Taxes and Inequality

By Dave Anderson:

Felix Salmon raises an interesting point about incentives and government revenue. Progressive taxation, he argues, may lead to increased inequality. This is intriguing, contrarian, but seems to be wrong once we look at data and history, at least in the United States.

Remember too that when you have a progressive tax system, especially when there are surcharges on people making seven-figure incomes, you also have a system where for any given level of national income, the greater the inequality, the greater the government’s tax revenues. And indeed federal revenues have been rising faster than median wages for decades now, thanks to the rich getting ever richer.

Given the government’s insatiable appetite for cash, it’s only natural that it would prefer to tax plutocrats, spending some of that money on poorer Americans, rather than move to a world where poorer Americans earn more (but still don’t pay that much in taxes), and the plutocrats earn less, depriving the national fisc of untold billions in revenue.

The government’s interests, then, are naturally aligned with those of the plutocrats — and when that happens, the chances of change naturally drop to zero.

Since World War II, income inequality and top marginal rates have varied greatly. Under Salmon's hypothesis, we would see the largest levels or growths of inequality in the mid-50s and early 60s when top bracket rates were extraordinarily high. However that is when we saw the great compression and the growth of a mass middle-class. We would have expected to see a decrease in inequality after the 1981 Kemp-Roth Reagan tax cuts or the 1986 tax code reform; instead we saw a steady increase in inequality. We would have expected to see inequality decrease after the Bush tax cuts at the start of this decade. We saw none of that. And a good portion of that is that the income tax system is reasonably progressive (as long as one has money and a bad accountant) but the rest of the tax system is not particurly progressive.

Kevin Drum ran the math on the incentives to for increasing inequality from a budgetary standpoint and the incentive is weak as hell:

shows the total federal tax rate (income tax, payroll tax, etc.) for various income groups.1 As you can see, it's progressive, but it's not that progressive. And that makes a difference.

Here's why: although the top 1% (the four richest groups in the chart) has a lot of income, the 60-80th percentile has about the same amount. That's because although their incomes are a lot lower, there are a lot more of them. So what happens if that group loses, say, 10% of its income and it goes instead to the very tippy-top earners? Answer: total revenue to the government goes up about 1%. The same is roughly true for the other income groups as well.

The policy changes over the past ten years have been to make the tax system much less progressive. We have seen dividends go untaxed, we have seen capital gain tax rates dramatically cut, and we have seen estate taxes eliminated and now ratcheting back to their pre-Bush levels unless the Democrats who are afraid of their own shadows but claim to be "deficit" hawk hypocrites can freeze those rates and exemptions again. Dividends, capital gains and massive inheritances don't accumulate in significant quantiy to any large number of families until the we reach the top quintile, and usually the top decile of the income distribution. And we have, unsurprisingly seen significantly greater inequality.

Comments

[John Ballard]

Don't forget payroll taxes which are not only flat for everyone with earned income but subject to an annual cap after which there will be no further taxes until the following January.
Payroll taxes have no analogue for those whose lifestyle derives from tax-free investments, annuities, and/or interest income.
Below the so-called middle class are the working poor who do not earn enough to pay income taxes, but whose earnings are taxed from the first dollar earned with no expectation for deductions. (Which is the rationale behind earned income tax credits.)
The cap on payroll taxes is the best-kept secret in America.

[Tax Help]

Our tax system is complicated. Its unfair that poor people have to pay more taxes. Its not healthy for the economy.