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Tax reform better than more welfare

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Last month, U.S. President Barack Obama called income inequality in the United States the "defining challenge of our time." Unfortunately, the president’s nod to raising the minimum wage and transfer payments offers little hope for the success he seeks. The heated arguments for these moves miss the critical step toward reducing income disparities: economic inclusion, the ability to work and earn in the economy. Bold action is needed — and is best taken through tax reform rather than an expansion of the welfare state.

Analysis of the weak earnings prospects of many Americans portrays a contest between those claiming the mantle of economic dynamism and those backing inclusion. An emphasis on dynamism — opportunities for commercially viable innovation — stresses the supremacy of economic growth: A rising tide lifts all boats. The president’s misconception of inclusion casts it as combating inequality via a higher minimum wage and enhanced unemployment insurance. But dynamism and true inclusion are not in opposition, particularly when more people are able to participate — obtaining rewarding work and a self-sustaining income. What is needed is a policy that furthers both objectives.

By focusing on low-paid workers, the president’s effort on the minimum wage seems to advance inclusion but ultimately does not. A higher minimum wage raises neither hours worked nor employment. Indeed, a core failure of a higher minimum wage as an anti-poverty tool is that it does not tackle joblessness.

In fact, a higher wage almost surely reduces employment, as David Neumark and William Wascher’s survey of empirical studies on the minimum wage concluded. And the costs of a higher minimum wage are borne by lower employment, lost profits to employers and higher prices for consumers — an odd way to fund a social objective.

Similarly, a critical test for a growth agenda is that it generate inclusion — mass prosperity, not just for the top earners. Such inclusion is good for its own sake: The difference between median earnings and those of low-skilled workers widened not only after the 2007-09 financial crisis but also before, and the tepid recovery has done little to narrow the gap. Moreover, supporting job creation and bolstering income from wages mean greater employment as well as a benefit in talent development and experience — to say nothing of the satisfaction — that work provides.

The economic-growth-lifts-all-boats camp needs to confront the question of what happens when growth alone fails to generate inclusion. When our leaders address a lack of inclusion by increasing transfer payments, many commentators respond with the unfortunate and inapt terms "maker" and "taker." The maker-taker distinction stigmatizes a group that depends on the welfare state through unemployment insurance or disability or early retirement benefits. While the growth-maker narrative may celebrate the benefits of dynamism for some, a paean to inclusion it is not.

A policy shift in favour of mass prosperity — dynamism and inclusion — is best conducted via fundamental tax reform. The discussion and policies to be considered, however, should look different from those in the present debate. The Obama administration has supported raising taxes on high-income earners and corporations to pay for expanded benefits to low-income Americans. Such an approach is unlikely to raise labour demand or labour-market earnings for those or other workers.

The opposing view, by contrast, centers on classic tax reform of "broaden the base, lower the rates." Unlike the Obama administration proposals, this tax reform will increase capital accumulation, economic growth and employment. But it is insufficient for increasing the inclusion of low-wage workers, whose incomes may not benefit fully from economic growth.

Two elements of tax reform stand out in an agenda for dynamism and inclusion. For employees, the tax code does little to encourage human capital formation, education or skills development. For many Americans, a simplification and expansion of education-related deductions would be a positive step. With an eye toward raising inclusion in the labour force, one could consider a voucher for low-income individuals for education, training, tuition or their children’s education.

A second employee-based approach builds on the earned-income tax credit, which promotes work as it reduces poverty. While successful, the credit could be improved if inclusion were the goal. As currently constructed, the credit mixes support for families with a tax credit on earnings. Increasing the credit for childless workers to an amount closer to that for families with children would augment the direct work incentive and help counter poverty among the working poor.

Greater support for inclusion through training and worker or employment subsidies must be financed, of course. Options include a consumption-based tax reform to substitute for payroll taxes, high marginal tax rates on wages and/or progressive reductions in the growth of Social Security and Medicare benefits.

Making progress on dynamism and inclusion requires a shift in policy priorities toward enabling work and success over simple economic security. Progress also requires boldness. In this regard, the president’s parry on inequality and the minimum wage is small beer.


Glenn Hubbard is dean of Columbia Business School and was chairman of the Council of Economic Advisers in the George W. Bush administration.


—The Washington Post

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