A familiar case for progressive taxation of incomes – and, more generally, for income redistribution – rests on the proposition that economists call “the diminishing marginal utility of money.” Consider, for example, this 2019 editorial in The Appalachian:
Wealth inequality in the U.S. is obscene. No one needs that amount of money, and the fact that they [billionaires] pay a lower effective tax rate is even worse. A cup of water means nothing to a man with a well, but everything to a man in the desert.
Arguments such as this one can be found, of course, not only in obscure publications, but also in august journals such as the New York Times, in economic textbooks, and on websites dedicated to explaining economics.
The validity of this case for intensely taxing the rich and transferring the proceeds to the poor(er) seems on its face to be undeniable – scientific, even. The ‘utility’ that Jeff Bezos would enjoy from spending his billionth dollar on consumption surely is less than is the utility that would be enjoyed by a poor person who is given that dollar to spend. And so because both Bezos and the poor person are equal moral agents in society, society’s welfare would be unambiguously increased by taxing that dollar away from Bezos and giving it to the poor person.
Whatever might be the merits of this argument as an economic, or utilitarian, justification for disproportionately heavy taxation of the rich, these merits exist only insofar as income is used for consumption. This argument does not hold insofar as income is used for investment.
Investment Today Yields Increased Consumption Tomorrow
Suppose that multi-billionaire Bezos invests rather than spends an extra dollar that he earns today. Obviously, he thereby forgoes the utility – the satisfaction – that he’d enjoy today had he spent that dollar on consumption. So if that dollar is instead transferred through taxation to a poor person, it is illegitimate to compare the utility the poor person gets from today spending that dollar to the utility that Bezos would have gotten had he instead today spent that dollar. Given that Bezos in fact invested that dollar today, the utility the poor person would get from today spending that dollar must be compared with two alternative utility ‘experiences’ – one enjoyed by Bezos and the other by many strangers.
The first of these alternative utility ‘experiences’ is the utility that Bezos would enjoy in the future by his spending, on consumption, that dollar and whatever investment returns it yields to him. The second such ‘experience’ is the utility that many other people would enjoy from consuming whatever additional goods and services are produced by Bezos’s investment of that dollar.
The previous two paragraphs are a mouthful. Here’s what they mean.
Assume (realistically) that Bezos refrains from spending a dollar today in order to invest it. He invests that dollar in the expectation of it yielding a positive return in the future. Specifically, his expectation is that the return on the dollar will be high enough that the satisfaction he’ll get from spending that dollar and its returns in the future will be greater than is the satisfaction that he foregoes by not spending that dollar today.
Suppose that Bezos is extraordinarily fortunate in his investment choice: The dollar yields in one year a return of $750 million. If so, the utility that would have been enjoyed by the poor person from spending this dollar today, had government transferred this dollar to him or her, must be compared to the utility that Bezos enjoys when he spends, on consumption, the $750 million one year from now. It’s no longer obvious that the satisfaction that the poor person would today enjoy from spending this dollar exceeds the satisfaction that Bezos would enjoy one year from now from spending this dollar and its handsome return.
Of course, even an entrepreneur as astute as Jeff Bezos will never experience such a magnificent return on investment. But the general point stands: Because investment is possible, conclusions about the fairness of tax policy, or of income redistribution, cannot be so easily reached by comparing the consumption satisfaction that a poor person will get from spending a rich person’s dollar to the consumption satisfaction that a rich person would get if he or she spends that same dollar. If Bezos invests a dollar and that investment has any positive return, then the consumption satisfaction that Bezos enjoys from this dollar is not the consumption satisfaction he’d have gotten had he spent the dollar today but, rather, the consumption satisfaction he will get when he spends that dollar and its returns tomorrow.
At some point – with returns high enough and with the delay in consumption long enough – the consumption satisfaction that a rich person experiences in the future from a dollar that would otherwise have been taxed away and given to a poor person becomes equal to, or greater than, the consumption satisfaction that the poor person would experience from spending that dollar in the present.
Other Consumers’ Satisfactions
The possibility of investment also renders relevant the increased satisfactions that the rich person’s investment today makes possible for other people to experience in the future. If Bezos’s investment is successful in the market, this investment creates more goods and services for many consumers. The additional satisfactions that these consumers enjoy from these goods and services would not exist without Bezos’s investment. Therefore, when comparing the amount of satisfaction that a poor person would experience today from spending a dollar taxed away from a rich person, the comparison must be not only to the consumption satisfaction that the rich person would eventually experience from using this dollar, but also to the consumption satisfaction that many other consumers would eventually experience from the rich person’s successful investment of this dollar.
Because rich(er) people generally invest a larger portion of their incomes than do poor(er) people, as a practical matter the ‘economic’ (or utilitarian) case for progressive income taxation and for income redistribution – a case built on comparing the “marginal utility” of income or wealth enjoyed by poor(er) people to that enjoyed by rich(er) people is not as straightforward as many professors, pundits, and politicians suppose. As is so often true in economics, being attuned to more than what is immediately obvious yields insights very different from those that arise from looking only at what is immediately obvious.
The post Rich Man, Poor Man: Comparing the Value of a Dollar to Each was first published by the American Institute for Economic Research (AIER), and is republished here with permission. Please support their efforts.