Tax Policies and Income Inequality

The rise in income inequality coincides with a period in which the top income tax rates have been drifting downward. This begs the obvious question as to whether or not there is a correlation. Timothy Noah addresses this concern, and others related to tax policy, in his book on the growth of income inequality: The Great Divergence.

Noah concludes that the top marginal rate can only be a small contributor to inequality because the effect of the various deductions and rebates available to the top earners had always lowered the effective top tax rate. This effective rate for the wealthy was, in fact, little changed over the years.

Noah suggests that tax policies do play a role in generating inequality, but the means and mechanisms are more subtle and not so easily identified. The US does have a progressive tax system, less so than most assume, and it does contribute to a redistribution of wealth. However, the extent of the redistribution seems to have diminished over time.

"The Congressional Budget Office calculates that in 1979 the combined effect of federal taxes and government benefits on income inequality (as measured by the Gini index) was to reduce inequality by 23 percent. By 2007 the combined effect remained progressive. The federal government was still distributing money downward. But it was reducing it by 17 percent. That means that during the Great Divergence the federal government has reduced its direct redistribution—through collecting taxes and awarding benefits—by about a quarter. So the effect of all federal taxes and benefits is significant—much more so than the effect of income taxes alone."

Some data provided by The Economist based on OECD analysis and presented here provides a look at how the US compared with the redistribution efforts of other countries in 2009.

In this analysis the US redistribution activities lower the Gini index by about 23%. It is not clear that the two data sets are comparable, CBO and OECD, and in 2009 the Great recession was still providing temporary influences on both incomes and government transfers. One thing is clear: policy decisions can have a large effect on inequality and the US does less than most European countries in alleviating it.

Noah suggests that "institutions and norms" have contributed to the growing inequality. He defines this phrase as "stuff the government did, or didn’t do, in more ways than we can count." Noah quotes Paul Krugman, from his book The Conscience of a Liberal: "....a strong circumstantial case for believing that institutions and norms....are the big sources of rising inequality in the United States." The notion that there are varied and subtle ways in which income distribution can be affected by government policy is supported by data that compares growth in income by income level under Democratic and Republican presidents. Republicans produce an environment in which income is heavily skewed toward the wealthier citizens; the Democrats produce a much more uniform growth in income. This issue was discussed in Democratic Presidents vs. Republican Presidents: Income and Jobs.

So "institutions and norms" contribute to income inequality. But what exactly does that mean?

Consider this data from The Economist on the ten largest tax expenditures under US policy. Tax expenditure is a term that refers to government distribution of funds via tax deductions, rebates and credits, rather than by direct budgeting of monetary transfers.

It is not difficult to conclude that each of these is designed to provide a greater benefit to the higher income members of society than to those at the lower end of the scale. Just those ten tax expenditures add up to $705B—with the total of all such expenditures adding to over $1T. The article provides this additional insight.

"...the bottom 40%....they collectively enjoy just 11% of all tax expenditures....the preferential rate on capital gains and dividends; 75% of those benefits go to the top 1% of households."

Suzanne Mettler addresses the issues associated with tax expenditures in her book: The Submerged State: How Invisible Government Policies Undermine American Democracy. She provides data on how three of the largest and most popular deductions are shared by the various income groups.

One might think that the deduction for employer provided health insurance would be neutral, but Mettler points out:

"As of 2009, in the lowest income quintile, only 16 percent of Americans under age sixty-five had employer-sponsored health insurance—compared to 85 percent of those in the top quintile....[in 2004] 30 percent of the benefit was allocated to families in the top 15 percent of the income distribution."

The deductions for mortgage interest and retirement contributions are even more biased toward the wealthy.

"The most skewed distribution accompanies the Home Mortgage Interest Deduction and the tax-free status of retirement benefits: in 2004, 69 percent and 55 percent of the benefits from each of these policies, respectively, were conferred on Americans with household incomes of $100,000 or more—the top 15 percent of the income distribution."

Mettler focuses on the tax expenditures specifically aimed at encouraging "socially useful" behavior. As of 2010, they were 151 in number.

"The costs are substantial: on net, as of 2008, the amount lost in federal revenues due to social tax breaks was equivalent to 7.4 percent of GDP, up from 4.2 percent in 1976. To put this in perspective, ‘visible governance,’ meaning total direct federal spending—on all domestic programs, the military, and interest on the debt—amounts to approximately 18 percent of GDP, making social tax expenditures comparable to between one-third and one-half as much."

While it is not possible to associate all, or probably even the majority, of the growth in income inequality to federal tax policies, clearly they have played a role. The net effect of these tax expenditures is to funnel money out of the general tax base and flush it preferentially upward towards the higher income earners—hopefully, not what most legislators were sent to Washington to accomplish.

Mettler’s book and some of her findings are also discussed in Governance in the United States: Confronting the Submerged State.