Income Inequality and Tax Policy: Q & A

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?

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.

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

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

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.

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.

As the original author of the OECD study notes:

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.

Federal Contract Workers Living in Poverty?

In his recent op-ed in the New York Times, M.I.T. economist Paul Osterman makes some sensible points about the troubling social implications of low-wage jobs. Although I disagree with some of his policy prescriptions, it’s difficult to deny the struggles that low-income households face on a regular basis. High rates of poverty can have a profound cultural impact, and I think this is an issue that social conservatives should take much more seriously.

Unfortunately, to make his point Osterman cites some research conducted by the Economic Policy Institute (EPI) that suggests “20 percent of federal contract employees earned less than the poverty level for a family of four, as opposed to 8 percent of traditional federal workers.”

This seemed like a pretty dubious finding, so I looked into the research methodology employed by EPI and was pretty shocked at what I uncovered.

Since the federal government doesn’t maintain any data on the number of federal contractors or their average wages, EPI collected information on the cost of each individual government contract from a database maintained by the General Services Administration’s (GSA). The GSA database also provides a record of which industry the contract targeted.

EPI compared the cost of each contract against the Bureau of Labor Statistics’ (BLS) Domestic Employment Requirements Matrix, which provides information on the number of jobs that we’d expect to see generated -- both directly and indirectly -- across all industries based on a $1,000,000 input in a particular industry.

The concept here is pretty simple. If the BLS matrix showed that a $1,000,000 input in the construction industry should be expected to generate three jobs, EPI assumed that a $100,000,000 investment in federal construction contracts would generate 300 federal contract workers.

After figuring out the total number of federal contractor workers in each industry, EPI multiplied this number by the proportion of workers in that industry who earned below the poverty wage level. This gave EPI a figure of approximately 20 percent of federal contract workers living below the poverty line.

As EPI notes, “[t]his methodology assumes that the same proportion of contract workers earn poverty level wages as workers in the private sector.” (A poverty level wage is defined as a wage rate that would place a full-time worker supporting a family of four below the poverty line.)

Even if we accept all of EPI’s other assumptions, the idea of industry-level wage equivalence between federal contract workers and other private sector workers is completely indefensible. A huge number of federal contract workers are subject to laws like the McNamara-O'Hara Service Contract Act (SCA) and the Davis-Bacon Act (DBA), which require contractors on federally-funded projects to pay their workers at least the prevailing wage in the industry. It’s almost nonsensical to assume these workers represent a random cross-section of workers in the industry. In fact, they are legally entitled to a wage that is at or above the industry average.

Moreover, if we can assert without evidence that federal contract workers are paid the same as private sector workers in a given industry, isn’t it just as fair to assert that federal contract workers are paid the same as federal employees in that industry area? The researchers who put this study together may believe that federal contract workers are paid less than similarly employed federal workers, but making this assumption undermines the entire analysis. EPI is simply asserting what it's attempting to prove.

There are two major lessons that I think need to be drawn from this example.

First, not all “research” is good research. It bothers me how often we hear that there is research “on both sides” of an issue. A blanket statement like this is an easy way to avoid checking the methodological rigor of different studies. This isn’t to say that a left-leaning or right-leaning think tank can’t do good work. It simply means that we need to understand the research design being employed so we can decide for ourselves whether the findings are valid.

Second, we shouldn’t simply trust research findings cited by an op-ed columnist to make a rhetorical point, particularly when those findings are produced by a research institute that is ideologically inclined to generate a particular result. Again, we should look at the study methodology and think through some of the assumptions.

I suspect that, when confronted with the assumptions inherent in this analysis, most people would find the results of EPI’s study questionable. But it’s hard to know that unless you’re nerdy enough or bored enough to do some real digging.

Update: A new study from the Project on Government Oversight (POGO) suggests that "the federal government approves service contract billing rates—deemed fair and reasonable—that pay contractors 1.83 times more than the government pays federal employees in total compensation, and more than 2 times the total compensation paid in the private sector for comparable services." I haven't combed through the methodology of this study yet, but a cursory examination reveals that it's far more sophisticated. At the very least, this study suggests that the key assumption in EPI's analysis is highly questionable based on other research findings.

My Complex Feelings on the Individual Mandate

With the Supreme Court now likely to take on challenges to the constitutionality of the individual mandate, it seems an appropriate time to explain my complex feelings about this controversial aspect of health care reform.

Let’s start with what I like about it.

There’s almost no question that the individual mandate is good policy. Anyone with even a cursory knowledge of insurance markets knows that adverse selection is a serious threat to the affordability of individual health coverage, and this threat is made worse by the guaranteed issue and community rating provisions in the Patient Protection and Affordable Care Act (PPACA).

The mandate corrects for an obvious market imperfection and achieves what almost everyone agrees is an important national priority: making sure that people aren’t driven into bankruptcy due to unforeseen illness. While the polling on health care reform is far from straightforward, it’s clear that a large number of Americans see affordable health care as a right of citizenship. The mandate itself doesn’t necessarily curb the long-term growth in health care costs, but it certainly expands access to medical services. It’s hard to argue that this is a bad thing.

The problem is that a mandate isn’t exactly the least intrusive means of achieving this important national priority. And even if it were the least intrusive means, it’s certainly not the only means, as many proponents of the PPACA would have you believe.

Indeed, anyone who can’t conceive of a workable alternative to the individual mandate probably hasn’t thought about it very hard. The Government Accountability Office (GAO) recently offered several promising approaches that are far more likely to pass constitutional muster. 

One of the most sensible options proposed by GAO is to impose a penalty on individuals who receive uncompensated health care, or on the employers of these individuals. This would incentivize the purchase or provision of health insurance in much the same way as a mandate, without stretching interpretations of the Commerce Clause (and the Necessary and Proper Clause) beyond the boundaries of logic.

The differences here may seem academic, but the constitutional implications are enormous. By imposing a penalty on individuals who receive uncompensated care, Congress would be regulating an actual economic transaction resulting from individual engagement in the health care market. That’s pretty different from Congress asserting the power to draw people into a market transaction, and then regulate that transaction.  

From a constitutional law perspective, the key question is whether the individual mandate is a valid use of Congress’s authority to regulate interstate economic activity. (We’ll return to the question of whether the associated “penalty” could be justified under the Taxing and Spending Clause in a moment.)

Because the Court has adopted an “aggregation principle” – whereby virtually any activity, however local or non-commercial, can be regulated if it would have a substantial effect on interstate commerce when collectively undertaken – the distinction between interstate and intrastate has become so fuzzy as to be almost irrelevant (see Wickard v. Filburn and Gonzales v. Raich).

So, no one denies that Congress has broad power to regulate even some of the most provincial activities under certain circumstances. But proponents of the individual mandate take the aggregation principle one step further, arguing that failure to engage in economic activity has a substantial aggregate effect on interstate commerce, and therefore falls under the regulatory purview of Congress.

This line of reasoning presumes that a lack of engagement in activity constitutes a form of activity. At the very least, it presumes that this distinction is irrelevant.

Whether the Court will ultimately allow the individual mandate on these grounds remains to be seen, but the logical problems here should be readily apparent. Even where the Court has upheld restrictions on fundamentally non-economic activities under the Commerce Clause, it has always pointed to some form of activity that, when taken in the aggregate, substantially impacts commerce. If the Court now finds the distinction between activity and inactivity meaningless, it’s very difficult to think of a limiting principle for congressional authority under the Commerce Clause.

Every minute that a person remains inactive is a minute she could be purchasing millions of products. If her failure to purchase these products constitutes interstate commerce, it’s not entirely clear what wouldn’t.    

The Court has previously expounded on the importance of a limiting principle with respect to the Commerce Clause (see United States v. Lopez):

The possession of a gun in a local school zone is in no sense an economic activity that might, through repetition elsewhere, substantially affect any sort of interstate commerce. Respondent was a local student at a local school; there is no indication that he had recently moved in interstate commerce, and there is no requirement that his possession of the firearm have any concrete tie to interstate commerce.

To uphold the Government's contentions here, we would have to pile inference upon inference in a manner that would bid fair to convert congressional authority under the Commerce Clause to a general police power of the sort retained by the States. Admittedly, some of our prior cases have taken long steps down that road, giving great deference to congressional action. The broad language in these opinions has suggested the possibility of additional expansion, but we decline here to proceed any further. To do so would require us to conclude that the Constitution's enumeration of powers does not presuppose something not enumerated and that there never will be a distinction between what is truly national and what is truly local.

If Court believes that the possession of a gun in a school zone has “no concrete tie to interstate commerce," by what line of reasoning could not possessing health insurance possibly constitute economic activity? The logic is at best strained, and at worst incoherent.

There is, of course, another possible constitutional justification for the individual mandate under the Taxing and Spending Clause. Many proponents of the mandate have argued that a non-compliance “penalty” assessed through the Internal Revenue Code is the functional equivalent of a tax, and thus clearly falls within Congressional authority under Article I, Section 8 to “lay and collect Taxes, Duties, Imposts and Excises.” This reasoning has been rejected by every court that has ruled on the constitutionality of the mandate.

To summarize the problems with this argument briefly: the penalty is clearly designed to be a “punishment for an unlawful act or omission” (see U.S. v. Reorganized CF&I Fabricators of Utah, Inc., et al.). It is referred to as a “penalty” in the legislation, and it unambiguously meets the Court’s definition of a penalty. Moreover, the penalty cannot be considered an excise tax because there’s no “event” to be taxed. It is also cannot be considered an income tax under the Sixteenth Amendment because it is not levied on “undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion” (see Commissioner v. Glenshaw Glass Co.), but rather triggered by a failure to purchase health insurance. To call the penalty a tax is to obviate any distinction between taxes and penalties.   

In short, justifications for the individual mandate under both the Commerce Clause and the Taxing and Spending Clause seem difficult to construct. It is at least plausible that the mandate will be struck down.  

Let me stress that I have no idea which way the Court will actually come down on this issue. Maybe there's something key here that I'm missing. If the mandate is upheld, I’ll have mixed feelings. Health care is a special case, and the federal government should be doing more to control costs and expand coverage. But it’s far from clear to me that there are no alternatives to the individual mandate. In fact, there are many ways to achieve this important policy goal through constitutionally legitimate means.

What concerns me is that this debate isn’t really about the individual mandate or health care reform at all. It’s about an expansive interpretation of federal power. That’s a fair discussion to have, but let’s not pretend that the whole controversy relates to a single policy solution for which there is no reasonable alternative.