Why Soaking the Rich Won't Fix Income Inequality

Closing the gap between rich and poor requires broad tax reform

U.S. Department of the Treasury Internal Revenue Service (IRS) 1040 Individual Income Tax forms for the 2014 tax year are arranged for a photograph in Tiskilwa, Illinois, U.S., on Monday, March 16, 2015.

Daniel Acker/Bloomberg

As Congress works through a budget and Americans file their tax forms, both Democratic and Republican presidential hopefuls have been talking about the gap between rich and poor. Hillary Clinton noted “the overriding issues of inequality and lack of mobility” at an event last week in Washington. Jeb Bush said in Detroit last month that “[t]oday Americans across the country are frustrated. They see only a small portion of the population riding the economy's up escalator.” Neither candidate, however, talked much about raising taxes as a solution—in fact, Bush was clear that “no tax, no welfare program will save our system or our way of life.”

In that, they reflected popular opinion. Survey evidence suggests people want a more equal society. But even when given data about the extent of inequality, Americans are no more in favor of raising taxes to battle the problem. And perhaps that popular skepticism is justified—we have so skewed the tax system in the U.S. that it is not a very effective tool to reduce the gap between rich and poor. Without tax reform, simply raising tax rates won’t do much to help.

When you ask Americans which of three wealth distributions they would prefer to see in their society—complete equality (the top and bottom fifth have the same share of wealth); a Swedish distribution (bottom: 11 percent, top fifth: 36 percent); or a U.S. distribution (bottom: 0.1 percent, top: 84 percent)—without telling them which reflects the situation in the U.S., only 10 percent of respondents chose the current U.S. distribution. That indicates a desire for greater equality. In fact, it doesn’t matter your income level, your political affiliation, or your gender: The widespread preference in the U.S. is for the top fifth of the population to control less than 40 percent of the country's wealth—which is less than half the amount they actually control. 

But recent experiments suggest Americans are deeply skeptical of taxes as a remedy.  Jan Zilinsky at the University of Chicago took 1,300 people and told some of them about income distribution in the U.S. The "informed" respondents became far more pessimistic about the American dream, in particular the notion that hard work is enough to get ahead. Yet learning about the actual level of income inequality did not make subjects more willing to support higher taxes as a response. A related study sponsored by the Washington Center for Equitable Growth confirms that the more Americans know about inequality, the more worried they are about it. This makes them willing to support higher estate taxes but unwilling to support increases in top income tax rates.  The researchers also note that “aversion to government intervention” on inequality “is due to a deep level of distrust in government.”

There is reason for skepticism. The tax system is a strikingly weak tool for making the country more equitable. Sure, tax rates are progressive–but tax deductions are regressive. More than half the savings from preferential tax rates on capital gains and dividends go to taxpayers in the top 0.1 percent.  More than 40 percent of the implicit subsidy on health-care expenditures and 70 percent of mortgage interest tax relief goes to the top income quintile.

The top 20 percent of households see their share of the nation's total income drop from 61.4 percent before taxes to 58.5 percent after taxes. The Earned Income Tax Credit improves these figures by one-tenth of a percentage point or so—but the bottom line is that Federal taxes hardly do anything to reduce inequality. And that’s to say nothing of regressive state sales taxes. Taking federal, state, and local taxes together, the top 1 percent of Americans get 21 percent of the income and pay 22 percent of the taxes. If you thought that simply raising rates under the current system would have a limited effect on inequality, you’d be right.

Government transfers—payments for pensions and unemployment, for example—are a little more progressive. But the combined effect of the U.S. tax and transfer system on inequality is one of the smallest in the OECD club of rich countries, even though the U.S. is one of the most unequal countries in that club to begin with. And regardless, there is no guarantee at all that revenue generated from higher taxes would go to fund more generous safety net programs rather than, say, the defense budget, as it might be.

But there are some tax reforms that could have an effect on inequality: Remove the cap on Social Security contributions for the highest earners, scrap the lower rate for capital gains, and place a limit on some of the biggest deduction items, such as mortgage interest. Expand the earned income tax credit and match the mortgage interest deduction with a rental payment deduction. States could move toward generating revenue through income taxes instead of sales taxes, then raise the rates on higher earners. For all the complexities of tax season, this answer to “how do we get more people on the economy’s up escalator” just takes some basic math.

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