The Economics and Politics of Inequality, Part 2 – The Role of Tax Policy

Economic inequality is an important issue this year, because a growing number of Americans now see it as a threat to their living standards and aspirations.  Mitt Romney and others say that envy, not facts, drives this debate.  But the facts are too large and well-known to dismiss, starting with the astounding one that from 1976 to 2007, the share of the country’s annual national income which the top 1 percent takes home rose from 8.7 percent to 23.5 percent.  Stated differently, over the last three decades, almost 15 percent of annual national income shifted from the bottom 99 percent to the top 1 percent.  To be sure, most Americans found this upward redistribution acceptable so long as their own incomes were rising.  But that changed in the 2002-2007 expansion when for the first time on record, the incomes of most Americans stagnated or fell through ostensibly good times.  And since the average income of the top 1 percent increased 65 percent over those same years, inequality accelerated. 

Does this new inequality reflect simply the way that an advanced market economy operates these days, or has public policy contributed to it?  The truth is, we are not helpless in the face of economic forces, and tax policy in particular is a real factor.  

To understand how and why, we have to start with the distribution of wealth as well as incomes.   The reason is that most of the income of those at the top comes from their wealth, in the form of capital gains, interest and dividends.  And wealth in America is now distributed even more unequally than incomes.  In 2007, the top 1 percent owned nearly 35 percent of all wealth in the United States, and the top 20 percent held 85 percent.  Moreover, this inequality of wealth is even more pronounced for the financial assets that produce the capital gains, interest and dividends.  In 2007, the top 1 percent held almost 43 percent of the value of all stocks, bonds and other financial instruments, including pension plans and retirement accounts; and the top 20 percent held an astonishing 93 percent of all those financial assets. 

Tax policy is a link between the inequalities of wealth and income, because we tax the income from wealth at lower rates than the income that most Americans earn from their own labor.  That is why, of course, Warren Buffett pays a lower tax rate than his secretary – and how Mitt Romney managed to pay only 13 percent in taxes on an income of more than $20 million last year.  Moreover, this tax favoritism for the income earned by those at the top has a compounding effect on the growing inequalities of both income and wealth.  The smaller tax bite leaves more of the income of those at the top to be reinvested in more financial assets, which then generate more income than is taxed at lower rates, and on and on.  

The defenders of these arrangements say that everybody benefits, because low taxes on capital income encourage more investment that raises productivity, which in turn lifts everyone’s wages.  It’s a nice story, but most economists cannot find hard evidence that lower taxes on financial income lead to significantly higher overall investment.  And even if there were such evidence, the link between productivity gains and broad wage increases broke down in the last decade, which is another reason why income and wealth inequalities have reached record levels.

We can see the role of tax policies by comparing what has happened to the incomes of different groups, before and after taxes.  To begin, from 1979 to 2007, after-tax income grew faster than pre-tax income up and down the income distribution.  Tax policy, then, reduced tax burdens across the board.   At the bottom, however, the effect has been distinctly progressive.  The average, inflation-adjusted pretax income of the lowest 20 percent of Americans declined by 7 percent from 1979 to 2007.   But the same group’s average, real post-tax income increased by 14 percent.  Similarly, the average real income of those in the second income quintile fell by 4 percent before taxes, and rose by 23 percent after-tax over the same years.  In short, tax cuts more than offset falling wages at and near the bottom, through especially the expansions of the Earned Income Tax Credit, the deduction for children and the standard deduction.  

The heart of the middle class, the third income quintile, saw their average income grow 11 percent before taxes and 23 percent after taxes over the same years.  That means that about half of their modest economic gains came from the economy and half from tax policy.  Similarly, for Americans in the fourth income quintile – the top 60 percent to 80 percent by income – average income grew 23 percent before taxes and 36 percent after taxes.  The economy delivered faster income gains to this group than to those in the middle, and then Uncle Sam added half again as much through tax policy.  

From this point until the very top, the gains from tax policy increase with income.  Across the top 20 percent, average income from 1979 to 2007 rose 49 percent before taxes and 96 percent after taxes, or roughly half from economic effort and half from tax policy changes.  The result: pretax gains grew twice as fast as those in the next lower income quintile; and thanks to tax policy, post-tax gains grew three times faster.  Similarly, for the top 5 percent of Americans, average incomes increased 73 percent before taxes and 160 percent after taxes – a split of 45 percent from the economy and 55 percent from the tax writers.  Put another way, the average pretax income of the top 5 percent grew 6.5 times faster than the average income of those in the middle.  Nonetheless, tax policy boosted the post-tax income of the top 5 percent over this period by an additional 87 percentage-points or 55 percent.

For the lucky few in the top 1 percent, most of the gains did come before taxes:  From 1979 to 2007, the average income in this rarefied group increased 241 percent before taxes and 281 percent after taxes.  So, the pretax incomes of the richest Americans grew 22 times faster than the incomes of middle-class Americans, and their post-tax incomes grew 12 times faster.  Stated differently, the very rich saw their incomes soar 241 percent over this period, and tax policy nevertheless further boosted their post-tax income an additional 15 percent or 40 percentage points. 

Over the last 30 years, then, U.S. tax policy has sustained at least two large themes.  As the income gains of many Americans slowed down, Washington has consistently used tax cuts to blunt some of the inevitable public disappointment and resentment.  And second, those tax changes have ultimately reinforced an historic increase in economic inequality, creating a treacherous new political environment for wealthy office-seekers who pay little taxes. 

For more on inequality, please read The Economics and Politics of Contemporary Inequality, Part 1