Taxes are being debated this month on Capitol Hill and one factor in the debate is the question of whether the government’s appetite for funds (approximately 45 percent of GDP; why it should require nearly half a country’s GDP to maintain roads, defend against invasion, etc. is a separate issue) can be satisfied by soaking the rich with higher tax rates. Economists generally argue against high tax rates because they reduce the efficiency of an economy. Rising income inequality in the U.S., however, has given a lot of ammunition to those who would ignore conventional economics wisdom.

Let’s look at the source of the increased income inequality, though. A lot of researchers (sample) have found that much can be attributed to a single industry: financial services, i.e., Wall Street. We’ve set up a system where a lot of money managers place bets on behalf of pension funds and other large investors. The winners get to keep 20 percent of the winnings on these multi-billion-dollar bets. The losers get paid 2 percent of the total fund size (actually so do the winners, as whipped cream on top of the 20 percent ice cream!). If the bets are placed randomly and there is a reasonable amount of volatility in the market, basic probability ensures that this system will result in enormous salaries for tens of thousands of workers.

Corporate management for public companies is set up the same way. Managers place bets on behalf of the shareholders. If the bets work out well, the manager takes home hundreds of millions of dollars. If the bets don’t pay off, the manager sticks the shareholders with the losses and contents him or herself with merely tens of millions of dollars in compensation (see Carly Fiorina, for example, or Robert Nardelli, who took approximately $500 million from Home Depot shareholders, or Stan O’Neal, who bankrupted Merrill Lynch after siphoning off hundreds of millions for himself). [Shareholders have little control over public company boards or management, due to SEC regulations and are more or less powerless to stop a CEO and board from looting out the enterprise that they nominally own.]

Voters and politicians look at Carly Fiorina, Robert Nardelli, and Stan O’Neal and say “these folks didn’t create anything, but benefited from a system set up by the government; they should pay more taxes to support the government that enabled them to become rich at shareholder expense.” The most direct example of this comes from England, where the government installed a 50 percent tax on financial industry bonuses (story).

Unfortunately, the clamor for higher taxes on these folks who took no personal risk, destroyed a lot of jobs, and shrunk the U.S. economy inevitably ensnares America’s entrepreneurs. Just as the TSA cannot distinguish between an 85-year-old Minnesota-born grandmother and a 23-year-old Islamic Jihadist whose own father had ratted him out to the CIA, the IRS has no way of charging Stan O’Neal, a guy who came into a 100-year-old company and destroyed it, a different tax rate from Ken Olsen, who founded Digital Equipment and created tens of thousands of jobs and a massive stream of exports that helped the U.S. economy grow from 1957 through the early 1990s when minicomputers succumbed to the PC.

The U.S. political system moves very slowly, especially now that Congress and the White House are no longer both controlled by one party. So we don’t yet know what changes to the tax code and other policies will ensue from the average voter watching his own wealth shrink while Wall Streeters and public company executives get richer. But I’m wondering if the result will be that the U.S. becomes uncompetitive as a place to set up new companies. Given a democracy, could it be that having a very successful financial services sector inevitably means a poisoned environment for entrepreneurs? England provides us with an example of a mature economy in which it is great to be a banker, but entrepreneurs are better off emigrating. (I compared the U.S. to the U.K. on October 1, 2008 and January 28, 2009, supplemented by a Mancur Olson piece on March 16, 2009.)