There’s been a lot of talk lately about the causes and consequences of income inequality, particularly in relation to tax policy. So, I figured I’d offer some thoughts (and some data) on this subject in the form of an extended Q & A. Enjoy.
Is rising inequality a uniquely American phenomenon?
Is rising inequality a uniquely American phenomenon?
The short answer is no. Since the late 1970s, income inequality has been steadily increasing throughout the industrialized English-speaking world. The time series chart below shows income shares of the top one percent across four major Anglo-Saxon economies.
Source:
Piketty and Saez, The World Top Incomes Database; retrieved from: http://184.168.89.58/sketch/
All four countries appear to be following a similar trend, though the United States is a bit of an outlier in terms of the magnitude of its growth in recent decades. What could possibly account for the discrepancy? If we scrutinize the data a bit more closely, we see a dramatic – and seemingly permanent – jump in the share of income accruing to top earners in the mid-1980s.
Whether or not this theory is correct, it’s clear that other post-industrial Anglophone countries have been following a similar (if slightly less extreme) upward trend. This suggests that the growth in earnings at the top of the income distribution is driven in large part by cross-national factors like globalization. The bottom line is that the increase in U.S. income inequality is far from exceptional, and probably has a lot more to do with larger macroeconomic forces than with U.S. domestic policy.
There doesn’t appear to be any clear pattern in this data suggesting a causal relationship. At the level of simple linear correlation, these factors are simply not associated:
Based on this table, the top ten percent of earners in the U.S. appear to pay a larger share of the income tax burden than in other industrialized nations. This is true both in absolute terms and relative to their proportion of income.
Piketty and Saez, The World Top Incomes Database; retrieved from: http://184.168.89.58/sketch/
All four countries appear to be following a similar trend, though the United States is a bit of an outlier in terms of the magnitude of its growth in recent decades. What could possibly account for the discrepancy? If we scrutinize the data a bit more closely, we see a dramatic – and seemingly permanent – jump in the share of income accruing to top earners in the mid-1980s.
Academic economists have proposed a number of explanations for this jump, but Scott Winship (a resident scholar at The Brookings Institute) makes a compelling argument that it is largely a figment of changes in the tax code:
It helps to know that the 1986 tax reform created big incentives for people who had previously reported income on corporate returns (where it is invisible to the datasets above) to report on individual income tax returns (where it appears as an out-of-the-blue increase). And if this may be considered a permanent change in the tax regime, then the effect is for more income to show up on individual returns after 1986 than before, artificially lifting the top income share in every subsequent year
Whether or not this theory is correct, it’s clear that other post-industrial Anglophone countries have been following a similar (if slightly less extreme) upward trend. This suggests that the growth in earnings at the top of the income distribution is driven in large part by cross-national factors like globalization. The bottom line is that the increase in U.S. income inequality is far from exceptional, and probably has a lot more to do with larger macroeconomic forces than with U.S. domestic policy.
Is U.S. tax policy driving the growth income inequality?
Though Winship provides further evidence to support his theory about the 1986 tax reform, it’s possible that a genuine shift in U.S. income inequality resulted from tax policy changes under the Reagan Administration. But this seems very unlikely given the data.
As wealthier Americans captured an increasing share of the income distribution, they continued to take on an equally large proportion of the federal tax burden. The time series chart below shows the share of income (including capital gains) accruing to the top one percent of households in the United States, along with their share of the federal tax burden.
Sources:
Piketty and Saez, The World Top Incomes Database; retrieved from: http://184.168.89.58/sketch/
Congressional Budget Office, Historical Effective Rates, Historical Effective Tax Rates, 1979 to 2005; December 2008; retrieved from: http://www.cbo.gov/ftpdocs/88xx/doc8885/Appendix_wtoc.pdf
Piketty and Saez, The World Top Incomes Database; retrieved from: http://184.168.89.58/sketch/
Congressional Budget Office, Historical Effective Rates, Historical Effective Tax Rates, 1979 to 2005; December 2008; retrieved from: http://www.cbo.gov/ftpdocs/88xx/doc8885/Appendix_wtoc.pdf
The pattern here is an astounding. At least at the level of simple linear correlation, there is a strong positive relationship between the top one percent’s share of income and their share of federal taxes. Looking at this graph, it’s difficult to argue that top earners have gained a larger proportion of income because they are paying a smaller share of taxes.
However, it is still possible to argue that the declining level of federal taxes paid by top earners is a primary driver of income inequality. Perhaps lower effective federal tax rates for the wealthiest Americans have enabled these earners to gain a growing share of the income distribution.
Again, this doesn’t seem very likely given the data. The time series chart below shows the effective federal tax rate among top earning households, along with the income share accruing to these households.
Sources:
Piketty and Saez, The World Top Incomes Database; retrieved from: http://184.168.89.58/sketch/
Congressional Budget Office, Historical Effective Rates, Historical Effective Tax Rates, 1979 to 2005; December 2008; retrieved from: http://www.cbo.gov/ftpdocs/88xx/doc8885/Appendix_wtoc.pdf
Piketty and Saez, The World Top Incomes Database; retrieved from: http://184.168.89.58/sketch/
Congressional Budget Office, Historical Effective Rates, Historical Effective Tax Rates, 1979 to 2005; December 2008; retrieved from: http://www.cbo.gov/ftpdocs/88xx/doc8885/Appendix_wtoc.pdf
There doesn’t appear to be any clear pattern in this data suggesting a causal relationship. At the level of simple linear correlation, these factors are simply not associated:
CORRELATION MATRIX | ||||
Total EFTR | Income EFTR | |||
Income Share | Income/Gains Share | Income Share | Income/Gains Share | |
R | 0.339 | 0.176 | 0.434 | 0.305 |
R-square | 0.115 | 0.031 | 0.188 | 0.093 |
Is more progressive taxation of income the best solution to rising inequality?
While it’s fairly clear that tax policy is not the central factor driving inequality in the United States, many policy experts have argued that progressive taxation should nevertheless be a central response to the problem.
While it’s fairly clear that tax policy is not the central factor driving inequality in the United States, many policy experts have argued that progressive taxation should nevertheless be a central response to the problem.
Thomas Piketty and Emmanuel Saez, two of the foremost researchers on global income inequality, argue that the “reduction in taxes at the top since 2001 has mechanically exacerbated the discrepancy in disposable income between the rich and the rest of us. Thus, it is obvious that the progressive income tax should be the central element of the debate when thinking about what to do about the increase in inequality.”
In other words, the Bush Administration’s reductions in top marginal income tax rates didn’t make the inequality situation any better. Whether or not tax policy has been a key driver of inequality, it’s certainly something that should be used to address the growing income disparity in the United States.
The argument seems very reasonable, and I personally support resetting the top marginal income tax rates to what they were in the 1990s. But as a long-term solution to the problem of rising income inequality, this simply doesn’t seem very sensible.
To begin with, the U.S. already has a highly progressive federal income tax structure relative to other industrialized countries. The Tax Foundation recently complied OECD data on the ratio of tax shares to income shares across different industrialized countries.
Alternative measures of progressivity of taxes in selected OECD countries, mid-2000s | ||||
Percentage share of richest decile | ||||
1. Share of taxes of richest decile | 2. Share of market income of richest decile | 3. Ratio of shares for richest decile (1/2) | ||
Australia | 36.8 | 28.6 | 1.29 | |
Austria | 28.5 | 26.1 | 1.10 | |
Belgium | 25.4 | 27.1 | 0.94 | |
Canada | 35.8 | 29.3 | 1.22 | |
Czech Republic | 34.3 | 29.4 | 1.17 | |
Denmark | 26.2 | 25.7 | 1.02 | |
Finland | 32.3 | 26.9 | 1.20 | |
France | 28.0 | 25.5 | 1.10 | |
Germany | 31.2 | 29.2 | 1.07 | |
Iceland | 21.6 | 24.0 | 0.90 | |
Ireland | 39.1 | 30.9 | 1.26 | |
Italy | 42.2 | 35.8 | 1.18 | |
Japan | 28.5 | 28.1 | 1.01 | |
Korea | 27.4 | 23.4 | 1.17 | |
Luxembourg | 30.3 | 26.4 | 1.15 | |
Netherlands | 35.2 | 27.5 | 1.28 | |
New Zealand | 35.9 | 30.3 | 1.19 | |
Norway | 27.4 | 28.9 | 0.95 | |
Poland | 28.3 | 33.9 | 0.84 | |
Slovak Republic | 32.0 | 28.0 | 1.14 | |
Sweden | 26.7 | 26.6 | 1.00 | |
Switzerland | 20.9 | 23.5 | 0.89 | |
United Kingdom | 38.6 | 32.3 | 1.20 | |
United States | 45.1 | 33.5 | 1.35 | |
OECD-24 | 31.6 | 28.4 | 1.11 | |
Source: Computations based on OECD income distribution questionnaire. | ||||
Based on this table, the top ten percent of earners in the U.S. appear to pay a larger share of the income tax burden than in other industrialized nations. This is true both in absolute terms and relative to their proportion of income.
Progressivity is not the same as redistribution. Progressivity measures how the distribution of the tax burden is shared, while redistribution measures how much the tax system reduces inequality. Redistribution is influenced both by the progressivity of taxes and the level of taxes collected . . . . [T]he USA reduces inequality a lot less than most other countries, because the other thing that you need to take into account is what taxes get spent on. While the US tax system is progressive and reduces inequality, the US welfare state is much less effective at reducing inequality.
Lest anyone fail to believe that federal income taxes in the United States are highly progressive, here is some additional data from the left-leaning Tax Policy Center:
Effective Federal Tax Rates Under Current Law, By Cash Income Percentile, 2011 | |||||||||||
Cash Income Percentile1 | Average Effective Tax Rate | ||||||||||
Individual Income Tax2 | Payroll Tax3 | Corporate Income Tax | Estate Tax | All Federal Tax4 | |||||||
Lowest Quintile | -5.7 | 6.2 | 0.4 | 0.0 | 0.8 | ||||||
Second Quintile | -2.8 | 8.1 | 0.5 | 0.0 | 5.7 | ||||||
Middle Quintile | 3.2 | 8.8 | 0.5 | 0.0 | 12.4 | ||||||
Fourth Quintile | 7.0 | 8.9 | 0.7 | 0.0 | 16.4 | ||||||
Top Quintile | 14.0 | 5.6 | 3.2 | 0.2 | 23.1 | ||||||
All | 9.0 | 7.0 | 2.0 | 0.1 | 18.1 | ||||||
Addendum | |||||||||||
80-90 | 9.3 | 8.9 | 0.9 | 0.0 | 19.1 | ||||||
90-95 | 11.7 | 8.1 | 1.3 | 0.0 | 21.1 | ||||||
95-99 | 15.1 | 5.3 | 2.4 | 0.1 | 23.0 | ||||||
Top 1 Percent | 18.5 | 1.7 | 7.0 | 0.5 | 27.6 | ||||||
Top 0.1 Percent | 19.1 | 0.8 | 10.3 | 0.7 | 30.8 | ||||||
We already have a progressive income tax structure. This is the key problem that Piketty and Saez seem to be overlooking. What we don’t have – and what we truly need – is a highly redistributive spending structure. Piketty and Saez aren’t alone in conflating income tax progressivity with redistribution. Pundits on both sides of the political spectrum tend to collapse these two concepts together. It’s simply the way that Americans frame this debate.
For those who support much more dramatic progressivity in the U.S. tax structure, the obvious question is why it really matters that our income tax system is already highly progressive. Given the dramatic growth in inequality over the past several decades, shouldn’t it be even more progressive?
There are several reasons why this is not the case, but I’ll focus on what I believe are the most compelling.
First, a more progressive tax system means far more revenue volatility, which means far more uncertainty for the federal government. When we narrow the tax base, we take on more risk. Any tax policy expert will tell you that a narrow tax base is risky for the same reasons an undiversified investment portfolio is risky. You’re putting all of your eggs in one basket. It’s particularly important to understand the problems with narrowing the tax base when we’re already deriving over 25 percent of our all federal revenues from the top one percent of earners whose incomes are the most volatile.
Second, exempting such a large portion of the income distribution from paying federal income taxes creates a potential free-rider problem. In 2010, about 45 percent of households paid zero (or negative) federal income taxes. While the majority of these earners contributed to federal payroll taxes, these levies were tied (at least in theory) to specific entitlement programs. It’s easy to see why this kind of tax structure poses a problem for our political system. People who pay no federal income taxes are more likely to vote for additional government services when they know someone else is consistently paying the cost of these services. As a practical matter, everyone should have some skin in the game.
Third, higher marginal rates have a dampening effect on productivity, though recent evidence suggests that behavioral effects are far smaller than many conservatives economists seem to believe. Even if increasing marginal rates had no impact on work incentives, however, it would still be distortionary in other ways. Higher marginal rates lead to less economically efficient outcomes, and typically cause wealthier earners to shelter money in places where the federal government can’t get to it.
Fourth, generating more revenue from a small number of wealthy earners may seem like a good way to limit their power, but it’s probably not. In fact, there’s good reason to believe that a highly progressive tax system has the opposite effect. If the federal government is financially dependent on a small number of wealthy Americans, it’s likely that these Americans will have more influence over our political system. If we want to make the government officials less beholden to the rich, it might be a good idea to make sure a large chunk of their paycheck isn’t coming from these individuals.
In the debate over income inequality in the United States, I wish we would spend more time talking about redistributing on the spending side and less time talking about taxing the rich.
