We have ample reason to believe that financial markets are quite useful. And yet our wonderful financial infrastructure has not yet brought us the harmonious society we might consider ideal. There remains the ugliness of extreme economic inequality, of some who endure hardship while others are pampered.

While some inequality is actually in many ways a good thing, for the motivation and stimulation it provides, arbitrary and extreme inequality poses problems. It is an imperative that people feel society is basically fair to them.

We see this aversion most clearly today in the worldwide protests associated with Occupy Wall Street and its variants. Rising inequality is certainly a valid concern, and one that must be addressed. But financial capitalism does not necessarily produce unjust wealth distribution.

There is widespread skepticism that those who become extremely wealthy through financial dealings, or very high executive-compensation packages, are sufficiently deserving of their wealth.

World’s Richest People

If we define the field of finance broadly, then most of the world’s richest people may be classified as connected to it. Looking at the Forbes 400 list of the wealthiest Americans, you see that the great majority are in charge of large enterprises that participate frequently in markets and deal-making. The Forbes 400 billionaires have usually made use of some kind of specialized knowledge to achieve their wealth, but they rarely stand out for important contributions in any intellectual or creative field. There appear to be no distinguished scientists on the list, no Nobel Prize winners.

Their wealth comes not solely from their own efforts and talent, but often from their ability to form and lead huge and effective organizations composed of many other talented people. Still, it remains a puzzle that those connected to finance can become so fabulously rich to the seeming exclusion of everyone else. Wouldn’t you think that at least one scientist could come up with a patentable idea that would top all their successes?

Part of the reason for a sense of injustice at the unequal distribution of wealth is that some of the inequality seems to be the result of family dynasties, through which the children of successful businesspeople become rich. Some of these children (Donald Trump, for example) keep working in the family business. But, in fact, only about a third of family businesses are continued by the children of the founders, and only a tenth of them by the grandchildren. Still, the later generations remain rich.

The tendency for wealthy families to annoy others by “showing off” -- by spending extravagantly and wastefully on themselves -- is also often a cause for resentment. This tendency toward consumption for show has been dealt with for centuries, going back to ancient Greece and Rome, by means of sumptuary laws that forbid specified forms of wasteful consumption. In seventh-century B.C. Greece, for example, women were forbidden to wear extravagant clothing or jewelry unless they were prostitutes.

Progressive Consumption Tax

A modern version of sumptuary laws is the progressive consumption tax: one that’s based on the amount one consumes rather than the amount one earns, with higher rates on higher levels of consumption. Such a tax was proposed in the U.S. Senate in 1995 by Sam Nunn, a Democrat from Georgia; and Pete Domenici, a Republican from New Mexico.

Switching from a progressive income tax to a similarly progressive consumption tax might be a good idea, for it would not penalize one for earning a large income. And it might encourage saving, philanthropy or both. However, there are serious implementation problems that make progressive consumption taxes difficult. It would be hard, for example, not to effectively reduce taxes on the highest-income people. And it would be hard to manage withholding on income, since responsible withholding would have to depend on unknown future consumption. Neither a sumptuary tax nor a progressive consumption tax is an easy and obvious solution to the problem of wasteful and resentment-inducing consumption that announces wealth or social position.

Estate taxes are one of the most effective ways of restoring a sense of fairness in society. If they were pursued aggressively, they would do much to reduce economic inequality. But, to some, estate taxes can seem extremely onerous.

In late 2010, when a law suspending the federal estate tax in the U.S. was set to expire, so that the maximum estate tax rate would rise to 55 percent from 0 percent, stories were told of elderly people in poor health asking their doctors to cut off further treatment so they would die before the year ended.

Ideally, estate taxes should be set at some intermediate level, so that they neither confiscate people’s wealth at death nor allow it to pass entirely to the next generation. In fact, most people believe that society should give in somewhat to the natural desire to make one’s children rich, but limit it. A 1990 survey that Maxim Boycko, Vladimir Korobov and I conducted found that people in both the U.S. and the Soviet Union thought that the estate tax should take about a third of an estate.

Taxes and Inequality

Another of society’s most important weapons against economic inequality is the progressive income tax. Higher tax rates are fixed on higher levels of income, and so revenue is raised disproportionately from high-income people, and much of the benefit of the proceeds is directed to, or at least shared by, the poor. Strangely, though, the income-tax system has never been designed with the express objective of managing inequality.

In the future, nations would be wise to index their tax systems to inequality. Under such a system, the government would not legislate fixed income-tax rates for each tax bracket, but would instead prescribe a formula that tied tax rates to statistical measures of pretax inequality. If income inequality were to increase, tax rates would automatically become more progressive. Inequality indexation could be considered a kind of insurance -- against worsening inequality.

Leonard Burman, a tax policy expert at Syracuse University, and I did a historical analysis of the possible effects of inequality indexation, had it been imposed many years ago. We found that if one had been legislated in 1979, freezing after-tax income inequality at the then-current level, the marginal tax rate on high-income individuals would have increased to an extraordinarily high level, more than 75 percent. This indicates how much economic inequality has worsened since 1979.

Progressive income taxes and estate taxes -- and possibly also progressive consumption taxes -- are important tools for dealing with excessive economic inequality. Real public concerns about inequality have already made some of these taxes common around the world.

But societies have great trouble dealing with the issue of inequality in a systematic manner. The principle has never been articulated that some degree of inequality is a good thing, that there should be some who are richly rewarded for their business success (or their parents’ success), but that society should put some limits on this inequality.

Because that principle has never been established, the effects of various tax laws are never considered systematically. Thus the wealthy instinctively oppose any increase in their taxes, fearing that acquiescing even to a limited extent might leave them open to a haphazard series of tax increases that, in combination, could amount to confiscatory taxation.

The inequality indexation scheme may not ultimately prove to be the right course, but it at least illustrates how more complex systems of tax rates grounded in risk-management theory and behavioral economics could work. We could introduce more responsiveness and nuance into the tax system to help achieve a better society -- one in which people feel that basic economic fairness is assured.

(Robert Shiller is a professor of economics and finance at Yale University, where he teaches financial markets in the Open Yale Courses program. He is the author of “Irrational Exuberance” and “The Subprime Solution.” This is the third in a series of four excerpts from his new book, “Finance and the Good Society,” to be published April 4 by Princeton University Press. The opinions expressed are his own. Read Part 1, Part 2 and Part 4.)

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author of this story:
Robert J Shiller at robert.shiller@yale.edu

To contact the editor responsible for this story:
Mary Duenwald at mduenwald@bloomberg.net