Inequality and fiscal reform

Just about everywhere in the West, proposals for tax reform have returned to the center of the debate. A recurring element of these proposals is the reduction of the rates affecting the wealthiest taxpayers. In the UK, the new government led by Liz Truss intended to reduce the maximum rate of personal income tax from the current 45% to 40%. Tweaks to lower rates do not alter the fact that the reform would have benefited the rich far more than the rest of the British population. In Italy, at least a part of the center-right majority remains faithful to the battle for the flat tax, initially to be applied only to specific categories of taxpayers but (at least in electoral promises) to be progressively extended to others as well.

Let's start with a clarification: reducing the maximum rate of the personal income tax or introducing a flat tax is not synonymous with reducing the tax burden. In fact, by appropriately modifying the rates it is technically possible to reduce fiscal pressure for everyone and at the same time increase progressivity of the levy. The real question, therefore, is not the reason why some propose to cut taxes (which, in principle, could be justified as an intervention in favor of economic growth), but why they want to do it by reducing the progressivity of the tax system. The question is particularly relevant since there is no empirical evidence that a reduction in fiscal progressivity provides an appreciable stimulus to the economy. On the other hand, there are numerous studies that suggest that there is a causal relationship between the decrease in progressivity of Western tax systems, and the upward trend in income and wealth inequality observed in recent decades.
To fully understand the nature of the problem, it is useful to try to reconstruct the origins of the idea that taxation should be as flat as possible. The personal income tax is the main fiscal innovation of the contemporary age. Despite some early attempts (soon abandoned due to practical difficulties) in Holland, the first modern example of an income tax is usually dated back to 1799, when Britain managed to convince its citizens that it was necessary to finance the war against Napoleon. It was a highly progressive tax, given that only the richest had to pay it, but it was also temporary: the British government had to undertake the commitment to eliminate it at the end of the war, and so it did in 1816. The new levy, however, had proved very useful for strengthening the fiscal capacity of the State and, consequently, its capacity to intervene in various domains. It is for this reason that Great Britain reintroduced it in 1842, subsequently imitated by all Western countries.

If originally it was limited to the richest, over time the personal income tax became universal, that is, paid by almost everyone. The widening of fiscal contribution from citizens went hand in hand with the extension of certain rights, including the right to vote, but the approach remained decidedly progressive, i.e. with rates increasing with respect to income. It is interesting to note that the highly progressive nature of the income tax was not substantially contested by anyone: at the end of the nineteenth century, and throughout the first part of the twentieth century, the progressivity of the income tax was indeed strengthened with all political formations contributing to this outcome, certainly not only the "leftwing" ones. At the end of the Second World War, in some countries (including the United States and Great Britain) the maximum rate of the personal income tax was in the order of 90%. Still around 1975, in Great Britain the maximum rate was 83%, in the United States it was 70%, and in Italy 72%. This was only the tip of a complex system, which provided for 10, 25, and 32 tax brackets in the three countries, respectively. In fact, personal income taxation had perhaps become too complex, as noted by many economists at the time. Excessive complexity could potentially translate into inefficiency and even injustice. It is with respect to this situation that some argued in favor of a flat tax with a single rate, plus perhaps an exemption area for the lowest income-earners, as a preferable solution.
In the United States, the idea of ​​a flat tax was embraced by President Reagan's Republicans and inspired the tax reforms of the 1980s, which brought the rates down to two and reduced the maximum one to 28%. Later there was a partial reverse: today US citizens are subject to seven rates, with the top rate being set at 37%. From the United States, the idea of ​​simplifying the tax system and at the same time cutting maximum rates spread to the rest of West, characterizing the political agendas of center-right parties in particular. In 1988, the Thatcher government reduced the brackets to two in Great Britain, with a maximum rate of 40%. In this case as well, a partial reverse was subsequently made, but without even remotely returning to the levels of progressivity of previous decades. Today, almost everywhere, the income tax structure has become simpler than it has ever been; in Italy, for example, there are only four brackets with a maximum rate of 43%, while in Great Britain there are only four brackets (including a no-tax area) with a maximum rate of 45% (the one that the government Truss would have liked to eliminate, returning to the levels of the Thatcher era). In short, the goal of simplifying the tax system has already been achieved; if simplicity itself really is the one factor bringing benefits, it is not unreasonable to think we are already enjoying them. As noted at the beginning, there is no evidence that a further reduction in the maximum rate would stimulate the economy per se (it could do so as part of a project to reduce the overall tax burden, and therefore not for its own sake – a project which, however, in the current context, would be very risky to undertake without adequate economic cover, as the financial turmoil following the announcements of the British government clearly demonstrates).

There is also the fact that any proposal (explicit or implicit) to reduce the progressivity of personal income taxation directly contrasts with what, in the history of the West, is specifically expected of the rich on the part of society as a whole. Since the Middle Ages, the idea that in times of crisis it is legitimate to ask the rich to contribute more has remained a constant in Western culture. In modern times, a good example is the New Deal of American President Roosevelt, which helped end the Great Depression and was also funded by highly progressive taxation on income and assets. In the twenty-first century, however, it seems it has become politically very difficult to tax the rich. In the United States, all the Biden administration's proposals to this effect have been met with hostility in Congress. In Britain, the new government, as seen, seems to want to move in the opposite direction, reducing fiscal pressure to a greater extent for the rich than everyone else. In Italy, the Draghi government regularly faced a veto in the face of any intervention that could even hint at a future increase in the levy on wealthy households (see for example the aborted land registry reform), and it seems difficult to imagine that the new government that is about to take office will change course on this issue.

This reluctance to make the rich contribute, or the tendency to favor them on the fiscal front, is historically even more bizarre when one considers that the crises of the twenty-first century have been exceptionally generous to them, harming the poor proportionally more. In Italy, during the Great Recession of 2007-2009 and the sovereign debt crisis of 2010-11, the share of the top 1% on total wealth grew: from 17% in 2007 to 19% in 2012. In the United States, during the same period the share of wealth going to the top 1% rose from 36% to 42%. The crisis caused by Covid-19 has also (relatively) spared the wealthy, and this is true almost everywhere in the West. Given the situation, it would seem appropriate to bring the distributive effects of the proposals to the center of any debate on tax reform, instead of considering them, as the current trend seems to do, at best a gloss compared to the (alleged) benefits for the overall economy.