In a post yesterday, I said:

We are nearing the point where a majority of Americans will not have any federal tax liability and that seems a dangerous situation. What incentive will citizens with no tax liability have to restrain government taxation and spending?

In today’s WSJ, Adam Lerrick, asks the same question:

What happens when the voter in the exact middle of the earnings spectrum receives more in benefits from Washington than he pays in taxes? Economists Allan Meltzer and Scott Richard posed this question 27 years ago. We may soon enough know the answer.

Over the last 20 years, there have been two seemingly unrelated trends: the percentage of total taxes paid by the upper income taxpayers has been rising and inequality between rich and poor has been rising. The goal of a progressive tax system is to prevent this growing gap between rich and poor, but it obviously isn’t working. Why? There are a number of potential explanations and Lerrick provides one:

Other nations have tried the ideology of fairness in the place of incentives and found that reward without work is a recipe for decline. In the late 1970s and throughout the 1980s, Margaret Thatcher took on the unions and slashed taxes to restore growth and jobs in Great Britain. In Germany a few years ago, Social Democrat Gerhard Schroeder defied his party’s dogma and loosened labor’s grip on the economy to end stagnation. And more recently in France, Nicolas Sarkozy was swept to power on a platform of restoring flexibility to the economy.

Reducing the incentive for the wealthy to work and invest affects the poor because the result is lower economic growth. That is at least one explanation for the rising inequality. Obviously, there is a limit to how much you can raise taxes on the “wealthy” and when that point is reached, the higher tax rates will cascade down the income ladder:

What next? A core group of Obama enthusiasts — those educated professionals who applaud the “fairness” of their candidate’s tax plans — will soon see their $100,000-$150,000 incomes targeted. As entitlements expand and a self-interested majority votes, the higher tax brackets will kick in at lower levels down the ladder, all the way to households with a $75,000 income.

A progressive tax system doesn’t reduce inequality for a variety of reasons, but to me the main reason is that progressive taxation shifts an economy from one that invests in capital goods to consumer goods. Wealthier people have a lower propensity to consume and therefore are the source of a country’s savings. Those savings get invested in long term capital goods which will ultimately create jobs. When their savings are reduced, the investment in capital goods declines and therefore job creation declines. That doesn’t help the poor obviously.

Having said that, I believe the reason raising taxes on the rich is not reducing inequality is because it does not address a major cause of inequality – inflation. Countries with high inequality have two factors which are common – corruption and inflation. Inflation of the money supply benefits the rich because they get that new money first and have a chance to benefit. By the time those lower on the income scale receive the new money its purchasing power has declined.

Increasing the progressivity of the tax code will not reduce inequality. The only way to reduce inequality is to eliminate inflation and flatten the tax code. It’s counterintuitive, as is much of economics, but it will work. The question is whether our politicians are really interested in solving the problem. I suspcet not.