Economics is all about consumption By Scott Sumner

Or at least it should be. And it was when I studied economics in grad school. In recent posts I’ve complained that the Piketty debate has focused on the wrong variables, income and wealth. These variables do not measure what people assume they measure–economic well-being.

I have finally found an article that actually discusses the Piketty book from a consumption perspective, over at Free Exchange:

Income inequality is the most commonly cited measure, primarily because the data on it is the most comprehensive. However, for the purpose of measuring how inequality affects a community it is also probably the least interesting yardstick of the three. Consumption inequality, though harder to measure, provides a better proxy of social welfare. This is because people’s living standards depend on the amount of goods and services they consume, rather than the number of dollars in their wage packet. . . . Within countries however, all three measures of inequality have a positive correlation with each other. Wealth inequality begets income inequality, which in turn begets consumption inequality. So why should we care about which yardstick we use? The yardstick matters when deciding how policy should best respond. Consider, for example, the progressive wealth tax that Mr Piketty promotes in his book. Taxing large family fortunes would surely decrease wealth inequality. However, its impact on consumption inequality is far less clear. While the tax would reduce wealthy households’ income, it would also increase their incentive to consume to avoid the burden of the tax. Thus it is possible the tax may actually increase consumption inequality, at least in the short run. Conversely, a progressive consumption tax, which is designed to reduce the level of consumption inequality, will exacerbate wealth inequality. These policies will have very different, perhaps even diametrically opposite, effects on the two measures on inequality. Thus the way we measure inequality, and the choice as to which we wish to minimise, will have a critical impact on the optimal policy response.

The correct response to economic inequality (from utilitarian perspective) is to abolish all taxes on capital income, and institute a progressive consumption tax.

Unfortunately, most of the Piketty supporters seem to think it’s better to have lower tax rates on a wealthy person who devotes his wealth to riotous living, as compared to a wealthy person who is thrifty, putting the money into capital formation, charity, and/or his children’s welfare. I have yet to see a persuasive justification for this bizarre policy preference.

One false argument for taxing wealth is that wealth is correlated with excessive political influence. But political influence is more closely correlated with consumption, i.e. what people have to lose. That’s why organizations representing groups like teachers, farmers, prison guards, small bankers, realtors, auto dealers, lawyers, etc., are so powerful. They represent a lot of consumption that could be lost if the economy were made more market-oriented. In contrast, America has the highest corporate tax rates in the developed world, and our top personal income tax rates in states with lots of rich people (New York, California, etc.) are unusually high for a “small” government country. No country goes after wealth hidden in overseas tax shelters more vigorously than the US. Never heard of FATCO? Talk to a banker from another country, you might be surprised to find out how hated we are overseas. The extremely wealthy in America are not as powerful as most people assume. Special interest groups (including the moderately wealthy) are extremely powerful.

Contrary to what you read in the press, the top federal rate on personal income is 43.4%. That’s because the US has two personal income tax systems, and the wealthy must pay both income taxes. In many states the top combined rate is close to 50%, higher than in most of Europe.

Ironically, the extreme wealth of the ultra-rich weakens their political influence in one very important respect. Because they can’t possibly spend all that wealth on consumption, they have no selfish reason not to be idealistic in policy advocacy. Thus they tend to split on issues like high tax rates for the rich, with Gates, Buffett, and Soros supportive, and the Koch brothers against. This weakens their message. In contrast, average (moderately wealthy) businessmen like auto dealers are much more unified in their opposition to free market policies. They don’t want to lose that 6 bedroom McMansion.

When I point out that billionaires like Gates and Buffett plan to give away most of their wealth, one response is that the “public” should get to decide who benefits from charity. By “public” I presume they mean the government. The government (public?) may believe that giving money to dictators in Pakistan and Egypt so that they can buy military jets is a better use of foreign aid than inoculating poor kids in Africa.

You can probably guess what I think of that argument.