Removing Rents: Why the Legal System is Superior to the Income Tax at Reducing Income Inequality
Abstract: Reducing income inequality is, in the eyes of many, one of the major political issues of this time. The conventional political approach to reduce income inequality is to raise taxes for the wealthy and redistribute the proceeds to the poor. This approach finds support in the economic literature, which postulates that redistribution through the tax system is more efficient than through the legal system. I argue instead that the legal system is intrinsically superior at reducing income inequality—at least to the extent that inequality is caused by rents (profits that would not have been earned in a perfectly competitive and transparent economy). The legal system is superior because it can address the specific market failures that make rents possible. This way, it can prevent income inequalities from occurring in the first place—an ex ante approach. The income tax system, by contrast, tries to correct the problem ex post—after it has already occurred. Rents can be analogized to implicit commodity taxes, the proceeds of which go to private individuals or companies rather than to the government. Just like explicit commodity taxes (with varying rates), they cause price distortion; and just like all explicit taxes, they cause labor distortion. Legal rules that reduce rents therefore reduce both price and labor distortion. Income taxes, by contrast, leave the price distortion unaffected and increase labor distortion (by being an overly broad instrument that treats income from rents and hard work alike). This finding has major implications. The first is that trade-offs between equity and efficiency should be made in the legal system whenever legal rules generate or reduce rents. The second is that rents (and windfalls) should be considered costs, rather than zero-sum effects, in law and economics models. As a result, many law and economics models may need to be revisited.
