Income inequality, taxation and redistribution

Steve Merrell |

As a financial planner, I constantly look for ways to explain important economic ideas that are accurate and easy to understand.  I recently came across the following gem in a piece written by Brian Wesbury and Robert Stein at First Trust Advisors. They, in turn, attribute it to Paul Zane Pilzer from his 1990 book titled “Unlimited Wealth.” Though written nearly 30 years ago, it seems especially applicable today given the tenor of the current political debate.

“Imagine 10 people live on an island. Each day they wake up, catch two fish, eat them, and go back to bed. Its subsistence living at the most basic level. There are no savings – no stored or saved wealth. If someone gets sick and can't fish, there's no way to help them. No one has any extra.

“Now imagine two of these people dream up a boat and a net. They spend six days catching one fish per day, slowly starving, but they make the boat and net. On the 7th day, they go out into the ocean and catch 20 fish in the net – it worked!!!!

“At this point, the island can go one of two ways. First, since two people now produce what previously took ten, resources are freed up to do other things. Farming corn, picking coconuts, cleaning fish, cooking, repairing the boat and net, the possibilities are endless. The island ends up with more (and better!) food, new technologies, higher standards of living, more assets, more wealth, and they can now afford to take care of their sick and vulnerable!

“Or...the eight people who don't have a boat and net could become envious. Two now produce ten fish per day, while everyone else can only produce two. Incomes are unequal: it's no longer 1:1, it's 5:1. So, they devise a plan to tax 80% of the income of the boaters (16 fish) and redistribute two fish to each of the other inhabitants.

“If the second plan is adopted, no one is better off. Each inhabitant still only has two fish. Moreover, the entrepreneurs have no incentive to fix their boat and net. The island will eventually revert to subsistence.

“This is the problem with taxation for redistribution: it robs the economy of the benefits of new technology. Certainly, some of our brothers and sisters need help, sometimes permanently; sometimes temporarily. However, taxation for redistribution doesn't make the economy stronger; redistribution hurts growth.

“Everyone on the island is better off because of the boat and the net. Taxing the inventors' wealth or income and redistributing it removes resources from a highly productive new technology. Moreover, the income inequality that exists on the island is a sign of more opportunity, not less.”

Some critics will dismiss this parable out of hand. They will say it oversimplifies the problem of income inequality and minimizes the very real suffering of those who have been left behind in the current economic boom. They will point to economic and political pressures that divide communities and weaken the fabric of our society. I do not disagree with any of that. In fact, I agree with most of it. My point is simply that proposals to tax and redistribute wealth create bigger problems than they solve. They stifle creativity and sap the vitality from our economic system. Government mandates are no substitute for creativity, personal drive and an entrepreneurial spirit.

Experience has shown that the general welfare is best served when those who govern focus on policies that make our economy more innovative and flexible. While an innovative economy naturally creates displacement (a process Joseph Schumpeter once called “creative destruction”), a flexible economy makes it easier for those who are displaced to get quickly back into the game. Examples of these policies might include help with retraining displaced workers and giving tax breaks for work-related relocation. They would also include policies to strengthen markets, improve police and fire protection, promote private property rights, and reduce burdensome regulation.

 

 

Steven C. Merrell  MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey.   He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning.  Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA  93940 or email them to: SMerrell@montereypw.com