The Impossible Trinity

No nation can simultaneously achieve low taxes, easy business conditions, and low inequality.
There are plenty of valid middle-ground combinations.
But a free market with a large social safety net (high taxes + easy business conditions) appears more effective at tackling inequality than a command economy (low taxes + stringent business regulations).

I’ve written before about how globalisation has actually been a spectacular success. It has generated monumental amounts of wealth, drastically reduced poverty, and fostered international relations. Consequently, the solution to rising inequalities in the developed world is not a retreat from globalisation. It is to more fairly share its benefits through the tax system – social welfare, infrastructure, education, health care, etc.

But there is another option – regulation. Instead of tackling inequality through higher taxes and a greater redistributive role of government, regulating business could reign in monopoly and monopsony power[1]. This would allow workers to share more in corporate success, thereby reducing inequality[2]. Theoretically, unions are supposed to facilitate this too, which can also be aided through regulation. Maybe businesses can also be regulated to provide more things like health insurance, education and training, and salary insurance to their workers. Mechanisms like ‘developer contribution plans’ even force the private sector to contribute to infrastructure like public transport – all of which would help address inequality.

And through this thought, I may have discovered something interesting – what I’m dubbing The Impossible Trinity of Inequality[3].

My hypothesis – it’s impossible to simultaneously achieve low taxes, easy business conditions, and low inequality:

·         If you want to go the capitalist route (easy business conditions and low taxes), you have to accept that there will be a high level of inequality, as those that are disadvantaged or simply unlucky in their employment or health fortunes, won’t receive the support they need;

·         If you want to have low inequality but easy business conditions, you have to have high taxes for the government to perform its redistributive role; and

·         If you want to have low inequality but low taxes, you have to have stringent business regulations that protect workers from exploitation and support social mobility.

The evidence?

I previously wrote of the link between income inequality and government tax revenue. An intuitive enough link – governments that collect more taxes can undertake a greater redistributive role (social welfare, infrastructure, education, health, etc.), resulting in lower rates of inequality.

The following graph illustrates this for the OECD countries, with surprising statistical accuracy (0.59 is actually a pretty good correlation).

This time though, I combined an index of ‘ease of doing business’ with tax revenue as a percentage of GDP. A lower value of this combined index indicates lower taxes and easier business conditions. The relationship is weaker, but still there, especially at the extremes. Countries with the lowest taxes and easiest business conditions tended to have the highest inequality.  And those with the highest taxes and most stringent business conditions tended to have the lowest inequality.

And most importantly, not a single country in the OECD was able to achieve the Impossible Trinity. No country simultaneously had low taxes, easy business conditions and low inequality (three green boxes below).

Some countries couldn’t even achieve two – Mexico, Chile and Turkey all enjoy low taxes, but stringent business conditions and high inequality. And Belgium, while achieving low inequality, achieved it at the cost of both high taxes and stringent business conditions.

But Norway and Denmark achieved both low inequality and easy business conditions only at the cost of high taxes. The US chose another trade-off – easy business conditions and low taxes at the cost of high inequality.

Korea was perhaps the only major success-story outlier – it achieved low taxes and easy business conditions at the cost of only moderate inequality.

Several countries also chose a successful middle ground:

·         Australia and Switzerland enjoy low taxes with average business conditions and average inequality;

·         The Czech Republic, the Slovak Republic, Slovenia and Iceland achieved low inequality with average business conditions and average taxes;

·         Estonia enjoys easy business conditions with average taxes and average inequality; and

·         Canada, Ireland, the Netherlands, Poland, Portugal, Spain and Germany were around average on all three indicators.

It’s worth noting though that no country was able to use stringent business regulations to achieve low inequality and low taxes. This was contrary to one of my above hypotheses. And it possibly suggests that heavily regulating businesses is not as effective at tackling inequality as high taxes and redistribution efforts. This is perhaps unsurprising. Income redistribution puts resources (and therefore, choice) in the hands of individuals. This is arguably more effective at helping those individuals than regulation, which requires the government to attempt to decide what is best for the individual.

Of course, these relationships aren’t perfect. And there are several different ways this data could have been sliced and diced. Further research could also yield the importance of personal vs. corporate tax rates. But this is a blog, not a submission to the Nobel Prize Committee. So for these purposes, I will still conclude thusly:

·         You can’t achieve all three – it is indeed an Impossible Trinity;

·         There are also plenty of valid middle-ground combinations;

·         But a free market with a large social safety net (high taxes + easy business conditions) like Norway and Denmark appears more effective at tackling inequality than a command economy (low taxes + stringent business regulations).

Task for humanity – can we turn it into The Possible Trinity? Can we provide for everyone in society without the need for high taxes or stringent regulations? An altruistic capitalist society, if you will. *laughter*

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[1] The ability of businesses to control not just the price of the products they sell, but also the price of the labour they buy.

[2] It would also help address the ‘two-speed economy’ between corporate (and therefore, asset market) success, and wage growth, thereby making the job of Central Banks easier.

[3] I first heard this expression when it referred to the Impossible Trinity of Central Banking – the idea that an economy could not simultaneously achieve a fixed exchange rate, open capital markets, and a Central Bank policy that targets internal stability.