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By Joseph Stiglitz, adapted from a white paper published in May by the Roosevelt Institute, where he is chief economist. Stiglitz received the 2001 Nobel Prize in Economics.

Americans are finally beginning to appreciate the magnitude of the inequalities in income and wealth that mark our society. Lately, this realization has been helped along by an unexpected source: the French economist Thomas Piketty, whose Capital in the Twenty-First Century is the surprise bestseller of the year. Piketty has collected the most extensive evidence available of the increases in economic inequality and inherited wealth over the past forty years, which are creating a new plutocracy. But while Piketty is right about the severity of the problem, he is not completely right about its cause — and how to fix it. If Americans take the wrong lessons from his work, we may fail to make the changes that could actually address our inequality problem.

Bluntly put, Piketty argues that inequality is the natural outcome of capitalism. In his view, the long period of shared prosperity that characterized the middle of the twentieth century was a historical anomaly, while the disparities of the Gilded Age and our own time are the norm. But what is practiced in the United States today is perhaps best described as an ersatz capitalism designed to create inequalities. This fact was made abundantly clear during the financial crisis, when we socialized losses but allowed the banks to privatize profits, extended largesse to the victimizers but did little to help the victims who were losing their homes and jobs.

Of course, there is no such thing as a “purely” capitalist system. We have always had a mixed economy, relying on the government for investment in education, technology, and infrastructure. The most innovative and successful industries in the U.S. economy (tech and biotech) rest on foundations provided by government research. A well-functioning economy requires a balance between the public and private sectors, with essential public investments and an adequately funded system of social protection. All this requires taxation.

A well-designed tax system can do more than just raise money — it can be used to improve economic efficiency and reduce inequality. Our current system does just the opposite. Piketty’s proposal for addressing inequality through taxation — a global wealth tax — is a political nonstarter, whatever one thinks of its merits. But there are steps the United States — home to the worst inequality among the advanced countries — can take on its own. With a sensible reform of our domestic tax code, we can simultaneously raise money, improve the performance of our economy, and address some of our biggest social problems — not just inequality but joblessness and looming environmental catastrophe.

At the top of the list of concerns in assessing any tax proposal should be its impact on the distribution of income. But three broad principles should also help guide thinking. First, it is better to tax bad things than good things — to tax pollution and speculation, say, than work and savings. Second, it is better to tax things like land, oil, and other natural resources, which don’t disappear when they are taxed (factors in inelastic supply, as economists put it). These two principles reflect a more general third principle: incentives matter. Taxes should encourage activities that are of widespread benefit and discourage those that are costly to our society. There are a host of reforms that would increase equity while conforming to these principles.

To begin with, corporate taxation should encourage firms to invest and create jobs in America by lowering taxes on those that do so relative to those that do not. Taxing multinational firms on their global income would close what might be called the Apple–Google loophole. Globalization has given these companies new opportunities to dodge taxes by claiming that their immense profits originate not from the ingenuity of their American researchers or the seemingly limitless demand from American consumers for their products but from a few employees scattered across low-tax jurisdictions, such as Ireland. By taxing all corporations on the basis of production and sales here, we can raise significant revenues to create jobs and spur growth.

In addition, there ought to be a special set of taxes on the financial sector. Given the role this sector played in the financial crisis, it is natural that it should pay some of the costs. Well-designed financial-sector taxes would increase the sector’s performance efficiency and induce it to do better what it’s supposed to do.

While Piketty tells us that market capitalism naturally creates obscene levels of inequality, I believe we have a different problem: our markets don’t act like competitive markets. We learn in the most elementary economics courses that competitive markets, which promote efficiency and innovation, drive profits down. Wealth winds up in the hands of a few multibillionaires because we don’t have a truly competitive economy. The most successful “entrepreneurs” have figured out how to create barriers to competition, behind which they can earn huge profits. It is not a surprise that the world’s richest person, Bill Gates, earned his fortune through a company that has engaged in anticompetitive practices in Europe, America, and Asia. Nor that the world’s second richest, Carlos Slim, made his fortune by taking advantage of a poorly designed privatization process, creating a virtual monopoly in Mexico’s telecom industry, and by charging prices a multiple of what they would be in competitive markets.

To the extent that we fail in our efforts to make markets truly competitive, we should tax monopoly profits, which are a form of what economists call rents. Just as the taxation of land doesn’t lead to less land, so too for a tax on rents. Other sources of rents include revenues received by the owners of natural resources. In many cases, oil, gas, and mineral companies don’t actually own these resources; they simply extract them from publicly owned land while paying just a fraction of their true value. The best solution to this inequity would be a fair and efficient auction, which would guarantee to the public the full return on these assets. In cases where corporations have already managed to get these resources while paying the public a fraction of their worth, we need to recoup that value by taxing the resulting profits at a higher rate.

Moving from corporate to personal taxes, we must enact a fair income tax so that those who work for a living aren’t forced to pay a larger portion of their income in taxes than those who enjoy the fruits of inherited wealth or manage private-equity funds. While most Americans accept the general principle that the rich should pay a larger fraction of their income in taxes, our system departs markedly from this principle in practice. The very richest pay a lower percentage of their reported income than do the merely rich — and their reported income is often a fraction of their actual income.

Many of the commonly discussed proposals for reform of the personal tax code focus on eliminating provisions designed to help the middle class — most notably deductions for mortgage interest and the tax exemption of employer-provided health insurance. Such provisions narrow the tax base and make the economy less efficient, so there is some virtue to eliminating them, if done carefully. In practice, the deduction in mortgage interest provides more assistance to rich homeowners than to the middle class — indeed, by some estimates, the government provides more housing assistance to the rich through the tax system than it does to the poor through public housing. The deduction encourages excessive housing consumption and excessive borrowing (not surprising, given the political clout of our banks). But our real estate sector is still struggling after the housing collapse, when millions of Americans lost a substantial portion of their wealth. Eliminating all subsidies now would make matters worse. A phase-out of the deduction should be gradual, and we should use some of the savings to encourage equity in housing — for instance, through a provision of extended assistance for first-time homebuyers.

Given how hard-pressed the middle class is — incomes, adjusted for inflation, have barely budged in decades — deduction reforms should not be viewed as ways of raising revenue. Instead, the resulting savings should be given back in the form of a reduction of the marginal income-tax rates that hit the middle class. Some would respond that there is no way to achieve significant deficit reduction while raising taxes only on the rich: they don’t have that much money. That was once true, but no longer. One upside of growing inequality is that we can raise enormous amounts of money while increasing tax burdens only at the very top of the scale.

Taxing carbon emissions is another way we could raise substantial amounts of money while improving the overall performance of our economy. The most basic principle in economics is that firms should pay the costs that are incurred in their production processes. This is what enables the price system to guide the economy toward efficiency. When production is subsidized, it creates distortions in the market. Our environment is one of our scarcest resources — those who damage it through pollution are imposing serious costs. Forcing firms with high carbon emissions to pay those costs will make the economy more efficient and at the same time raise revenue.

Taken together, these proposals would make real inroads into reducing inequality, returning us to an economy more like that of the post-war years. Those were the years when America was becoming the middle-class society it had long professed to be, with decades of rapid growth and widely shared prosperity, when those at the bottom saw their incomes grow faster than those at the top. They are also the years that Thomas Piketty views as an anomaly in the history of capitalism. But getting back to that time doesn’t require eliminating capitalism; it requires eliminating the market distortions of the ersatz capitalism practiced in this country today. This is less about economics than it is about politics. We don’t have to choose between capitalism and fairness. We must choose both.

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September 2014

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