5.16: The Role of Tax Policy

The Role of Tax Policy

Economic inequality in the United States has increased during the last three decades. The loss of manufacturing jobs and unions accounts for some of this increase. However, a primary reason for the rising inequality has been tax policy. More specifically, the federal government has implemented steep cuts in the highest tax rates for income from salaries and wages and especially in tax rates for income from dividends and capital gains (Hacker & Pierson, 2011).Hacker, J. S., & Pierson, P. (2011). Winner-take-all politics: How Washington made the rich richer—and turned its back on the middle class. New York, NY: Simon & Schuster. This latter cut is especially important because dividends and capital gains account for a much larger share of the income of wealthy families than the income of ordinary families. To be more specific, dividends and capital gains account for only 0.7 percent of the income of the bottom four-fifths of the nation’s families, but for 18.8 percent of the income of the top fifth, 38.2 percent of the top 1 percent, and a striking 51.9 percent of the top 0.1 percent (Hungerford, 2011).Hungerford, T. L. (2011). Changes in the distribution of income among tax filers between 1996 and 2006: The role of labor income, capital income, and tax policy. Washington, DC: Congressional Research Service. In a related statistic, three-fourths of all capital gains are received by the top 1 percent (Krugman, 2012).Krugman, P. (2012, January 20). Taxes at the top. New York Times, p. A27. Relative to its national wealth, the United States is the lowest-taxed industrial democracy in the world (Leonhardt, 2012).Leonhardt, D. (2012, January 20). Why taxes aren’t as high as they seem. New York Times, p. A15.

Keep this context in mind as we note that tax cuts in 2003 lowered the tax rate for dividends and capital gains from 28 percent to 15 percent. Meanwhile, the top tax rate for income from salaries and wages is 35 percent. Thus many very wealthy families and individuals pay a lower percentage of their income in taxes than many middle- and upper-middle-class families do because so much of the wealthy families’ income is from dividends and capital gains. In fact, the four hundred wealthiest families and individuals in the country pay only about 18 percent of their income in federal tax (Krugman, 2012).Krugman, P. (2012, January 20). Taxes at the top. New York Times, p. A27. As the director of Citizens for Tax Justice explained, “The low taxes on capital gains and dividends are why people who make a ton of money, which is largely from investment income, do awfully well. The Warren Buffetts, the hedge fund managers—they pay really low tax rates” (Confessore, Kocieniewski, & Parker, 2011, p. A1).Confessore, N., Kocieniewski, D., & Parker, A. (2011, January 18). Romney shares some tax data; critics pounce. New York Times, p. A1. This fact prompts a critical question from Paul Krugman, winner of the Nobel Prize in economics: “Is there a good reason why the rich should bear a startlingly light tax burden?” His answer: “Such low taxes on the very rich are indefensible” (Krugman, 2012, p. A27).Krugman, P. (2012, January 20). Taxes at the top. New York Times, p. A27.

The lowering of tax rates has helped make the nation’s wealthiest families even wealthier. After adjusting for inflation, their after-tax income grew by a much greater amount than that for the poorest families from 1979 to 2007. Income grew by only 18 percent for the poorest fifth but by 65 percent for the wealthiest fifth (excluding the top 1 percent), and it also grew by a whopping 275 percent for families in the top 1 percent (Congressional Budget Office, 2011).Congressional Budget Office. (2011). Trends in the distribution of household income between 1979 and 2007. Retrieved from http://www.cbo.gov/ftpdocs/124xx/doc12485/WebSummary.pdf. As a result, economic inequality increased. Figure 12.6 shows that wealthiest 1 percent now have a much larger share of the nation’s total posttax income than they did in 1979, while the poorest fifth have a lower share. As the saying goes, the rich get richer, and the poor get poorer.

Figure Growth of Economic Inequality in the United States (Percentage Share of Total National Income)

Source: Economic Policy Institute. (2011). Share of total income by income fifths and a breakdown of the top 20%. The State of Working America. Washington, DC: Economic Policy Institute. Retrieved from http://stateofworkingamerica.org/charts/household-income-shares-1979-2007.

The Impact of Economic Inequality

Why should we care if economic inequality has increased and if the United States has the highest degree of inequality of all industrial democracies? One answer is that it is a matter of fairness. The United States is not only the wealthiest nation in the world; it is also a nation that historically has stressed that everyone is created equal and that everyone has an equal opportunity to pursue the “American dream” by becoming economically successful. Against this backdrop, a high degree of economic inequality is simply “un-American” and unfair.

Beyond this rather philosophical critique are more practical considerations. First, a high degree of economic inequality is strongly associated with a high degree of poverty and near poverty: If the rich are getting richer, there is normally less wealth to “go around,” and the poor get poorer. For the same reason, high economic inequality is also associated with a shrinking of the middle class. In the United States, as both poverty (and near poverty) and wealth have increased, the size of the middle class has reduced, as the chair of the Council of Economic Advisers has emphasized (Krueger, 2012).Krueger, A. B. (2012). The rise and consequences of inequality in the United States. Retrieved January 19, 2012, from http://www.americanprogress.org/events/2012/01/pdf/krueger.pdf.

Second, a high degree of economic inequality is also associated with low economic mobility (the movement of people up or down the socioeconomic ladder) (Krueger, 2012).Krueger, A. B. (2012). The rise and consequences of inequality in the United States. Retrieved January 19, 2012, from http://www.americanprogress.org/events/2012/01/pdf/krueger.pdf. As noted earlier, the United States is the most economically unequal of all industrial democracies. It also has lower economic mobility: Americans born into poverty or near poverty are less likely than their counterparts in other democracies to be able to move up the socioeconomic ladder (DeParle, 2012).DeParle, J. (2012, January 5). Harder for Americans to rise from lower rungs. New York Times, p. A1.

Next, high economic inequality may slow economic growth. This possible effect occurs for at least three reasons (Krueger, 2012).Krueger, A. B. (2012). The rise and consequences of inequality in the United States. Retrieved January 19, 2012, from http://www.americanprogress.org/events/2012/01/pdf/krueger.pdf. First, the wealthy tend to save their money rather than spend it. Second, a shrinking middle class means there is less spending by the middle class to stimulate the economy. Third, workers’ morale is likely to be lower in a society with higher economic inequality, and their lower morale decreases their productivity. As the chair of the Council of Economic Advisers has stated, “The evidence suggests that a growing middle class is good for the economy, and that a more fair distribution of income would hasten economic growth. Businesses would benefit from restoring more fairness to the economy by having more middle class customers, more stable markets, and improved employee morale and productivity” (Krueger, 2012).Krueger, A. B. (2012). The rise and consequences of inequality in the United States. Retrieved January 19, 2012, from http://www.americanprogress.org/events/2012/01/pdf/krueger.pdf.

Finally, many social scientists consider nations with high degrees of economic inequality to be “unhealthy societies,” to quote the title of a book on this issue (Wilkinson, 1996).Wilkinson, R. G. (1996). Unhealthy societies: The afflictions of inequality. New York, NY: Routledge. Economic inequality is thought to undermine social cohesion and increase polarization, and also to cause other problems (Barash, 2012; Wilkinson & Pickett, 2011).Barash, D. (2012, January 13). The wanton wages of income inequality. The Chronicle of Higher Education. Retrieved from http://chronicle.com/blogs/brainstorm/the-wages-of-inequality/43020?sid=pm&utm_source=pm&utm_medium=en; Wilkinson, R., & Pickett, K. (2011). The spirit level: Why greater equality makes societies stronger. New York, NY: Bloomsbury Press. Among the world’s industrial nations, higher degrees of economic inequality are associated with worse physical and mental health, lower life expectancy, and higher rates of violent crime. High economic inequality, then, is a matter not only of fairness but also of life and death.

Tax Evasion

Another significant problem in the American economy is tax evasion. The Internal Revenue Service (IRS) periodically estimates the amount of tax evasion and derives a figure it calls the tax gap: the difference between what Americans owe in federal taxes and what they actually pay. Much of the annual tax gap results from the failure of professionals such as physicians and attorneys to report self-employment income and from the claiming of false deductions by wealthy individuals and families (Braithwaite, 2009).Braithwaite, V. (2009). Tax evasion. In M. Tonry (Ed.), The Oxford handbook of crime and public policy (pp. 381–405). New York, NY: Oxford University Press.

In January 2012, the IRS released its estimate of the tax gap for 2006. The initial tax gap was $450 billion. After payment of late taxes and certain enforcement efforts, this gap was reduced to $385 billion, still an astronomical figure; tax evasion by corporations amounted for about $70 billion of this amount. The total tax gap is about twenty times greater than the annual economic loss from property crimes such as burglary and motor vehicle theft. In 2006, the federal budget deficit was $248 billion. If everyone had paid the taxes they owed, there would have been no deficit at all, and the federal government in fact would have had a surplus of $137 billion (Pizzigati, 2012).Pizzigati, S. (2012). Law and order 24/7, except at tax time. Retrieved January 14, 2012, from http://toomuchonline.org/tax-gap-law-and-order.

Despite the huge problem of tax evasion, budget cuts in 2011 weakened the ability of the IRS to enforce the tax code. In 2012, the IRS had 3,000 fewer employees working in enforcement than it had in 2010 (Pizzigati, 2012).Pizzigati, S. (2012). Law and order 24/7, except at tax time. Retrieved January 14, 2012, from http://toomuchonline.org/tax-gap-law-and-order.