Taxes and Income Inequality

By :: October 14th, 2010

Lori Montgomery’s nice piece in the The Washington Post this morning described how some congressional Democrats want to use the looming tax increases on high-earners to help redress income inequality in the U.S. But would these tax hikes matter very much?

There are two issues to think about here. The first: Would relative after-tax incomes change a lot if the Bush-era tax cuts were extended for low- and moderate-income taxpayers but allowed to expire for the highest-earners? The second is what would the government do with the extra revenue it receives if those top-bracket tax cuts do expire? Would it necessarily spend the funds in a progressive way?

The answer to the first question is "less than you might think." The answer to the second  is "no." 

Here are some numbers to help you think about the effect of taxes on incomes:
First, there is no doubt that incomes have risen much faster for the highest earning one percent of households than for the rest of us. According to the Congressional Budget Office, between 1979 and 2007, average pre-tax income for the top one percent more than tripled--from $550,000 to nearly $1.9 million. By contrast, average pre-tax income for those households in the middle 20 percent of income rose by only about 20 percent--from $54,000 to $64,500.

But how much did taxes affect incomes of the wealthy? The CBO numbers give a rough idea, and you might be surprised by the answer.  From 1979 to 2007, after-tax income for those top-earners rose from $347,000 to $1.3 million—a rate of increase that wasn’t much different than before they paid taxes.  

The pattern changed somewhat, however, after the 2001 and 2003 tax cuts. For those top-earners, average pre-tax income rose from $1.5 million in 2000 to $1.9 million in 2007, an increase of about 27 percent. But from 2000-2007, their after-tax income increased from about $1 million to $1.3 million, a hike of about 30 percent, largely because Congress cut their average federal tax rate from 33 percent to 29.5 percent. Thus, those Bush-era tax cuts did play a part in boosting after tax-incomes for high-earners.  But for the most part, those folks got rich thanks to the money they made, not from the taxes they saved.

And remember that President Obama’s proposal to extend the tax cuts  for income under $200,000 (or $250,00 for couples) would still increase after-tax incomes for the highest earners by about 2 percent--relative to all the tax cuts expiring.

Btw, for those middle-income households, after-tax income rose from about $50,000 in 2000 to $55,000 in 2007, an increase of about 10 percent.  Their average federal tax rate was cut from 13.5 percent to 13.1 percent. 

But keep in mind that the CBO calculations show the direct impact of tax payments (as well as federal income transfers such as Social Security) on income. They exclude a potentially more important factor—how the tax laws helped high-earners make their money in the first place. For instance, a lot of folks got very rich in the real estate business over this period—an industry fueled by tax subsidies. And few politicians are talking about addressing those tax code issues.

Finally, let’s take a quick look at what government would do with those tax revenues, and whether higher taxes on the wealthy would generate more progressive spending. This is very hard to know, but my guess is that it would not.

Here’s why: The biggest government programs—defense, Medicare and to a lesser degree even Social Security-- are not aimed at the poor. Many other subsidy programs, both those administered through the tax code and those designed as direct spending, tend to be regressive. For instance, the biggest beneficiaries of farm assistance are agribusinesses, not family farmers. The big winners from the home mortgage deduction or the exclusion for employer-sponsored health insurance are higher-earners, not the middle-class households. 

Quantifying all this is not simple, but I certainly wouldn’t assume that more tax revenues will equal more spending on the poor or middle-class. And even if it did, the amount of increase would be pretty small.   

Bottom line: The Democrats are right that income inequality is a problem. But they are wrong if they think that letting the 2001-2003 tax cuts on high-earners expire will do much to solve it. 

7Comments

  1. Anonymous  ::  8:47 pm on October 14th, 2010:

    And yet, conservatives like Rep. Cantor argue that not keeping the tax cut in place is some form of class warfare. As I posted on the Fiscal Times, a reason for governmental redistribution is to correct for the maldistribution of income in an unfree labor market – which is made possible by government benefits to corporations and other capitalist businesses. The fact that this correction is not adequate to the subsidy for the rich is not grounds for endiing the correction, but for increasing tax rates on the wealthy even more.
    Back before the Reagan tax cuts, companies had less of an incentive to play hardball on salaries, since most of the money going to investors and/or managers for doing so would be taxed. It is no accident that salary raids and union busting began in earnest under Reagan and not just because of lax DOL enforcement – but because changes in the tax code made doing this pay.
    The problem becomes how to undo the implicit inequaltiy. Controls don't work and taxes will never go up as high as they used to be (although the prospect is tempting).
    Social Security reform may be an avenue for equalizing wages if personal retirement accounts are managed by the union and if they can be managed to maximize salary benefits as well as short term return. The other option is to allow concentrated ownership of one's employer in personal accounts. Eventually, most firms will go private (or stay private) and be owned by rank and file employees rather than management – with the rank and file in control of what management and executives are paid. This would especially be the case if the employer contribution to these accounts was equalized (decoupled from salary) with the income cap removed – with the added feature of shifting all contributions to employers).
    Now that would be successful class warfare.
    The other aspect of redistribution is land reform. The current crisis is masking a land grab by the wealthy – which must lead to a discussion of land value taxes as a way to equalize income – since people's largest expense is still housing. An LVT which extracts the value of these holdings will cause excessive land accumulation to end, especially if this is attached to a citizen dividend that both redistributes income and cancels out the tax obligation of single-family homeowners.
    None of these three of these options (high taxes, personal accounts, land value taxes) are ever discussed – they are essentially off limits – even at TPC. I can assure you that if the personal account scheme I have described was discussed, no one would talk about Social Security reform for a while – especially on the Republican side. Indeed, the Tea Party would protest anyone who did. Discussing any of these would also jeapordize the funding of Brookings, Urban and TPC, so I doubt a more in-depth discussion will occur (although I would love to be proven wrong on this).

  2. Anonymous  ::  4:25 am on October 15th, 2010:

    Raising tax rates on high incomes will certainly reduce the inequality in reported taxable income. However it will have very little effect on total economic incomes at the high end. The rich will simply shelter income or refrain from realizing capital gains.
    Raising rates to suppress reporting of taxable income is like putting ice on a thermometer to reduce the temperature. Only the measurement changes; reality remains the same.

  3. Anonymous  ::  7:59 pm on October 18th, 2010:

    Can somebody explain to me the “problem” with income inequality?
    I can only see two reasons:
    1. It's morally wrong
    2. It creates inefficiency in the economy
    If it's seen as “morally” wrong then its only a matter of taste, a point of view i.e. if you can get a majority of the voter to agree. However it has no intrinsic value.
    If it creates inefficiency then in my opinion it has to be addressed.
    However the problem is how to measure income inequality.
    I've read so many studies on the subject that I've come to the conclusion that you can find authoritative studies for any point of view.
    So I would like you to talk about income inequality as a problem for a social scientist to address. It's purely a political and philosophical problem. A pure matter of taste!
    Let me illustrate it simple. We have a pair of identical twins, they have the same cognitive abilities and an IQ over 125 and an GMAT score of 750.
    One becomes a banker with an MBA and makes $ 1,000,000 a year and the other has a master in creative writing. He's been working on his “Great American Novel” and as a result never have held a job for long only long enough to qualify for unemployment and welfare benefits.
    So tell me why should two individuals be taxed differently because of their personal choices? How can it be morally right to tax the banker 50 % of his income and redistribute it to his brother? If there ever was an undeserving poor it is the non productive brother. A true parasite on society!

  4. Anonymous  ::  8:01 pm on October 18th, 2010:

    Correction:
    “So I would like you to stop talking about income inequality as a problem for a social scientist to address.
    It's purely a political and philosophical problem. A pure matter of taste!”

  5. Anonymous  ::  6:29 pm on October 19th, 2010:

    I think the CBO's numbers are on realized income. They entirely ignore unrealized gain.
    The tax rate for the truly wealthy (think Gates, Buffett, Ellison, and Page & Brin) is effectively zero because they never realize their gains, but can borrow against their holdings and spend the borrowings, without tax. Larry Ellison is famous for having borrowed $1 billion against his Oracle stock.
    This is the effect of our realization system of taxation and it is a significant factor in explaining how the wealth of the 0.1% richest has increased disproportionately to the remaining 99.9%.
    A mark-to-market system of taxation for the publicly-traded securities of the wealthiest 0.1% would fix this, level the playing field between wage earners and stockholders, and finally subject shareholders to the same tax on economic income that wage earners are currently subject.
    For more on this, see govinfo.library.unt.edu/taxreformpanel/meetings/docs/miller_052005.ppt and http://www.cadwalader.com/assets/article/120505MillerTaxNotes.pdf

  6. Anonymous  ::  1:24 am on October 20th, 2010:

    Sweden is now changing its taxation of capital gains to a system were everybody has an account and in that account an annual tax of 27 % of the base government interest rate is paid as an annual tax.
    It would go far to mitigate the super rich paying no taxes and would stimulate ordinary savers and basically get rid of all tax planning. A super efficient system and extremely fair.

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