TOP TAX RATES AND CULTURAL CHANGE
Low taxes probably played a role as well, as argued by Thomas Piketty. When tax rates on the very top income are 70 percent or more, firms are more likely to decide that paying stratospheric wages is a waste of their money and cut back the top salaries.
With these tax rates, the board faces a stark trade-off: at a 70 percent marginal tax rate, a dollar in salary is only thirty cents in the pocket for the manager, versus a whole dollar for the firm. It makes salary less valuable for the CEO, and it becomes cheaper for the board to pay the CEO in other “currencies,” such as allowing him to pursue his dream projects. This might not always be what the shareholders want (they want higher profits, not size per se)—economists in the 1960s and 1970s were concerned with empire-building by managers—but could be better for the workers, or the world. For example, the CEO could prioritize growing the firm, being popular with the workers, or pursuing some new product because it is good for the world, even if it is not the best for share value. The shareholders may tolerate this to keep their CEO happy. It might even be part of the reason why workers’ salaries were rising when top tax rates were high.So the point of the very high top tax rates of the 1950s and 1960s, which applied only to extremely high incomes, was not so much to “soak the rich” as to eliminate them. Almost nobody ended up paying the top rates, because those very high incomes had all but disappeared.58 When the top tax rates went down to 30 percent, ultra-high salaries became attractive again.
In other words, high top tax rates may actually lead to a reduction not just in inequality after taxes, but also in inequality before taxes. This is important because, as already discussed, a large part of the reason for the divergence in inequality between Europe and the United States in recent decades comes from pre-tax inequality.
And some evidence hints at the possibility that the decline in top tax rates may have something to do with it: at the country level, there is a strong correlation between the size in the cuts in top tax rates between 1970 and today, and the increase in inequality. Germany, Sweden, Spain, Denmark, and Switzerland, where top marginal tax rates stayed high, did not experience sharp increases in top income shares. In contrast, the United States, Ireland, Canada, the UK, Norway, and Portugal cut the top tax rates significantly and experienced large increases in top income shares.59However, beyond tax rates, in the United States it is also likely there was a cultural change that created a social environment in which high salaries were acceptable. After all, how did people in finance manage to convince their shareholders and the world they could be paid that much for their services, if we are correct that they are mostly earning rents?
In our view, beyond the tax cuts, the narrative of incentives that underpinned the Reagan-Thatcher revolution convinced a substantial fraction of the non-rich (and most of the rich who had any doubts about it) that those sky-high salaries were legitimate. Low taxes were a symptom of it, but the ideological shift was even deeper. The rich could go ahead and pay themselves more money than they could ever spend, without raising any hackles, as long as they had “earned” this money. Many economists, with their unconditional love for incentives, played a key role in spreading and legitimizing this narrative. As we saw, many economists remain in favor of high CEO pay today even though they are not opposed to higher taxation across the board. The narrative has spread: even today, while many in the US and the UK clearly resent their own economic situation, they tend to blame immigration and trade liberalization rather than the increasing vacuuming of resources toward the very rich.
Was the basic presumption, that high take-home salaries were essential to encourage the most productive people to do their best and create prosperity for the rest of us, correct? What do we know about the effect of taxes on the effort of the rich?