There's only one sensible way to measure economic inequality By Scott Sumner

Consumption is the bedrock upon which essentially all of economics is built. We assume that all economic activity is aimed at creating consumption (defined broadly to include the value of leisure time, and non-market factors such as clean air.) Of course one could raise objections to this view, but as we’ll see if you don’t at least start with consumption, you are likely to reach absurd conclusions.

I’ve been somewhat dismayed to see so many economists debate the economic inequality issue using highly flawed income and wealth data, instead of consumption inequality data. Recently I was listening to an interview with Thomas Piketty when he suddenly said something that caught my attention. He advocated a progressive property tax. That sounds like a great idea, as the consumption value of housing is probably closely correlated with the market value. And then he ruined everything by adding that it should not be levied on the gross value of property, but rather the net value after mortgage debt was subtracted. That defeats the entire purpose of a progressive consumption tax!

Imagine a cop and a nurse live in a modest $350,000 house on Long Island. They are very thrifty, and have paid off their mortgage ahead of time. In a suburb of Dallas an executive lives with his (homemaker) wife in a sprawling $1,500,000 mansion, with a $1.2 million mortgage. The housewife hosts lavish parties for the other ladies in the neighborhood. Which family gets more consumption out of their home? Which family should pay a higher tax? Which family does Piketty think should pay a higher tax?

I don’t know of any respectable intellectual argument for Piketty’s policy proposal. In the comment section of previous posts I’ve only run across one argument that is even logical, and it seems so preposterous that it would be laughed at by most voters. The claim is that lack of thrift is a sort of disease. So if twin brothers make identical lifetime wage income, but one consumes that income early in life and the other consumes the exact same income (plus interest) later in life, the thriftier brother should pay a higher tax rate, because the one that blows his income while young on BMWs, parties, travel, motorboats, etc., has a mental illness. They rely on Greg Mankiw’s reductio ad absurdum attack on utilitarianism—that tall people like Mankiw and me would have to pay higher taxes because we are born with “good” genes. Except they take it seriously. (Disclosure: I’m both tall and thrifty.) I can’t quite tell, but I don’t think these people are joking. I wonder what principle Piketty chooses to favor a wealth tax over a progressive consumption tax?

As an aside, in theory total wealth is the present value of consumption–including heirs, charity, etc. So if we could measure wealth accurately (including human capital) a wealth tax should be identical to a consumption tax.

You cannot put the burden of a tax on someone unless you cut into his or her consumption. If the Obama tax increases did not cause Gates and Buffett to tighten their belts, then they paid precisely 0% of that tax increase. Someone else paid, even if they wrote the check. If they invested less due to the tax, then workers might have received lower wages. If they gave less to charity then very poor African’s paid the tax. I have no idea who paid, but I’m pretty sure it wasn’t Gates and Buffett.

Of course there are plenty of billionaires who splurge on things like 500-foot yachts. Now we are getting somewhere! The labor and materials that went into constructing that yacht could have produced 10,000 cars for average people. That sort of inequality is real. That’s what we (should) mean by “economic inequality.” That’s the way all of us economists were taught, but 99% of us seem to have forgotten what we learned about consumption. Consumption is what you should tax. Of course when we tried to do that a bunch of Democratic politicians who have apparently never heard of Bastiat said the luxury tax was a bad idea because it cost jobs in the yacht making industry. (I’m not joking.) Nor are they willing to cut back on intellectual property protections for companies like Disney.

Revealed preference: They seem more interested in reducing the amount given by Gates and Buffett to charity than the amount David Geffen spends on a 450 foot yachts.

Yes, charity is tax deductible, but for people who give at the end of their lives, capital taxation greatly reduces their resources. Or perhaps the goal is to make relatively poor Chinese consumers pay more for Disney toys so that the profits can be taxed in America and given to teachers unions. Yet many progressives seem to forget that the problem of global inequality is much worse than the comparatively minor issue of American inequality.

Matt Yglesias has a better understanding of the importance of consumption than most economists (and he’s not even an economist.)

But the really interesting thing about the sale of the Bucks [for $550 million] is that it challenges a piece of longstanding conventional wisdom among economists. Traditionally, economists have believed that investment income should be taxed at a lower rate than labor income or even not taxed at all. An alternative way of putting it is that the economics profession generally believes that consumption should be taxed rather than income. This is because you want to create incentives for people to defer consumption, save, and invest in building up the country’s stock of capital goods. Yet something Thomas Piketty points out in his celebrated new book on wealth inequality around the world is that at the high end the distinction between wealth and consumption tends to break down. For a normal middle class person, the difference between spending $5,000 on a vacation and putting $5,000 into the stock market to save for retirement is obvious. But while buying a professional basketball team is technically a business investment, it’s also the case that owning a pro sports team is pretty fun.

Love that; “Traditionally, economists have believed”. Just as traditionally we believed that low rates don’t mean easy money, or that zero rates don’t prevent central banks from stimulating the economy, or that a demand failure is a monetary policy failure. This really is the new dark ages of economics.

Here’s what Yglesias misses. Unequal consumption matters because of opportunity cost—another bedrock of economics. The resources that went into that $200 million yacht could have produced lots of other goodies for average people. But if the psychic benefits of owning a basketball team go to a hedge fund manager, they are denied to one average guy–a problem too trivial to even mention. Yes, there are practical problems with consumption taxes just as with any other taxes. But can’t we all agree that we should start with a progressive consumption tax, and then add on a few fixes for the hedge funds managers engaged in dodging taxes? Can’t we agree that the vast majority of ordinary people with full time jobs and some money in stock and bond funds should pay zero interest on their investment income? At one time I thought really smart progressives like Yglesias would take that bargain, now I see the left drifting away from economic rationality, to the point where they embrace 90% tax rates on the assumption that the rich are producing relatively little of value, and that their incomes are pure exploitation. That’s true in a few cases, but if we go down that road we are essentially throwing in the towel. Admitting we are no better than an oligarchic state like Russia and just need to give up on reform.

I’m not ready to give up yet.

PS. Here’s Tyler Cowen:

A more sensible and practicable policy agenda for reducing inequality would include calls for establishing more sovereign wealth funds, which Piketty discusses but does not embrace; for limiting the tax deductions that noncharitable nonprofits can claim; for deregulating urban development and loosening zoning laws, which would encourage more housing construction and make it easier and cheaper to live in cities such as San Francisco and, yes, Paris; for offering more opportunity grants for young people; and for improving education. Creating more value in an economy would do more than wealth redistribution to combat the harmful effects of inequality.

I’m certain that Yglesias also supports the call for less restrictive zoning in California. If we did so, income and wealth would immediately become less equal, as vast capital gains would go to affluent landowners near the coast of California. But consumption would become much more equal, as many more Americans (including me) could enjoy living in the nice climate near the California coastline.

It’s all about consumption.

PPS. Anyone who thinks owning the Milwaukee Bucks is “fun” has not been a Bucks fan during recent decades. Back around 1990 they were the 2nd winningest team in the NBA since being founded in 1968. And now . . . don’t ask.