Friday, 20 December 2013

Income is meaningless

The analysis of political issues in terms of “income” quartiles can get pretty misleading. A married couple where dad earns £65,000 a year and mum works part time bringing home £15,000 a year is in the fourth quartile of the income distribution. A 70 year-old widower whose £2 million in savings bring him an annual income of approximately £80,000 is also in the fourth quartile. But their policy-relevant economic interests are unlikely to have very much in common since in reality their financial situations are entirely dissimilar.

Let us take this a step further.

Suppose the old guy with £2 million earned £200,000/year for 40 years, and was a high saver. Suppose his twin brother had the exact same income, but spent all his money. The twin brother lives on Social Security. Who is better off? Neither. Both had the same lifetime wage income, and hence equal resources.  Economists take a “lifetime consumption” perspective. The only difference between these brothers is one chose to spend the money when young and the other chose to spend it when old. It is as if one lived by himself in a house and the other lived with roommates in an apartment. No sensible person would say you are better off [than someone who chooses to live alone] because you share an apartment with others and thus pay less rent. These are consumption CHOICES.

The guy with £2 million has already been fully taxed on that wealth, and should of course pay no tax on his capital income. That is why smart progressives like an American called Yglesias favour progressive consumption taxes, at least where it’s possible to clearly identify and separate wage and capital income, as with someone surviving on their 401k mutual funds.

In all probability the guy with £80,000 in retirement income earned far more wage income when younger than the hypothetical family discussed by Yglesias, where each member made an average of £40,000/year. So on utilitarian grounds he should have paid a higher rate of wage tax during his earning years than the hypothetical family making a total of £80,000 in wage income.

So how does a government decide on taxes?

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