As a regular reader of Brad DeLong I was slightly alarmed at a recent post reporting an outbreak of unpleasantness about which OECD country has the most progressive tax system.
Brad DeLong linked to an article by Jonathan Chait which rather sharply criticised Veronique de Rugy of the Mercatus Centre for arguing that “Contrary to common belief, the United States already has a more progressive tax system than do the most industrialized democracies worldwide. ”
Chait pointed out that “the amount of taxes paid by the rich is a function not only of their relative tax rate but also their relative share of the income. If rich people earn a far larger share of the income in the U.S., which they do, then they may pay a higher share of the tax burden even if the U.S. income tax system is less regressive.”
Responses have subsequently ping-ponged across the internet, as is common in controversies of this sort. Veronique de Rugy has responded twice, and Jonathan Chait had another go. Paul Krugman and Clive Crook take opposing sides
The figures initially quoted by Veronique de Rugy came from the chapter on redistribution in an earlier OECD study “Growing Unequal” published a few years ago. Readers, I wrote that chapter – hence my concern that people understand what it means.
In fact, the chapter quoted by Veronique de Rugy found that the USA did have the most progressive distribution of direct taxes in the OECD, as we can see in the chart below. This includes income taxes and employee social security contributions, but not indirect taxes.
As Jonathan Chait correctly points out, part of the reason why the US has a very progressive tax system is that it also has a very unequal distribution of market income. An identical tax scale would collect more money from rich people in one country if they had a higher share of income than the rich in another country. However, we also calculated what was the effect of greater inequality in the USA, and found that the direct tax system in the USA was now the second most progressive (after Ireland).
Another objection to this finding is that by looking at only direct taxes, we leave out the less progressive taxes that may impact more heavily on low income households. It is correct that taking account of employer payroll taxes and sales taxes would make the overall US system less progressive, but employer payroll taxes and VAT are much heavier in Europe, and also less progressive than their direct taxes, so the US ranking would almost certainly not change.
This finding is not new - Peter Lindert has pointed this out before – English-speaking countries tend to have more progressive tax systems, but lower overall levels of taxation, while Europe has less progressive and higher levels of taxation.
It is important to understand what progressivity means in this context. Some time ago Don Arthur pointed to earlier debates about this.
Progressivity measures the differences in taxes paid at different income levels. Progressivity is measured as the rate of increase in taxes, not the level of taxes. This is simply the widely accepted standard for measuring progressivity used in the technical literature.
In the OECD report and in the figure above progressivity was measured by the concentration coefficient of household taxes, which is the Gini coefficient but calculated with households ranked by their disposable income rather than their tax payments.
It is the distribution of taxes that is used in calculating progressivity, but this tells you nothing about the level of taxes. The extent to which the tax system redistributes income is determined by both the level of taxes and their progressivity.
For example, in the USA, the taxes paid by the richest 10% amount to 41% of their income, while the taxes paid by the poorest 10% are about 12% of their income. If you take Sweden, the richest 10% pay 58% of their income in taxes, nearly one and a half times what the corresponding group in the USA pay.
However, in Sweden the poorest 10% pay nearly 25% of their income in direct taxes, or more than twice the rate for low income Americans. Put another way the richest 10% in the USA pay 3.5 times as much in taxes as the poorest 10%, while in Sweden the richest 10% pay 2.3 times as much in taxes as the poorest income group.
So taxes in the USA are more progressive than in Sweden, but rich people in Sweden pay much higher taxes than rich people in the USA.
Most importantly, progressivity is not the same as redistribution. In a simplified sense, countries have four fiscal tools for addressing income inequality – the first is the overall level of taxes, and the second is the progressivity of the tax structure, the third is the overall level of social spending, and the fourth is structure of spending, which can also be defined in terms of progressivity. As I have pointed out before, Australia has the most progressive distribution of benefits in the OECD. However, for assessing redistribution you need to look at the combined effect of all four factors together. But it is also useful to look at each component separately, in order to understand how specific policy changes impact on income inequality.
Because European countries collect a lot more in tax they spend a lot more on social security transfers and government services. It is through the spending side that other countries achieve much greater redistribution and reduce inequality to a larger extent than the USA. In fact, the USA has one of least redistributive social security and welfare systems in the OECD – only South Korea is less redistributive. The USA is the only OECD country which reduces inequality more through the direct tax system than through transfer spending.
What is important, however, is the combined effect of taxes and spending, and when you put the two together the USA is about the fourth least effective OECD country in terms of reducing inequality, as shown below.
Another way of visualising this is look at the distribution of taxes and transfers together. This means that we treat benefits as negative taxes and add them to the positive taxes that households pay.
When you do this, the picture looks like this. For simplicity, I have only included the USA, Sweden and Australia. In order to standardise across countries net taxes are expressed as a percentage of overall average household income in each country. In all three countries, tax rates are negative for most of the bottom half of the income distribution. and become increasingly positive in the top half of the distribution. What stands out most, however, is that the USA has the lowest negatives in the bottom half of the distribution. For the bottom decile, net transfers in the USA are about two-thirds the level of Sweden and only half the level of Australia. This difference is entirely due to the transfer side of the equation – remember that taxes on the bottom decile are much higher in Sweden than in the USA.
So it is certainly not correct to say that the USA has the most progressive tax-transfer system, even it is correct that it has the most progressive direct tax system. So my reading is that Veronique de Rugy is correct, although not comprehensive.
It is worth noting that part of the explanation for the higher progressivity of the US direct tax system is that they provide support through the tax system in the form of the earned income tax credit (EITC) and refundable child tax credit, which here in Australia we do through the family payments system as cash transfers.
As an outsider, I find it puzzling to see the US discussion focus only on the progressivity of taxes. This is important, but it is only one of the tools that can be used to reduce inequality. The reason why most other OECD countries reduce income inequality more than the USA is that they place greater emphasis on spending – and collect the taxes necessary to pay for it.