The Importance of Redistributive Taxes Cannot Be Overstated

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The idea that higher income inequality has pernicious effects on economic growth has been considered for decades. Many studies have been written to establish the negative relation between income inequality and growth, as well as to explain the channels through which this relation can occur. Some argue that greater inequality in a society due to lack of access to education can reduce growth since increasing the skill level of the workforce is a key component of growth. Others argue that higher inequality generates conflict and political instability, which can be bad for the investment climate and for growth in general. Importantly, others indicate that higher inequality and lower earnings for middle- and lower-income households limit their purchasing power and consumption and, as such, reduce growth. A less-studied channel is the positive effect that redistributive policies and programs that reduce income inequality can have on risk taking and entrepreneurial behavior, which in turn encourages growth.

Income redistribution in the form of tax and transfer programs provide social insurance and protection against many types of risks over a person’s lifetime and over his or her career that are not always provided through private insurance. Thus, social insurance in the form of transfer programs—such as the Temporary Assistance for Needy Families, or TANF, program; Medicaid; the Supplemental Nutrition Assistance Program, or SNAP, formerly known as food stamps; and the Special Supplemental Nutrition Program for Women, Infants, and Children, more commonly referred to as WIC—allows individuals to make decisions that involve higher risk, while at the same time affording them greater mobility than they would otherwise undertake. In particular, social insurance can encourage labor mobility either to new businesses, new occupations or sectors, or new areas of the country, which is key to the efficient workings of any economy. Indeed, entrepreneurship and greater labor mobility make it easier to allocate resources to the best possible uses, which in turn increases productivity and growth by allowing more productive businesses to expand while less-productive businesses contract.

While there is some aggregate evidence on the impact of social insurance on aggregate risk taking, there is little evidence on how tax and transfer systems impact individual risk taking in the labor market. This analysis, based on the author’s calculations (see the technical appendix), provides new evidence on the impact that the progressivity of the tax system—the tax rate increases as taxable income increases—and state and federal transfer programs—programs providing support to families in need in the form of cash, in-kind help, and services—have in three areas of the labor market, specifically:

  • Occupational and industrial mobility
  • Geographical mobility
  • Entrepreneurship and self-employment

This report estimates the effects of the progressivity of the tax system, of the generosity of TANF, and of the generosity in coverage of Medicaid, SNAP, and WIC on labor mobility. According to the findings of this report:

  • A more progressive tax system encourages occupational and industrial mobility, along with geographical mobility and mobility from self-employment to wage employment.
  • Greater coverage of medical services for the poor through programs such as Medicaid are also key to encouraging occupational and industrial mobility and encouraging mobility from self-employment to wage employment.
  • More generous TANF benefits increase occupational mobility.
  • In-kind transfers in the form of food assistance, however, have mixed effects on mobility. While expanded coverage of food-assistance programs to families with WIC benefits increases occupational mobility and self-employment, SNAP seems to generally be associated with less mobility.

All in all, these findings suggest that a more progressive tax system and increased access to medical services and cash transfers tend to encourage labor-market mobility and afford individuals, particularly the poor, with the possibility of changing occupations, industries, and locations. Additionally, a more progressive tax system—along with transfer programs—provides individuals with opportunities to start their own businesses, which, combined with the aforementioned benefits, are key to improving efficiency in the economy by providing more services without using more resources.

The importance of redistributive taxes, cash transfers, and health insurance for the poor cannot be overstated; what is less obvious are the benefits of tax and transfer systems to society. By encouraging occupational, industrial, and geographical mobility—allowing people to pursue jobs in growing professions and go where those jobs are located—tax and transfer systems improve the workings of the overall economy. Thus, the thrust of this report is to make the case that progressive taxation and transfer to the poor is not only the right thing to do; it is the smart thing to do.