Hunting the Elephant in the Room: Inequality (Part II – Taxes)

Introduction:

In part 1 of “Hunting the Elephant in the Room,” I discussed the emerging critical mass in inequality studies and how that might be harnessed to the public’s unheralded egalitarian values. However, coming to the realization that “policy can reduce inequality” is not the same thing as knowing what kind of policy to push for.

The first thing to understand is that there are many different ways for reducing inequality. Broadly speaking, policy approaches to inequality can be categorized by when in the economic process they take place – pre-tax interventions into the socio-economic order, the tax system, and then post-tax transfers.

Today, I’ll discuss how our tax system can be turned into an engine for equality.

General Approaches:

Before I get into the specific details of public policy, I want to address the question of general philosophic approach. One of the most influential approaches within inequality policy has tended to be a kind of quasi-Rawlsian insistence on targeting either the very top or the very bottom. While focusing on the ultra-wealthy does have a certain logic – especially given the increasing hyper-concentration of wealth within the top 10%, 5%, 1%, .1% and so on – I don’t agree that focusing our efforts solely on the very poorest is a good approach. I’ve written in the past that structuring public policy to synch with popular psychology is vital to success, and the same is true here. As the Fabian Society’s research demonstrates, highly-targeted programs tend to backfire: they sap public support for redistribution, they empower an us/them politics in which beneficiaries are transformed into an “Other,” and this leads to social stigma that then acts as a vicious cycle which results in underfunded and inadequate efforts.

By contrast, redistribution within universal systems has the opposite effect. On the level of policy, universal systems allow us to tackle inequality all the way up and all the way down the income scale; this ensures that we don’t waste effort pushing poor people up into a working class in decline, or waiting until working class families fall into poverty before we act. On the level of politics, universal systems increase support for redistribution (because more people feel that they will gain from redistribution), create a solidaristic politics in which people from poorer families are seen as “just like me,” and prevent stigma from forming.

Taxation:

Using the tax system to reduce inequality is actually the most common and least controversial proposal; it avoids direct intervention in the labor market (which tends to annoy economists), it doesn’t require the reconstruction of the economic order, and it has the virtue of familiarity. And in fact, the U.S actually has one of the more progressive tax systems of the advanced economies – one of the remaining legacies of the New Deal:

 

Source: Lane Kenworthy

If you look at the white circles on the left, you can see that the U.S tax system is actually more progressive than those of many European nations celebrated for their egalitarian policies – Sweden, Denmark, and Norway (which make up for it with progressive transfers, more on that later). A lot of this has to do with the composition of our taxation systems; European nations rely heavily on VAT taxes, while the U.S leans more heavily on income taxes.

At the same time, we could certainly stand to make our tax system more progressive than it is now. The U.S tax system was much more progressive in the past than it is today:

 

Source: Mark Thoma

We have become much more of a flat-taxing nation de facto, due to a combination of higher payroll taxes, a modest reduction of upper-class income taxes, and much sharper decreases in corporate, estate, and capital gains taxes. When this is added to an existing trend towards higher incomes at the top of the income scale and stagnant and declining incomes for the majority, the tax system begins to lose its progressive character.

Taxing the Wealthy:

Three changes would dramatically reduce the capacity of the wealthy to escape their tax burdens:

• Reforming Top Rates: the top income, capital gains, and corporate income taxes are well-below not merely Clinton-era but also Reagan-era tax rates. Returning them to their Reagan-era levels would take a significant bite out of top incomes, as well as provide $297 billion a year in revenues that can be spent on programs that benefit the majority.
• Reforming Tax Allowances: almost as significant as the drop in rates has been the expansion in income tax deductions, credits, and allowances. Because 66% of households owe more in payroll taxes than they do in income taxes, the majority of these benefits (even benefits that are theoretically benign, like the Child Tax Credits) accrue to those with large income tax bills and many lower-income households do not benefit at all (more on this later). Capping income tax deductions as Obama proposed to do in his 2009 budget (or eliminating them altogether) would close this escape routes for the wealthiest.
• Taxing the Financial Sector: this is probably the most politically difficult measure, given the wealth of the financial sector and its skill at influencing the government through donations, lobbying, and the hiring of prominent ex-public officials. However, the reality is that we cannot put a major dent in inequality when 40% of corporate profits flow into one industry, an industry which has won preferable tax rates, and in which executives can determine their own incomes unilaterally, dominating within the top 1%. Both in terms of individual inequality of incomes, inequality between sectors, and inequality between workers and management, we need to “bend the curve” on the size of the financial sector:
  • Equalize Capital Gains to Income Tax Rates, Close the Hedge Fund Gap: as I’ve discussed in part 1, one of the major sources of inequality at the top is access to capital, in part because capital has been growing as a percentage of GDP (so there’s more to go around), but also because capital is taxed much lower than wages in the U.S. Increasing capital gains taxes from the current rate of 15% to the current rate of income tax (35% at the top) would be a major step in spiking the stock-option-driven increase in top incomes, but it would also serve as a moral statement that wealth should not be given preference over work. Even within the top 1%, closing the loophole that allows hedge fund managers and other financiers the ability to declare their commissions as capital gains instead of as income would not only close one more escape route for the wealthy, but would also reduce the “brain drain” into the financial sector.
  • Restore the Estate Tax: after being greatly reduced (and even temporarily eliminated) by the Bush tax cuts, the estate tax now exempts all estates below $5 million in value, and has a maximum rate of 35%. This has several negative consequences: on an practical level, it allows people to become multi-millionaires tax-free, which greatly increases inequality; in terms of social mobility, it raises the stakes for anyone who would try to climb the ladder and gives those at the top an unfair advantage in competition; and as a moral statement, it suggests that unearned wealth should be treated equally with wage labor. Returning to the Clinton-era estate tax rate of a top rate of 55% on estates over $833,000 would both restore tax fairness and reduce a major barrier to social mobility.
  • Bank Taxes: finally, we can tax the banks themselves, which both redistributes between corporations and workers and shrinks this “too big to fail” sector of the economy, freeing up resources for genuinely productive uses. The proposed Robin Hood tax (also known as a Tobin Tax) on financial transactions, proposed taxes on runaway bonuses, or differential tax rates on financial sector corporate income and capital gains taxes are all ways of recovering the income that the financial sector has gobbled up, and provide a systemic incentive for shifting investment and employment to sectors that actually create value.

Taxing Everyone Else:

Overall, the Federal system is still fairly progressive on the lower end of the economy, especially when it comes to the Earned Income Tax Credit essentially acting as a negative income tax for working poor families with children. However, as I’ve discussed before, the payroll tax is a glaring departure from an otherwise admirable setup. Making the payroll tax progressive would dramatically increase the incomes of 66% of American households, countering the effects of wage stagnation and decline. Accompanied by lifting the cap on payroll taxes, it would also reverse the current inequality-increasing situation where a person making $10,000 and $100,000 a year pay the same payroll tax rate, whereas someone making $200,000 a year pays half, and increasingly less as you go up the income scale.

In addition, it would create a number of pre-tax feedback effects: progressivizing the payroll tax would have the same effect as a payroll tax holiday on employment, only permanent, lowering unemployment rates and providing the leverage for workers to negotiate more equitable wages. Similarly, it would create a disincentive for corporations to allow top pay to increase out of control – whereas the current situation allows a company to save on taxes by distributing $100,000 as a bonus to one executive versus creating two $50,000 jobs or providing 100 workers with a $1000 raise, a progressive payroll tax would provide a tax incentive for corporations to invest in better wages and a larger workforce and penalize corporations that remained on the path of runaway executive compensation.

Finally, one of the major sources of regressive taxation in America is actually on the state level. States, especially in the South and increasingly in the West, rely heavily on sales taxes, even including groceries as part of their sales taxes. As Katherine Newman and Rourke O’Brien show in their book, Taxing the Poor, this has a dramatic impact on low-income families, both reducing their take-home pay and contributing to poor health, early mortality, and other social ills. Preserving and expanding state-level EITCs, making them fully refundable against state taxes, reducing states’ reliance on sales taxes, and creating an income exemption for sales taxes would prevent the good that is done at the Federal level from being undone by the states.

Conclusion:

In the end, taxation occupies a Janus-like role in American public policy. It is a profound shaper of the economic order, and never let free-market zealots convince you that “the Federal government can’t affect the economy.” At the same time, it is also a moral statement about what we consider to be fair and just. In the last forty years, conservatives have advanced an ideological case that equal rates for people with unequal incomes is fair, that taxing those who have become wealthy is unfair, that reducing taxation on the wealthy is always right, but that reducing taxes for the poor is socialism.

Progressives cannot win this debate through a technocratic defense of the status quo. We have to make the case aggressively that taxing people according to their ability to pay is the only fair way to tax, that our tax system can and should be used to prevent the emergence of “malefactors of great wealth” and maintain a republic of citizens with a “rough equality of means,” and that a more equal society is a more just society.