How the Tax System Could Help the Middle Class

By :: March 13th, 2014

Today I testified at a Senate Finance Committee hearing on “Innovative Ideas to Strengthen and Expand the Middle Class.” The middle class certainly needs help. I shared several suggestions, the most important of which is that we replace automatic inflation indexation with regular adjustment of tax parameters to mitigate growing economic inequality.

figure 1As many commentators have noted, wages have lagged behind productivity for decades.  Median earnings have barely kept pace with inflation since 1974 even as output per worker has soared.   

Some of those productivity gains have paid for increasingly costly fringe benefits, especially health insurance and the employer’s share of payroll taxes. But that cost growth explains only about 10 percent of the gap between wages and productivity. 

Much of the productivity gain has gone not to middle class workers, but to wealthy owners of capital. Globalization and machines that are increasingly good substitutes for workers—think of the self-checkout machines that have supplanted many cashiers—are putting downward pressure on workers’ salaries, even as the owners of capital and executives are doing better than ever.

The solutions to middle class stagnation lie mostly outside the tax system. For many, education is the key to a better life. Specialized training of the sort now offered by many community colleges in collaboration with local businesses can prepare workers to operate complex machines. That would make it possible for them to benefit from technology rather than become victims of it. And a college degree is still the surest path to a comfortable upper-middle class life.  Policymakers should aim to simplify the bewildering array of higher education programs and subsidies (some of which are in the tax system) and make sure that middle class kids know that a degree is within their reach, without the burden of crushing debt.

Policymakers should also redouble their efforts to control health care costs. If health inflation moderates, employers could raise wages instead of increasing payments for health insurance.

Encouraging saving would help the middle class, who often lack sufficient assets to protect themselves from job losses or other shocks to income. Policymakers should revisit the Universal Savings Account program that the Clinton Administration proposed—a progressive retirement savings vehicle. It is similar in some ways to the current Savers’ credit in that the subsidy is highly progressive and to the President’s MyRA proposal, which allows for automatic enrollment, but USAs would include automatic annual contributions of up to $300 per worker for low- and moderate-income workers along with the matching contributions.  The subsidies would automatically go into 401(k)-type accounts.  Clinton’s original proposal was targeted at retirement saving, but the accounts could also protect against job loss or help pay for a down payment or education.

Encouraging saving and education would fit well into a bipartisan opportunity agenda—and there seemed to be support for that approach among the senators in attendance. But they are not the only solutions: The progressive income tax plays an important role in mitigating the gap between rich and poor and it could do more

My most “innovative”—some would say “radical”—policy option would replace across-the-board price indexing, which exists under current law, with indexation that reflects changes in economic inequality.

Currently, tax bracket thresholds and some other parameters of the tax law are adjusted proportionately to account for inflation. Thus, if prices rise by 3 percent, the standard deduction, personal exemptions, tax rate thresholds, and certain other parameters also go up by 3 percent.

My alternative would adjust those tax provisions in a different way: If incomes at the top rise while all other incomes stagnate, then the parameters that most affect low- and middle-income households would be adjusted the most. The credit rate for the EITC, the size of the child tax credit (CTC), and the size of the personal exemption and the standard deduction would increase disproportionately, while the top tax rate thresholds might not change at all. I would not raise top marginal tax rates (as I did in an earlier proposal with Bob Shiller and, Jeff Rohaly) and so would not change incentives for those with high incomes. But the plan would push gently against the winds of rising economic inequality.

My alternative would change total tax revenues by the same amount as price indexation. Tax rates would not change and income thresholds for each bracket would never decline in nominal terms—so someone whose income didn’t grow would never land in a higher tax bracket. If all incomes grow proportionately, indexation would operate just as it does today.   

Over time, there is a lot of money in play. My Tax Policy Center colleague Amanda Eng estimates that if inflation plays out as CBO predicts, indexation under current law will reduce tax revenues (compared with the current level of tax parameters) by over $200 billion in 2025. Reallocating the money so it most benefits those who suffer most from increasing income inequality won’t solve the problem, but it would help those being left behind.

You can find my testimony here.  Feel free to share your own ideas for helping the middle class in the comments section.


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