Economists—and society generally—have long been concerned with the trade-off between equity and efficiency. A more equitable society might be less productive, according to standard theory, because taxing wealth, and redistributing it, can lower incentives to work and produce.
But reality invariably complicates theory, and a recent Opportunity & Inclusive Growth Institute paper, “Heterogeneous Workers and Federal Income Taxes in a Spatial Equilibrium,” (IWP3) by Institute visiting scholar Mark Colas of the University of Oregon, with eBay’s Kevin Hutchinson, looks at how economists’ theoretical understanding of the equity/efficiency trade-off is deepened by the reality of geography.
The economists focus on the variation in productivity from one location to another across the United States. Productivity is higher in Boston, for example, than Akron. Wages reflect that difference. This isn’t surprising; wages almost always vary with productivity (output per hour worked).
In addition, more-educated workers, who generally earn higher wages, are also significantly more mobile than less-educated workers, so skilled workers can better take advantage of gains from tax changes (by migrating to higher post-tax pay locations) than unskilled workers who are less able to move when rents increase.
“Our results suggest that a progressive income tax code can reduce between-group welfare inequality without decreasing total worker welfare.”
Given this inequality in wages across locations, and differences in worker mobility and productivity, what is the impact of the federal income tax? How does it influence equality among workers, and how does it affect overall economic output? In a nutshell, what effect does spatial variation in productivity have on the classic equity-efficiency trade-off?
A spatial model to evaluate tax structures
The answer, find Colas and Hutchinson, is that the current tax structure leads to a “moderate” loss of economic efficiency (2.1 cents per dollar of tax revenue) relative to a flat tax that applies a fixed tax rate at all income levels. Their model further estimates that reducing the current tax code’s progressivity—as some recommend—would cause a large increase in inequality with no increase in overall worker welfare.
Landowners, in contrast, would benefit from a flat tax, reaping benefits as workers move to cities where housing supply responds very little to demand. (San Francisco and Boston are obvious examples where geography and/or regulation restrict the housing market.)
The economists reach these conclusions with a sophisticated spatial model of the national economy. Locations differ by wages, rents and amenities. Workers choose location by the utility it provides them, determined by post-tax income, rent levels, amenities and personal preferences. The model allows for a wide variety of preferences, including what data show to be a significant factor for migration: how close the location is to the worker’s state of birth. Workers also differ by marital status, number of children, experience and education.
Landowners are another crucial part of this model economy, since they may choose to rent their land for housing. Taxes are a final key element, with federal, state and payroll taxes—and their expenditure on public goods—accounted for.
Using estimated parameters for labor demand, housing supply and wages, as well as rents and the share of income that goes to housing, the model generates results for tax incidence (whom taxes fall upon), wages, rent, welfare and location choices. After determining that the model is a good fit to reality for the current tax structure, they run simulations to gauge effects of raising or lowering federal tax progressivity.
“Overall,” the economists write, “our results suggest that a progressive income tax code can reduce between-group welfare inequality without decreasing total worker welfare.” How do progressive taxes both reduce inequality and improve worker well-being? “By shifting the distribution of workers toward cities with more elastic housing supply.” Workers migrate toward cheaper housing; benefits that landowners would reap from a flat tax flow toward workers instead.