it a strength of the measure that the denominator (the median household income) is relatively uninfluenced by the unemployment rate. And using the Brandeis trigger similarly is independent of the impact of illegal immigration on the economy – so we don’t have to worry that in the shadow of a Brandeis tax that Congress would have particularly different incentives to include or exclude new lower paid households from entering the economy. There are important debates and reforms needed to respond to the separate questions of structural unemployment and undocumented workers, but the Brandeis is geared toward another – to our minds – even more important policy issue.
The Brandeis ratio as a measure of income inequality also doesn’t pay attention to the relative success of 2- or 3-percenters over time. Focusing just on the relative income of the richest one percent is appropriate if we are concerned with the deleterious impacts of inequality on our democratic institutions because one-percenters (those currently making more than $330,000) disproportionately fund our political campaigns. As emphasized by Lawrence Lessig in Republic, Lost (presaged somewhat in Ayres’ book with Bruce Ackerman, Voting With Dollars), the bulk of campaign finance dollars comes disproportionately from not just the 1% club, but the richest one-half of one-percenters. Focusing on the average income of one-percenters is a good proxy for the rising political power of plutocrats.
But at the end of the day, we’re not wedded to the idea that there needs to be any single sufficient statistics. We could imagine a world in which a Brandeis tax was contingent on a different inequality measure or even upon multiple measures.
For example, one might argue that rising wealth inequality could be an even worse problem for democracy than income inequality. Accordingly, one could imagine a wealth tax or an estate tax that was contingent on some measure of wealth inequality. But given the current political environment, an income-contingent wealth tax is bridge too far.
Steve Silberstein has been promoting an interesting way to make the corporate income tax for specific corporations contingent on an analogous inequality ratio. As mentioned in the New Republic:
[A]nother proposal, put forward by investor Steve Silberstein, would adjust the corporate tax rate based on the ratio of CEO pay to the average worker. A company with a ratio at the 1980 level of 50:1 would pay tax at the current rate of 35 percent, with the rate rising for companies with a higher ratio and lower for those with a narrower pay gap.
We had briefly thought about modifying our proposal to allow one percenters to avoid a trigger Brandeis tax if they could show that their income was less than 36 times the median income of workers who produced it, but concluded that personalized Brandeis ratios would be an administrative nightmare. The Silberman corporate tax proposal is by comparison elegantly straightforward.
While we proposed a Brandeis tax based on the 2006 pretax Brandeis ratio of 36, it would be more natural to use a trigger based on an after-tax Brandeis ratio which went from something like 8 medians in 1980 to about 25 medians in 2006.1 Accordingly, the IRS might each year calculate the after-tax ratio and trigger the Brandeis tax if the ratio exceeds 25 medians.
Our proposal of a 36-median cap was doubly conservative. The first reason is because the tax only asked that the after-tax ratio not exceed the pretax 2006 ratio and the second is because the tax used the 2006 year as a trigger, a year that probably had a higher Brandeis ratio than we would find today. The Brandeis ratio is likely to decline during a recession because the average income of one-percenters (think hedge-fund managers) is more sensitive to the recession than the median U.S. income. Indeed, another debate which we would like to promote is about the question of the appropriate trigger size.
Our proposal starts with an out-of-the-money status quo inequality trigger as a way to promote political common ground. You can vote for a contingent Brandeis tax without voting to necessarily raise taxes. Ours is a “tax more tomorrow” idea where the relevant tomorrow may never come. Our trigger avoids the concern that we’re engaged in crude “class warfare.” It doesn’t take away any of existing inequality, it just tries to make sure that 99% share in prospective future gains of the 1%. But reasonable people could argue for either higher or lower triggers – for example, returning to a simpler time when rich people only earned 20 medians. Perhaps like with carbon emissions we could seek to lower inequality to 1990 levels by 2020.
1 Our after-tax estimates of the Brandeis ratio are estimates, because we do not have comparable information on the after-tax median household income. As a proxy, we used CBO after-tax data and divided the after-tax average income of one-percenters by the average income of the third quintile.
and 
. You can also watch it on 
If history has proved one things it is that using the tax code for social engineering is doomed to failure.
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My wife always says how much she hates politics. She thinks it is stupid to even discuss taxes.
This is her first year in the workforce and her first “real” job.
She recieved a nice Christmas bonus of $1,000 – but only received $638. She was angry, “how can they take that much!?!?” I said, “Welcome to caring about politics.”
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Your wife is very lucky! You know how much of a Christmas bonus I received? $0.00
That doesn’t even take into account the 10% paycut that was just enacted. But what do I know? I’m just a good for nothing state worker, working in a “right to work” state, making sure that peoples’ air and drinking water isn’t polluted.
The reason this idea is particularly stupid is that rich people are easily able to avoid having taxable income. Most of the growth in their wealth comes from unrealized gains (appreciation in assets). In turn they can pay for their lavish lifestyles by borrowing against this appreciation, all without having any taxable income. Jack and Jill on the other hand, who come from middle class families, work and study very hard to become a big firm lawyer and a surgeon at a prestigious hospital and then continue to work grindingly long hours, will experience nearly all the growth in their wealth in the form of taxable income (likely W2 income or allocated partnership income). They in turn will take it in the shorts as a result of a tax like this. Meanwhile, the trust fund babies with the much larger homes down the street will not be touched by this tax.
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Guess what? I don’t care!
If you’re in the 1% of the income percentile you can’t afford to pay more. Don’t like it? Then work less, and earn less. If any of these people think they are being treated unfairly I’ll be more then happy to exchange my salary for theirs. That way they won’t have to pay that horrible income inequality tax.
I really have to question the fundamental assumption on which this tax scheme is based, which is that wealth inequality is a bad thing. On the contrary, it’s a very good thing, and one of the basic foundations on which this country was built. There are plentiful examples, for instance (John Jacob Astor came to the US as a poor immigrant in 1784, and by his death had a fortune estimated at $110.1 billion in 2006 dollars), Cornelius Vanderbilt, Stephen Girard. All of these were richer, both in comparison to the average American and as a fraction of GNP, than most of today’s 1%.
Hot debate. What do you think?
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“There used to be no income inequality in China because everyone was poor. This is a tradeoff you accept for growth and freedom”
-Michele Caruso-Cabrera
The entire basis for this tax proposal seems to be based on the authors’ opinion that wealth inequality, above a certain threshold is bad and that we have reached (or are about to reach that threshold).
I would have liked to see more evidence presented that this problem is really so urgent. The evidence presented in the NY Times op-ed seems to be a quote from Brandeis:
“We may have democracy, or we may have wealth concentrated in the hands of a few, but we cannot have both.”
and four sentences from the authors:
“We believe that we have reached the Brandeis tipping point. It would be bad for our democracy if 1-percenters started making 40 or 50 times as much as the median American.
Enough is enough. Congress should reform our tax law to put the brakes on further inequality.”
Those opinions, without anything else presented to back them up, aren’t persuasive to me.
Buying elections, as the first Freakonomics book pointed out, is not nearly as easy as some think. From the book:
“Here’s the surprise: the amount of money spent by the candidates hard matters at all. A winning candidate can cut his spending in half and lose only 1 percent of the vote. Meanwhile, a losing candidate who doubles his spending can expect to shift the vote in his favor by only that same 1 percent.”
Rehajm makes some excellent points:
1. Reform in campaign finance rules are equally necessary to avoid the political distortions that go along with high concentrations of wealth and income. Unfortunately, since politicians write the rules and at the same time are the main bebeficiaries, asking them to cut off the tap is like asking the pigs to leave the trough;
2. Ben – yoir example of the town with 100 people ignores certain factors: what if some of the citizens began paying the mayor to assign the the best ocations in town; limiting access to the local schools to their children; ensuring their businesses received the lion’s share of town funds; serving on each others oversight boards and voting for each others salaries? Would you still call it a purely meritorious outcome?
3. Mr.AtoZ – how can generating more revenue from the top percentile help the 50th percentile? Let’s see: increased funding for Pell Grants and other needs-based educational loans; more money for poorer schools; increases to shamefully low teacher salaries; investments in relevant urban and rural infrastructure; increased funding for retraining and workforce education programs so the jobless can get back to work; or how about simply lowering taxes on the bottom 50%?
4. Scheinemann – history proves exactly the opposite. The history of the 19th and 20th centuries is one of growing empowerment and wealth, as a share of the total, for the poorest classes. The fact that there was strong economic growth AND greater equality of income makes rubbish of the arguments that you need income or wealth inequality to generate new jobs or economic growth. In fact, the opposite is true – extractive plutocracies are almost always net destroyers of national wealth.
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Fernando -
Thanks for trying to put words in Ayres et al’s mouth, as there was nothing in the Brandeis proposal about how the added revenue from huge marginal rates on the 1% was to be earmarked in ways that would be meaningful to those below the 50% median.
That said, let me raise a couple relevant points about how you might choose to spend that added revenue: money for schools and teachers is mostly a state and county issue, and this is federal dollars. Beyond that, there is not a great track record that more money for either really achieves great outcomes in terms of the capabilities of the students who graduate from public schools.
Also, “simply lowering the taxes on the bottom 50%” has already occurred. As this blog has mentioned in the recent past, those in the lower half often pay no effective INCOME tax when all is said and done.
Mr. AtoZ:
Where do I represent myself as Mr. Ayres spokesman? People expressed their opinions in this section – I responded with my own opinions. Please don’t but words in my mouth either, or misrepresent my intentions.
Money for schools and teachers is not only a state and county issue. The Federal government spends millions every year to support school budgets at all levels, as well as supporting programs for disadvantaged students.
As for there not being a great track record for such spending, I beg to differ with you. There is plenty of research to support increased spending in education. There are some good publications easily found on the Brookings Institution and Pew Center websites. The fact that not every single federal dollar is well spent, nor every single federal program is effective, is hardly a justification for a blanket dismissal of all such programs.
Regarding your third point, it is quite true that many of the poor end up paying no effective income tax. That does not invalidate it as an answer to your question.
Fernando, it’s *supposed* to ignore certain factors. The point is that the Brandeis ratio varies enormously even in this hypothetical town with perfect equality. So, how can it possibly be a good measure of real inequality? The point is not that real life is like my example, the point is that the Brandeis ratio is not a good indicator of inequality of opportunity.
Isn’t this effectively a 100% tax on all income above a certain threshold? That won’t earn the government any money; at best it will limit the incomes of some people, likely at the cost of tax revenue. Instead of getting 30-40% of the over-threshold income, the government gets 0%, because CEOs don’t pay themselves money they don’t get to keep (unless they can write it off as a deduction).
Zakarov – not at all. The authors are suggesting a taxation mechanism, at no point do they say what that tax rate should be.
Undoubtedly it would be scaled, so that the greater the inequality, the greater the tax rate.
Remember that the US used to have a maximum tax bracket of 70%, and the economy did just fine back then. Better than now, in fact.
Fernando, your understanding of taxation is weak at best. The amount of tax that any individual pays is a function of the tax rate (the percentage that must be paid) and the tax base (the metric to which the tax rate is applied). While it is true that in the early parts of the 20th century U.S. tax rates were much higher, the tax base was also much lower because of the legality of a large number of tax shelter schemes. The tax reforms of the 1980s largely eliminated these tax shelters. As a result, comparing historical tax rates to modern day ones is misleading. This would be kind of like pointing out in support of an argument that the rich have hijacked the polity of a fictional country that there used to be a 100% tax rate but today the rate is only 10% without pointing out that the old tax only applied to cash you kept in your right pocket and there was no rule preventing you from just putting/transferring your money to your left pocket instead.
Silberstein’s suggestion is an interesting one, but like all issues of taxes the question would be how easy is it to avoid. I seem to recall that 401k programs used to have a trigger based on the average worker savings to limit how much the highest earning employees could save.
The impact was that large corporations started outsourcing the lower paid jobs so that the average worker pay increased because they manipulated the denominator.
Interesting if accurate…
But now all 401(k) contributions are the same – the company will only match a certain percentage of salaries for everyone. But you can contribute whatever percentage of salary you like. Doesn’t this solve that issue?
So you have just incetivised never hiring someone new. Since that would lower the average salary.
Several problems, a history graph that only goes back 40 years whan we have 200 years availabble, hints at extreme cherrypicking of data.
Does not differentiate size of company. A company with 4 employees vs a company with 4,000,000 employees has and should have a very different looking pay pyramid.
Part of the reason higher ceo incomes is the size of the companys have gone up.
Think of it this way, your companys profits margin are 2% of an employees salary per employee.
In that 4 employee comapany, you ar making hardly anything 8% of the average salary, but ing the 4,000,000 person company, you are making 40,000 times the avg worker salary.
Much of the so called income inequality is a matter of company scale.