Higher Taxes, Lower Pre-Tax Incomes?

In Wednesday's post, I debunked Beale's Law. Beale's Law reflects the pseudo-scientific economush advocated by the political left and political right. It provides that "income inequality levels inversely track the top tax rate--as the rate increases, income inequality decreases." Sounds like physics, right? But a close look at the numbers demonstrates that income inequality levels do not track "inversely" to the tax rate.

I'm not picking on Professor Beale. She is a bombastic advocate on behalf of the political left, which provides some counterweight to her counterparts on the political right. When it comes to data manipulation for political purposes, the right and the left are engaged in a long-running tug of war. They both abuse statistics and economic common sense to influence public opinion in the short term. It's great sport for incumbent politicians, blogging left-wing academics and Washington lobbyists. Not so great for the country in the long run.

As I said on Wednesday, this is all about political expedience: fitting complex economic issues into a simple box for widespread consumption by the relatively unsophisticated masses. But enough on data manipulation. One more question about Beale's Law while the topic is fresh.

Pre-Tax Income vs After-Tax Wealth

Beale's Law posits that income inequality is inverse to tax rates. Imagine that we plot a curve with the pre-tax incomes of the lowest-earning taxpayers on the bottom left, and the highest-earning taxpayers on the top right. Beale's Law predicts that, when top tax rates are high, the curve will "flatten out." Conversely, when top tax rates are low, the curve will "steepen up." Put another way, the difference between the pre-tax incomes of the top 400 taxpayers and the bottom 400 taxpayers should decrease as tax rates increase. And vice versa.

My last post demonstrated that Beale's Law doesn't apply in the real world. It reflects ideological and political wishful thinking, not an interpolation of real-world data. However, I remain puzzled by the logic underlying the pseudo-science. Specifically, I find it puzzling that the political left attempts to link the pre-tax income gap to the top tax rate.

The data indicate that we have a pre-tax income gap and an after-tax wealth gap in our country. I follow that increasing tax rates may "flatten" the after-tax wealth gap. If we taxed the highest-earning taxpayers at 90% marginal rates, we would diminish their ability to accumulate wealth.

In response, many of those individuals would ramp up tax sheltering activity -- shifting taxable income into non-taxable perks, relocating to lower-tax jurisdictions, etc. Longer term, such a policy would drain the wealth controlled by the richest Americans. We wouldn't necessarily observe a "redistribution" of wealth. There is no reason to expect an increase the wealth of the bottom 50% of taxpayers or bottom 400 individuals. But the curve plotting the difference between the top 400 wealthiest individuals and the bottom 400 individuals would likely flatten over time, because the wealthiest individuals would become less wealthy and/or relocate to lower-tax jurisdictions.

The fact that we could flatten the after-tax wealth gap does not mean that we could also flatten the pre-tax income gap. In 2010, LeBron James, Chris Bosh and Dwayne Wade signed $100+ million, six-year contracts with the Miami Heat basketball team. If the top tax rate were, say, 70%, would we expect that James, Bosh and Wade would have signed for less money? Or is the theory that higher tax rates at the top would support higher government spending and thus "trickle up" into higher wage rates across the board?

It's very difficult to identify any logical nexus between higher top tax rates and lower pre-tax income inequality. But no surprise -- as noted, Beale's Law is ultimately about ideological and political wishful thinking.