Hunting the Elephant in the Room: Inequality (Part III – Transfers and Pre-Tax)

Introduction:

In part 1, I discussed the emerging intellectual critical mass on inequality; in part 2, I discussed how our tax system can be made into a great engine of egalitarianism. Today I want to talk about the remaining major areas of public policy that can act against inequality – namely our post-tax transfer system and our pre-tax regulatory state.

Transfers:

As I mentioned in part 1, a good part of why the American tax system is less progressive than it could be is that the way we handle income transfers (which includes social insurance programs, social welfare programs, and tax credits) is quite regressive. While Social Security is mildly progressive when you combine a progressive benefit structure with a regressive taxation, there’s also a massive “hidden welfare” state in the tax code that exists largely for the well-to-do. There also obvious holes in our social safety net that contribute to inequality.

This is not a matter of fiddling around the edges – according to the Fabian Society, if the U.S had a tax and transfer system equivalent to that of Denmark (and keep in mind that we have a more progressive tax system), inequality would be reduced by 50% overnight.

Reforming Tax Welfare: because many Americans earn too little income to benefit from itemizing their deductions (which includes both the poor and the working class), they lose out on valuable income tax deductions. Home owners can deduct both interest on their mortgages and their property taxes, and given that they can do this for two houses, this provides even more benefits to the wealthy than it does to the middle class with whom this benefit is associated. Local and state income taxes can be deducted, which further decreases the progressivity of the tax system. The child tax credit provides $1000 per child to families with as much as $130,000 in income (thus including up to the top 16th percentile), but the full benefit only accrues to those who owe more than $1000 in income taxes after the standard deduction. And the list goes on…

The result of these deductions is to greatly increase inequality, especially within income groups. As we can see from the chart, the top 25% of middle income taxpayers (earning between $35k-55k) pay at a higher effective rate than the median fourth-quintile tax payer (earning between $55-88k). Those in the top bracket may pay 27% of their income or .5% of their income in income taxes – which reduces the progressivity of the overall tax, given that they’re supposed to be paying a marginal rate of 35%.

Changing some of the most worthy deductions (housing especially if a renter’s credit is established, child credit, EITC) by merging them into a single and fully-refundable Universal Credit (as the Fabian Society recommends for the British tax system) would greatly even the playing field for people with modest incomes. Likewise, allowing people to declare credits against the combined value of their income and payroll tax burden would open these benefits up to the 66% of Americans who owe more in payroll than they do in income taxes. At the same time, capping these deductions and designing credits to slope progressively across the board would ensure that the wealthy are no longer able to add to their wealth through tax avoidance and evasion.

In this fashion, a Universal Credit could serve as the foundation of a genuine Guaranteed Annual Wage, which would decrease inequality both by lifting up the poor and by providing a cushion for those in danger of falling into poverty.

Retirement:

Similar to income tax deductions discussed above, many of the retirement vehicles that the U.S government subsidizes (including 401ks, IRAs, Roth IRAs, etc.) suffer from a major flaw when it comes to egalitarianism. First, they are really prone to upswings and downswings in the business cycle, which creates inequality across age cohorts. More significantly, due to stagnant wages, many Americans cannot afford to save (let alone increase their savings) without decreasing their living standards, thus losing out to their richer peers who can. Thus, the phenomenon of “under-saving” is not merely behavioral; there are real constraints to the ability to save.

Federal Annuities: instead of limiting our Federal subsidy of retirement accounts to matching contributions, we can offer a progressive Federal old-age annuity to workers who cannot afford the minimum contribution requirements of the retirement funds of the middle class.

Social Security: in addition to the changes to Social Security taxes described last week, changing the benefit formula to offset the penalty incurred by temporary, part-time, and low-wage workers in building up the necessary levels of contributions, and increasing the minimum benefit to above the poverty would greatly reduce inequality in old age.

Health Care:

As many people learned during the debate over the Affordable Care Act, public policy on health care creates inequality in that low-income workers are less likely to have health insurance (and therefore get tax-free status for their contributions and deductions for their payments). Shifting these provisions to a universal flat-rate health care credit, and allowing people to use that credit as premiums under Medicare/Medicaid would both greatly expand health care coverage, reduce medical inequality, and reduce medically-induced bankruptcies (which then creates downward inequality).

Pre-Tax Regulations:

Dealing with inequality before taxation is the least discussed method, in part because it lacks the simplicity of just taxing and spending the problem away, and in part because it might leave to government intervention in the economy. However, it’s a nettle that has to be grasped. As I’ve discussed before, we are living in an economic order that stifles the economic progress of the majority, while greatly increasing the incomes of the wealthy. In such a system, the wealthy will use their capital to avoid, evade, lobby, and donate their tax burden away while tamping down on even the most blameless form of economic transfers. Without tackling the sources of inequality coming out of the labor market, all other policy will be fighting against a constant riptide.

Living Wage and Labor Market Policy: as I have argued before (see the link immediately above), one of the major sources of inequality at the bottom is a weak labor market that has led to wage stagnation and decline. Establishing a living wage should provide a backstop against wage stagnation-driven inequality and additional leverage to workers seeking a fairer share of their labor. At the same time, permanently lowering unemployment through Job Insurance and other forms of labor market policy both removes another source of inequality at the bottom and empowers workers to demand a more equitable distribution of wealth.

Workplace Regulations: over the last decade, the focus of the broader left when it comes to pre-tax inequality has tended to focus on passing some version of EFCA and thereby boost the union movement as a “countervailing force.” This is quite sensible, since unions act to increase the wages of all workers (both union and non-union) and to organize politically to expand the “social wage.” However, there’s more that we can do to make workers feel protected enough to speak up for themselves, to finally end the state of affairs that the workplace is the least free place in America (outside of the prisons). Only when workers are free to express themselves can they begin to pressure their employers for higher wages or to join unions.

Corporate Regulations: a final approach is to tackle corporate power directly, especially the ability of corporate boards to make decisions about the pay and benefits of both executives and line workers (and the division of revenues more generally) in secret and without accountability. Requiring a binding affirmative majority shareholder vote to approve executive compensation packages, and allowing shareholders to block the payment of golden parachutes to executives who fail to meet performance standards would make a major difference in slowing down runaway executive compensation; likewise, requiring all payments to executives to be reported as income paid to the executive and a cost born by the company would eliminate a major loophole by which executives escape taxation on their income.

Conclusion:

In the end, all societies have as much inequality as they are willing to tolerate. Inequality is not necessary for prosperity, nor is reducing it particularly difficult – the question is one of political will.

Are we willing to deal with inequality in a serious way, in a way that might make some well-off people uncomfortable or might involve new ways of doing economic policy? That is the question before us.