Taxation, Redistribution, and Social Insurance

Thomas Piketty provided many interesting revelations about economics and society in his book Capital in the Twenty-First Century.  Some of the most fascinating were the insights provided concerning the development of a distinct middle class in the years after World War II.  In particular, it was revealing to note that middle class wealth developed more readily in the high-tax welfare states that developed in Europe in the postwar years, than in the lower-taxed, less-regulated economy and society of the US.  This phenomenon and Piketty’s data were discussed in The Creation of the Middle Class.

Piketty uses a simple prescription to define economic class: the top 10% in terms of wealth comprise the upper class, the next 40% the middle class, and the bottom 50% make up the lower class.  Prior to the tumultuous era spanning the two world wars and the Great Depression the upper class in Europe owned about 89% of the wealth, while the US was slightly more egalitarian with an upper class in possession of 81%.  The fraction of wealth residing in the upper class bottomed out in both regions around 1970 at 60% in Europe and about 64% in the US.  The data implies that the wealth possessed by the middle class in Europe increased from 5% to 35% over that period, while it increased from about 14% to 25% in the US.

An obvious question to ask of this data is why the middle class fared so much better in Europe than in the US.  One is tempted to assume that the higher tax rates existing in Europe simply take money from the rich and distribute it to those in the middle and lower classes.  The situation is much more complicated than that—and much more interesting as well.  According to Piketty:

“….modern redistribution does not consist in transferring income from the rich to the poor, at least not in so explicit a way.  It consists rather in financing public services and replacement incomes that are more or less equal for everyone, especially in the areas of health, education, and pensions.”

All countries have their unique tax policies.  Consider the situation in France where Piketty provides this description of the tax base:

“….a detailed study of French taxes in 2010, which looked at all forms of taxation, found that the overall rate of taxation (47 percent of national income on average) broke down as follows.  The bottom 50 percent of the income distribution pay a rate of 40-45 percent; the next 40 percent pay 45-50 percent; but the top 5 percent and even more the top 1 percent pay lower rates, with the top 0.1 percent paying only 35 percent.”

 The taxes are certainly high by US standards, but it would be difficult to describe them as a “soak the rich” scheme.  It would actually be more accurate to describe the system as one that taxes most heavily those who benefit the most from the services provided by the taxation.  There is an intriguing sense of fairness about this approach.

Tony Judt discussed the European welfare states in his book Postwar.  He provided this insight:

“….although the greatest immediate advantage was felt by the poor, the real long-term beneficiaries were the professional and commercial middle class.  In many cases they had not previously been eligible for work-related health, unemployment or retirement benefits and had been obliged, before the war, to purchase such services and benefits from the private sector.  Now they had full access to them, either free or at low cost.  Taken with the state provision of free or subsidized secondary and higher education for their children, this left the salaried professional and white collar classes with both a better quality of life and more disposal income.  Far from dividing the social classes against each other, the European welfare state bound them closer together than ever before, with a common interest in its preservation and defense.”

So, the French middle class pays the highest tax rates, but benefits most from the services provided by the state and comes out ahead, thriving under the system.

An outfit called Citizens for Tax Justice tallied the total tax rates (federal, state, and local) paid by income group for the US.

By this reckoning, the US middle class pays about 30% of their income in taxes.  This compares with 45-50% in France.  However, the French middle class has grown wealthier than that of the US by paying a 15-20% higher tax rate.  How can this be?

What if an insurance company came to some US middle class household and made the following offer: “Pay us 15% (or 20%) of your salary and we will provide you and your family with a guaranteed income level, childcare, healthcare, education, and a pension at retirement that will allow you to maintain your lifestyle.”  Would that be considered a good deal?  Remember that financial advisors are telling those in the US that they should be saving at least 10% of their income just for retirement expenses.

One could argue that the proposal does not add up; the services promised would cost more than the revenue provided by the insurance premium.  The insurance representative would answer with the obvious reply that that is the way insurance is supposed to work.  If everyone pays their 15%, different classes of people will receive different levels of benefits.  Some will pay more and receive less, some will pay less and receive more, but all will pay the same rate and have the same access to benefits.  The lower class may have most need of income support, but they will have the same access to healthcare and education as everyone else.  The wealthy will have need for the services provided, but by paying about the same share they will have access to the services and support those who are less able to contribute.  The people who will demand most in terms of services from the system—relative to their ability to pay—are the middle class.  They will benefit the most.

This helps explain how Piketty’s indirect redistribution works via provision of services, and also provides an explanation for why the European middle class has fared better.  Casting taxation as a mechanism for providing social insurance that guarantees the services one might need as one goes through life seems more productive than thinking of it as a wasteful confiscation.  Of course, the government would have to actually provide the services.

We in the US are, at present, paying taxes at a healthy rate, but receiving services at an unhealthy rate.  Demanding lower taxes will not improve the service.  We should be demanding better services—the government works for us, doesn’t it?—and we should be willing to pay for them.

Greater prosperity through higher taxes—for everyone!  It actually makes sense!