How Do Low Tax Rates Lead To Inequality?

In my previous post, Do Tax Cuts Hurt Growth?, I presented evidence from Piketty, Saez and Stantcheva that low tax rates lead to higher income inequality.

Since the introduction of the income tax in 1913, there have been three periods where the top marginal tax rate was below 40%:

1. 1913-1917.
2. The late 1920’s.
3. 1986-present.

These are also the three periods of highest income inequality. The years between WWII and 1982 saw tax rates above 70% and the lowest income inequality. Why would this be the case? The answer is fairly simple.

When the top tax rate is high, it doesn’t make sense for corporate executives to pay themselves lavish salaries, since most of each additional dollar they pay themselves will be taxed away. Rather, it makes more sense to re-invest that money into their business and increase their employees’ pay and benefits. Not only do these actions reduce income inequality, but they also have the added benefits of attracting better employees, reducing turnover and increasing employee loyalty – all helping to ensuring the company’s longer-term prosperity.

However, when the top tax rate is low, there is a big incentive to reduce worker pay and benefits in order to increase executive compensation.