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 not caused by effort or talent differences but 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 a problem ex post — after it has already occurred.Rents can be seen as implicit commodity taxes, the proceeds of which go to private individuals or companies rather than to the government; just like explicit commodity taxes, they cause labor and price distortion. Legal rules that prevent rents therefore reduce labor and price distortion. Income taxes, by contrast, increase labor distortion and leave the price distortion unaffected. They are less efficient at redistributing income because they are an overly broad instrument, treating 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 as costs, rather than as zero-sum effects, in law and economics models.