How public debt can reduce income inequality

This article is based on research by Calin Arcalean

The gains from globalisation are large but very unequally distributed. For example, mobile capital can easily escape taxation, whereas immobile workers bear the excess burden. How can governments redistribute the gains more equitably?

A study by Esade Associate Professor Calin Arcalean shows how public debt can help workers when countries engage in tax competition over mobile capital.

Many of the drawbacks of globalisation are by now obvious

Many of the drawbacks of globalisation are by now obvious. Former US president Barack Obama once said: "When we see people, global elites, wealthy corporations seemingly living by a different set of rules, avoiding taxes, manipulating loopholes ... this feeds a profound sense of injustice. The current path of globalisation demands a course correction to make sure that the benefits of an integrated global economy are more broadly shared by more people, and that the negative impacts are squarely addressed."

In a study published in Economic Inquiry, Prof. Arcalean shows how such a course correction – aimed at achieving a better redistribution of the gains of globalisation – might already be in place, in the form of public debt.

Moving capital across borders has become a normal activity in today's globalised world. Sometimes the reason for moving capital to other countries has solid legitimate business purposes; other times it is a strategy for tax evasion.

"Globalisation has allowed capital owners to shop around for lower tax rates and freely move to other countries that may offer better tax conditions," says Prof. Arcalean. This fact has given rise to competition among governments to set lower tax rates to attract capital.

Public debt and redistribution

While tax competition has been around for some time, the connection to public debt is not well understood. Arcalean's analysis reveals that tax competition and capital mobility across national borders may contribute to increasing public debt.

Why would this happen? "Tax competition for capital among governments may also increase income inequality between capital owners and workers. In this case, issuing public debt becomes a way to redistribute income in a context where redistribution through taxation is made very difficult."

Raising public debt can reduce the tax burden

The model shows that raising public debt can reduce the tax burden on workers because it allows a higher share of public spending to be financed with future revenues from capital income taxes.

Lower taxes don't necessarily mean less tax revenues

To understand these findings, it helps to recall that in most rich economies, corporate tax revenues as a share of total tax revenues are constant despite declining tax rates. How is this possible? "In addition to other factors, such as broadening the tax base, a direct effect of persistently low capital tax rates is that capital owners will get richer, which contributes to an increase in the global stock of capital," says Arcalean.

While restricting the ability of national governments to tax capital, globalisation also incentivises policymakers to play a game between present and future.

Public budget deficits can help reduce income inequality in a globalised world

Despite the inability to increase capital tax rates, knowing that tomorrow there will be more capital to tax allows governments to issue more public debt today, in an effort to push more of the public spending burden onto future periods when capital taxes will generate relatively more revenues.

"My research shows that public budget deficits can ease redistribution and thus help reduce income inequality in a globalised world. I believe this additional dimension is important in the current debate on fiscal sustainability and more generally on the role of fiscal policy in developed economies," concludes Arcalean.