Optimal taxation, economic growth and income inequality

Up to a point, government spending on public goods – such as national defence and protection of property – can raise the economic growth rate. However, nations with high rates of economic growth experience more income inequality among their citizens than would otherwise be the case. If there is a tax rate that maximises the growth rate, and if there is a trade-off between income inequality and economic growth, there is also an income distribution that maximises the growth rate, says Gerald W. Scully, a senior fellow with the National Center for Policy Analysis.

A good measure of income inequality is the Gini coefficient, which is bound between 0 (a perfectly equal distribution of income) and 1 (a perfectly unequal distribution of income). The higher the value of the Gini coefficient, the more income inequality in a society.

One way of looking at the Gini coefficient is to examine what a reduction in inequality costs. An analysis of the U.S. Gini coefficient for the years 1960 to 1990 revealed that an improvement in the Gini of 0.001 costs 1.33 per cent per year in per capita economic growth. Thus:

Assuming a 3.4 per cent annual growth rate, median household income (which was $50,233 in 2007) would increase by nearly $20,000 over 10 years.

However, improving the Gini by 0.001 point per year would reduce the growth rate to 2.1 per cent per year, and, as a result, median household income would increase by only $11,422.

Some policy implications arise from this research and the research of others cited in this study:

The size of the government is too large.

Politicians need to be less concerned about income inequality and more concerned about the prospects for economic growth.

Source: Gerald W. Scully, Optimal Taxation, Economic Growth and Income Inequality in the United States, National Center for Policy Analysis, Study No. 316, September 2008.

For text: http://www.ncpa.org/pub/st/st316/st316.pdf

For more on Taxes: http://www.ncpa.org/sub/dpd/index.php?Article_Category=20

FMF Policy Bulletin/ 23 September 2008