Stabilizing and destabilizing levels of inequality for inclusive societies: tax policy implications

(Thank you to Daniel Fichmann for review and suggestions)

In this blog I develop the following premise: While it seems reasonable to assume that a “certain” level of inequality is a stabilizing factor as it creates/ reflects incentives to work, innovate and be creative, “too” high levels of inequality may be a destabilizing factor, as it puts inclusive societies under pressure from an economic and social perspective. I will provide arguments to support this premise by reviewing and connecting the analysis of 3, in my view, important papers.

Anna Pettini’s short paper on “Economics and Nature: a long-neglected Combination” (CESifo Working Paper, no 10631) is a must-read. The paper starts with the following paragraph:

“In a recent study published in Nature Scientific Reports, climate scientist Craig Rye and economist Tim Jackson (2020) use the critical deceleration theory, known in physics, to study the oscillations of economic cycles over hundreds of years. According to this theory, a system displaced from a point of equilibrium will return to it more quickly the stronger the pulling forces. The fluctuations around equilibrium increase until the system becomes unstable when the internal pulling forces are weakened. The latter case is analogous to the conditions under which the pandemic crisis of 2020 unfolded. The stabilizing forces of many mature economies have been progressively weakened over the last decades ("secular stagnation"), and the Covid-19 shock has all the characteristics to leave them deeply marked and highly unstable. A highly unstable system, on the other hand, can more easily be led to a different equilibrium than the one before, and this opens up a window of opportunity that was unimaginable until the early 2020s. Since the first months of the pandemic, certain lines of research, hitherto essentially unheard of, have gained greater voice and attention, as the essential forces that sustain and stabilize an economic system are undeniably revealed. The crucial and irreplaceable role of the public sector has become clear, as has the damage caused by spending cuts in its most strategic areas, the weight of accumulated technological backwardness and the digital divide. And, above and beyond all this, how important it would have been to be better equipped to deal with the interdependence of the economic system with the natural system.”

This is a powerful paragraph. Having grown up with integrals and Hamiltonians, in my mind, dynamic optimization was limited to decisions that either put the economy on a balanced growth path or to factors and starting conditions that lead the economy away from that path. I think I have not been brave enough to go beyond the constraints that mathematics bring to the unexperienced mind and focus on underlying social and economic processes first.

Rye and Jackson (2020) base their analysis on the theory of Critical Slowing Down (CSD) in physical systems. They describe this theory with the abstract example of an oscillating system:

“Consider an object that is suspended between two springs, in a windy environment (the spring-object-spring system; Fig. 2a). The springs provide a deterministic restoring force (black arrows), and the wind provides a series of stochastic perturbations. As the wind pushes the object away from its equilibrium position the springs pull the object back, leading the system to oscillate about its equilibrium. If the springs are strong (strong restoring), the oscillations are fast and small. If the springs are weak (weak restoring), the oscillations are slow and large. If the relative strength of the springs becomes weaker over time, then the oscillations of the system transition from small and fast to large and slow (Fig. 2b). This transition is characteristic of CSD behaviour”.

And also:

“Rather, a state of instability refers to a state of relatively slow, large, recession cycles. It can be thought of as a state of weak restoration to the equilibrium growth path or a period where an economy takes a relatively long time to return to its equilibrium growth trend, following a perturbation. CSD theory suggests that a movement from a stable to an unstable state implies the onset of a ‘critical transition’ or tipping point. However, a clear tipping point, following a period of CSD, is not apparent in any of the GDP time series examined in this study. Following Kéfi et al. (2013), instability indicators may also be viewed as indicators for changes in the behaviour, interactions, inputs, or structure, of an economy”.

The premise of Rye and Jackson (2020) is that CSD theory may also be applicable to economic systems. The authors than use this premise to analyse economic growth rate variability and secular stagnation in historical GDP data. Building on the authors’ premise that CSD theory may be applicable to economic systems, we can then try to identify factors that contribute to stabilising or destabilising our economies. Are there factors that can be both stabilising and destabilising depending (perhaps) on their “intensity”? And then, as a tax economist: Which design features function as springs and which features push economies away from their stable equilibrium? And perhaps a bit more challenging: How to design tax systems when there are stabilising and destabilising factors at play?

In their article on “Inequality and growth, a review on a great open debate in economics,” Enea Baselgia and Reto Foellmi (2022) conclude that:

“Without making a statement on welfare, we synthesize the theoretical arguments to suggest that some intermediate level of inequality is likely growth maximizing. This is because when inequality is extremely low, there are few incentives to save, invest in (human) capital or innovate, while as inequality rises, the negative channels – such as credit market imperfections or socio-political instability – gain importance and exert a more adverse impact on growth. Taken together, it seems fair to say that a society that has lower inequality of opportunities and fewer barriers to human capital accumulation has a better shot at achieving prosperity and stability. Economic and political institutions leading to an equal primary income and wealth distribution are crucial in this regard. After all, when the ex-ante distribution is relatively equal, there is less need for potentially costly redistribution ex-post. Instrumental to achieving such a state is an education system and a free economic environment allowing all people to realize their potential. With equal market distribution and low inequality of opportunity, social mobility is high, and a broad part of the population is able to stand on its own. Therefore, such a country is likely to enjoy active engagement of broad segments of the population in its economic and public spheres”.

Based upon these articles, I would like to put forward the following premise: While it seems reasonable to assume that a “certain” level of inequality is a stabilizing factor as it creates/ reflects incentives to work, innovate and be creative, “too” high levels of inequality may be a destabilizing factor, as it puts inclusive societies under pressure from an economic and social perspective. Let me present some arguments that support this premise.

Inequality that is driven by differences in effort and productivity levels can create an incentive to work more, to save and build up wealth. This form of inequality then may induce people to work hard and increase their productivity, possibly even increase the level of risk they are willing to take to further enhance their careers and lives. But when income and wealth inequalities become too large – for instance because wealth that is passed on from generation to generation may result in large wealth inequality across the population over time – these inequalities are no longer driven by differences in effort and productivity and also no longer act as an incentive to work more; in fact, they may become a source of envy. Too high inequality may become a destabilising factor, in particular if a large part of the population feels excluded and has taken awareness that they do not face the same opportunities as the happy few that are born into wealth. This will particularly be the case when high inequality results in a lack of opportunity in terms of education and opportunities for personal development, or when wealth starts influencing the political decisions that a country takes.

There is a growing literature that finds that the middle class is under pressure. Particularly the lower-middle income class faces an increasing risk, in many countries, of dropping into poverty. Risk itself is unequally distributed across households, and if a large share of the population is at risk, this may enhance negative shocks and slow down economic recovery. Welfare systems will be put under pressure when an increasing share of public spending will be allocated to provide, in one way or another, financial support. In fact, while automatic stabilizers function as a spring that hold the system together, if countries need to rely too much on them, the spring may weaken over time through a shortage of government funds that is available to absorb the shocks that households and businesses have experienced.

The series of crises that the world has faced since the beginning of the 2000s – from the great recession to the COVID-19 pandemic and, more recently, rising food and energy prices – have pushed up debt levels around the world as governments have spent huge amounts of money (either through automatic stabilizers or new spending). Governments took up their responsibility and ensured that their citizens and businesses have made it through the crisis. So, in this sense, higher levels of inequality (measured as a larger number of households and businesses that need support when a shock hits) may have required larger increases in public support, as there were more households and businesses without own financial means to make it through the crisis. However, a rising public debt level becomes a destabilising factor by itself, as it, for instance, increases the interest rates that a government needs to pay to service its debt. It also may restrict the amount of financial support the government can provide in the future when a new crisis arises.

What does this premise mean for the design of the tax system? Is there a larger “stabilizing” role to play for the tax system when there are a wide range of “destabilizing” factors at play? Does this, for instance, imply that the optimal level of progressivity of the tax system varies according to the strength of the destabilizing factors. Piketty, Saez and Stantcheva (2014) argue that this is the case when remuneration for work does not (only) reflect productivity but also bargaining power.

The automatic exchange of financial account information between tax administrations, the digitalisation of the tax administration, and tax base broadening measures that reduce or abolish regressive tax expenditures, as discussed in our inclusive tax work – Brys, et. al. (2016) and O’Reilly (2018) – are examples of stabilizing measures that reinforce the functioning of the springs.

The premise reflects that a one-size-fits-all country tax reform does not exist, as tax reform recommendations will depend on the country specific characteristics, including the economic and social stabilizing and destabilizing factors at play within each country.

Stabilizing and destabilizing factors may create country-spill over effects. A weak health care system in one country may contribute to the spread of pandemics across borders, for instance. The absence of a tobacco product track and trace system in one country may result in large amounts of illicit tobacco trade in other countries, thereby undermining the tobacco health policies and reducing tobacco tax revenues. This points at the need for global health tax reform. International tax collaboration (in a wide range of areas) may therefore function as a stabilizing factor.

This raises also the question to which extent there are limits of what one can ask from the tax system, as tackling the inequality at source might be a more effective tool. Is it feasible to continue raising tax rates to raise revenues to spend on pro-poor policies, or does tax reform need to be complemented with market interventions that ensure that incomes are sufficiently high across the income distribution (so that people can foresee in their housing needs, energy, food, etc.)? These questions are highly relevant in light of the future challenges that countries are facing, including climate change, loss of biodiversity, rising inequalities, the ageing of the population, automation and AI. Or, as Anna Pettini suggests, does rising instability create an opportunity for new types of (tax) reform that would not have been possible in stable economic environments??

References:

Baselgia, Enea and Reto Foellmi (2022). “Inequality and growth: a review on a great open debate in economics,” WIDER Working Paper 2022/5. UNU-WIDER : Working Paper : Inequality and growth: a review on a great open debate in economics

Brys, Bert, Sarah Perret, Alastair Thomas and Pierce O’Reilly (2016). “Tax design for inclusive growth,” OECD Taxation Working Paper Series, no. 26. https://www.oecd-ilibrary.org/taxation/tax-design-for-inclusive-economic-growth_5jlv74ggk0g7-en

O’Reilly, Pierce (2018). “Tax policies for inclusive growth in a changing world,” OECD Taxation Working Paper Series, no. 40. https://www.oecd-ilibrary.org/taxation/tax-policies-for-inclusive-growth-in-a-changing-world_1fdafe21-en

Pettini, Anna (2023). “Economics and Nature: A Long-Neglected Combination”, CESifo Working Paper No. 10631. SSRN:?https://ssrn.com/abstract=4564443 ?or?https://dx.doi.org/10.2139/ssrn.4564443 ?

Piketty, Thomas, Emmanuel Saez and Stefanie Stantcheva (2014). “Optimal taxation of top labour incomes: a tale of three elasticities,” American Economic Journal: Economic Policy, vol. 6, No. 1 (pp. 230-271). https://www.aeaweb.org/articles?id=10.1257/pol.6.1.230

Rye, Craig D. and Tim Jackson (2020). “Using critical slowing down indicators to understand economic growth rate variability and secular stagnation”, Nature Scientific Report 10, 10481. https://doi.org/10.1038/s41598-020-66996-6

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