Capital in the Twenty-First Century (88 page)

Figure 14.2
shows a slight upward tick in Britain around the turn of the century, somewhat greater
for the estate tax than for the income tax. The rate on the largest estates, which
had been 8 percent since the reform of 1896, rose to 15 percent in 1908—a fairly substantial
amount. In the United States, a federal tax on estates and gifts was not instituted
until 1916, but its rate very quickly rose to levels higher than those found in France
and Germany.

When we look at the history of progressive taxation in the twentieth century, it is
striking to see how far out in front Britain and the United States were, especially
the latter, which invented the confiscatory tax on “excessive” incomes and fortunes.
Figures 14.1
and
14.2
are particularly clear in this regard. This finding stands in such stark contrast
to the way most people both inside and outside the United States and Britain have
seen those two countries since 1980 that it is worth pausing a moment to consider
the point further.

Between the two world wars, all the developed countries began to experiment with very
high top rates, frequently in a rather erratic fashion. But it was the United States
that was the first country to try rates above 70 percent, first on income in 1919–1922
and then on estates in 1937–1939. When a government taxes a certain level of income
or inheritance at a rate of 70 or 80 percent, the primary goal is obviously not to
raise additional revenue (because these very high brackets never yield much). It is
rather to put an end to such incomes and large estates, which lawmakers have for one
reason or another come to regard as socially unacceptable and economically unproductive—or
if not to end them, then at least to make it extremely costly to sustain them and
strongly discourage their perpetuation. Yet there is no absolute prohibition or expropriation.
The progressive tax is thus a relatively liberal method for reducing inequality, in
the sense that free competition and private property are respected while private incentives
are modified in potentially radical ways, but always according to rules thrashed out
in democratic debate. The progressive tax thus represents an ideal compromise between
social justice and individual freedom. It is no accident that the United States and
Britain, which throughout their histories have shown themselves to value individual
liberty highly, adopted more progressive tax systems than many other countries. Note,
however, that the countries of continental Europe, especially France and Germany,
explored other avenues after World War II, such as taking public ownership of firms
and directly setting executive salaries. These measures, which also emerged from democratic
deliberation, in some ways served as substitutes for progressive taxes.
²⁷

Other, more specific factors also mattered. During the Gilded Age, many observers
in the United States worried that the country was becoming increasingly inegalitarian
and moving farther and farther away from its original pioneering ideal. In Willford
King’s 1915 book on the distribution of wealth in the United States, he worried that
the nation was becoming more like what he saw as the hyperinegalitarian societies
of Europe.
²⁸
In 1919, Irving Fisher, then president of the American Economic Association, went
even further. He chose to devote his presidential address to the question of US inequality
and in no uncertain terms told his colleagues that the increasing concentration of
wealth was the nation’s foremost economic problem. Fisher found King’s estimates alarming.
The fact that “2 percent of the population owns more than 50 percent of the wealth”
and that “two-thirds of the population owns almost nothing” struck him as “an undemocratic
distribution of wealth,” which threatened the very foundations of US society. Rather
than restrict the share of profits or the return on capital arbitrarily—possibilities
Fisher mentioned only to reject them—he argued that the best solution was to impose
a heavy tax on the largest estates (he mentioned a tax rate of two-thirds the size
of the estate, rising to 100 percent if the estate was more than three generations
old).
²⁹
It is striking to see how much more Fisher worried about inequality than Leroy-Beaulieu
did, even though Leroy-Beaulieu lived in a far more inegalitarian society. The fear
of coming to resemble Old Europe was no doubt part of the reason for the American
interest in progressive taxes.

Furthermore, the Great Depression of the 1930s struck the United States with extreme
force, and many people blamed the economic and financial elites for having enriched
themselves while leading the country to ruin. (Bear in mind that the share of top
incomes in US national income peaked in the late 1920s, largely due to enormous capital
gains on stocks.) Roosevelt came to power in 1933, when the crisis was already three
years old and one-quarter of the country was unemployed. He immediately decided on
a sharp increase in the top income tax rate, which had been decreased to 25 percent
in the late 1920s and again under Hoover’s disastrous presidency. The top rate rose
to 63 percent in 1933 and then to 79 percent in 1937, surpassing the previous record
of 1919. In 1942 the Victory Tax Act raised the top rate to 88 percent, and in 1944
it went up again to 94 percent, due to various surtaxes. The top rate then stabilized
at around 90 percent until the mid-1960s, but then it fell to 70 percent in the early
1980s. All told, over the period 1932–1980, nearly half a century, the top federal
income tax rate in the United States averaged 81 percent.
³⁰

It is important to emphasize that no continental European country has ever imposed
such high rates (except in exceptional circumstances, for a few years at most, and
never for as long as half a century). In particular, France and Germany had top rates
between 50 and 70 percent from the late 1940s until the 1980s, but never as high as
80–90 percent. The only exception was Germany in 1947–1949, when the rate was 90 percent.
But this was a time when the tax schedule was fixed by the occupying powers (in practice,
the US authorities). As soon as Germany regained fiscal sovereignty in 1950, the country
quickly returned to rates more in keeping with its traditions, and the top rate fell
within a few years to just over 50 percent (see
Figure 14.1
). We see exactly the same phenomenon in Japan.
³¹

The Anglo-Saxon attraction to progressive taxation becomes even clearer when we look
at the estate tax. In the United States, the top estate tax rate remained between
70 and 80 percent from the 1930s to the 1980s, while in France and Germany the top
rate never exceeded 30–40 percent except for the years 1946–1949 in Germany (see
Figure 14.2
).
³²

The only country to match or surpass peak US estate tax rates was Britain. The rates
applicable to the highest British incomes as well as estates in the 1940s was 98 percent,
a peak attained again in the 1970s—an absolute historical record.
³³
Note, too, that both countries distinguished between “earned income,” that is, income
from labor (including both wages and nonwage compensation) and “unearned income,”
meaning capital income (rent, interests, dividends, etc.). The top rates indicated
in
Figure 14.1
for the United States and Britain applied to unearned income. At times, the top rate
on earned income was slightly lower, especially in the 1970s.
³⁴
This distinction is interesting, because it is a translation into fiscal terms of
the suspicion that surrounded very high incomes: all excessively high incomes were
suspect, but unearned incomes were more suspect than earned incomes. The contrast
between attitudes then and now, with capital income treated more favorably today than
labor income in many countries, especially in Europe, is striking. Note, too, that
although the threshold for application of the top rates has varied over time, it has
always been extremely high: expressed in terms of average income in the decade 2000–2010,
the threshold has generally ranged between 500,000 and 1 million euros. In terms of
today’s income distribution, the top rate would therefore apply to less than 1 percent
of the population (generally somewhere between 0.1 and 0.5 percent).

The urge to tax unearned income more heavily than earned income reflects an attitude
that is also consistent with a steeply progressive inheritance tax. The British case
is particularly interesting in a long-run perspective. Britain was the country with
the highest concentration of wealth in the nineteenth and early twentieth centuries.
The shocks (destruction, expropriation) endured by large fortunes fell less heavily
there than on the continent, yet Britain chose to impose its own fiscal shock—less
violent than war but nonetheless significant: the top rate ranged from 70 to 80 percent
or more throughout the period 1940–1980. No other country devoted more thought to
the taxation of inheritances in the twentieth century, especially between the two
world wars.
³⁵
In November 1938, Josiah Wedgwood, in the preface to a new edition of his classic
1929 book on inheritance, agreed with his compatriot Bertrand Russell that the “plutodemocracies”
and their hereditary elites had failed to stem the rise of fascism. He was convinced
that “political democracies that do not democratize their economic systems are inherently
unstable.” In his eyes, a steeply progressive inheritance tax was the main tool for
achieving the economic democratization that he believed to be necessary.
³⁶

After experiencing a great passion for equality from the 1930s through the 1970s,
the United States and Britain veered off with equal enthusiasm in the opposite direction.
Over the past three decades, their top marginal income tax rates, which had been significantly
higher than the top rates in France and Germany, fell well below French and German
levels. While the latter remained stable at 50–60 percent from 1930 to 2010 (with
a slight decrease toward the end of the period), British and US rates fell from 80–90
percent in 1930–1980 to 30–40 percent in 1980–2010 (with a low point of 28 percent
after the Reagan tax reform of 1986) (see
Figure 14.1
).
³⁷
The Anglo-Saxon countries have played yo-yo with the wealthy since the 1930s. By
contrast, attitudes toward top incomes in both continental Europe (of which Germany
and France are fairly typical) and Japan have held steady. I showed in
Part One
that part of the explanation for this difference might be that the United States
and Britain came to feel that they were being overtaken by other countries in the
1970s. This sense that other countries were catching up contributed to the rise of
Thatcherism and Reaganism. To be sure, the catch-up that occurred between 1950 and
1980 was largely a mechanical consequence of the shocks endured by continental Europe
and Japan between 1914 and 1945. The people of Britain and the United States nevertheless
found it hard to accept: for countries as well as individuals, the wealth hierarchy
is not just about money; it is also a matter of honor and moral values. What were
the consequences of this great shift in attitudes in the United States and Britain?

If we look at all the developed countries, we find that the size of the decrease in
the top marginal income tax rate between 1980 and the present is closely related to
the size of the increase in the top centile’s share of national income over the same
period. Concretely, the two phenomena are perfectly correlated: the countries with
the largest decreases in their top tax rates are also the countries where the top
earners’ share of national income has increased the most (especially when it comes
to the remuneration of executives of large firms). Conversely, the countries that
did not reduce their top tax rates very much saw much more moderate increases in the
top earners’ share of national income.
³⁸
If one believes the classic economic models based on the theory of marginal productivity
and the labor supply, one might try to explain this by arguing that the decrease in
top tax rates spurred top executive talent to increase their labor supply and productivity.
Since their marginal productivity increased, their salaries increased commensurately
and therefore rose well above executive salaries in other countries. This explanation
is not very plausible, however. As I showed in
Chapter 9
, the theory of marginal productivity runs into serious conceptual and economic difficulties
(in addition to suffering from a certain naïveté) when it comes to explaining how
pay is determined at the top of the income hierarchy.

A more realistic explanation is that lower top income tax rates, especially in the
United States and Britain, where top rates fell dramatically, totally transformed
the way executive salaries are determined. It is always difficult for an executive
to convince other parties involved in the firm (direct subordinates, workers lower
down in the hierarchy, stockholders, and members of the compensation committee) that
a large pay raise—say of a million dollars—is truly justified. In the 1950s and 1960s,
executives in British and US firms had little reason to fight for such raises, and
other interested parties were less inclined to accept them, because 80–90 percent
of the increase would in any case go directly to the government. After 1980, the game
was utterly transformed, however, and the evidence suggests that executives went to
considerable lengths to persuade other interested parties to grant them substantial
raises. Because it is objectively difficult to measure individual contributions to
a firm’s output, top managers found it relatively easy to persuade boards and stockholders
that they were worth the money, especially since the members of compensation committees
were often chosen in a rather incestuous manner.