How much can tax policy curb income inequality growth? Maybe a lot
Since the late 1970s, the United States has experienced a sharp divergence in the distribution and growth of market-based income, with gains overwhelmingly skewed toward the very top of the income distribution and away from the bottom. This era of widening income inequality represents a sharp break from the first three decades following World War II, when the gains from growth were shared fairly equally across the income distribution, even tilted somewhat favorably towards lower-income over upper-income workers. The increasingly lopsided concentration of income growth at the top of the distribution comes at the expense of stagnant or falling living standards for working families.
Policymakers have lately taken more of an interest in curbing income inequality growth, and to that end, it is critical to understand the impact and scope of tax policy. Changes in tax and transfer policies are one of the more easily quantifiable contributors to income inequality, say compared with policies (or lack thereof) related to labor protections, collective bargaining, minimum wage erosion and trade.
While both tax and transfer policies can influence inequality growth, tax policy is particularly policy relevant. Tax policy can more easily be fitted to the upwardly skewed income distribution than transfer policy, and there is vastly more market-based income than transfer income at the top of the scale, so doing so would further advance Congress’s prioritization of deficit reduction. Additionally, changes in tax policy can be implemented faster than changes in many transfer benefits, as politicians are reluctant to change retirement benefits for those approaching retirement.
Most importantly, new economic research suggests that changes in tax policy over recent decades—particularly reductions in top marginal tax rates—have exacerbated market-based income inequality growth. This is critical because the shift in market-based incomes, particularly capital income’s rise as a share of total income, is driving income inequality growth. Tax policy changes have exacerbated post-tax, post-transfer income inequality by less than one might reasonably suspect, and there are practical limits to how much increased redistribution can push back against strong market trends (though we should be pushing harder). Meaningfully curbing income inequality growth necessitates reducing the market income share accumulating to upper-income households, and higher top marginal tax rates may be one of the more concrete policy levers to advance that end, as I explain in a new briefing paper.
Market-based income inequality, as measured by the “Gini” index, rose 23.1 percent between 1979 and 2007, while dampened post-tax, post-transfer income inequality rose 33.2 percent.1 That’s because the federal tax and transfer system reduced the Gini index of income inequality by only 17.1 percent in 2007, down from a 23.4 percent reduction in in 1979. Roughly three-tenths of the percentage rise in post-tax, post-transfer inequality is attributable to changes in the redistributive nature of tax and budget policy since 1979.
But the declining redistributive nature federal tax system, however, is only responsible for a 3.6 percent increase in overall post-tax, post-transfer inequality between 1979 and 2007, again measured by the Gini index. This may seem surprisingly low given the sharp decline in top tax rates on labor and investment income over this period, among other tax policy changes. But the progressive income tax also exerts a countervailing effect on after-tax inequality as incomes—particularly at the top of the income distribution—rise faster than the inflation adjustments to tax brackets, the phenomenon referred to as “bracket creep.”
Yet recent research by Piketty, Saez, and Stantcheva (pdf) suggests that the post-World War II reduction in top marginal income tax rates has encouraged “rent seeking” behavior by executives and managers to bargain a higher share of total income, without changing the overall size of the pie being divided up. Essentially, a lower top tax rate increases the rate of return to efforts demanding greater compensation from boards of directors, and successful efforts will come out of workers’ paychecks, not shareholders’ portfolios. Time series regression analysis for the United States as well as cross-country comparisons suggest that a substantial portion of the net behavioral response to top tax rate cuts reflects this zero-sum, nonproductive shift of income from nonsupervisory workers to managers and executives. Research by my colleagues Larry Mishel and Natalie Sabadish regarding U.S. executives’ compensation in relation to workers’ average compensation similarly suggests that staggering increases in executive compensation, particularly in the financial sector, has fueled rising income inequality.
This “rent seeking” model suggests raising top marginal tax rates could yield large reductions in market-based income inequality growth without substantially reducing productive economic activity.
Moreover, economic research shows that there is already considerable scope to raise top tax rates without unduly burdening growth (but with big revenue gains) irrespective of these bargaining dynamics. Best estimates of behavioral responses to taxation (pdf) peg the revenue-maximizing tax rate at 73 percent (across federal, state, and local governments). But if this zero-sum “rent seeking” by executives constitutes a good chunk of the overall behavioral effect, Piketty, Saez, and Stantcheva estimate the revenue-maximizing top rate could be as high as 83 percent.
The bottom line for policymakers: Raising top tax rates could yield large results in slowing income inequality growth without unduly hampering economic growth. This is just one more piece of evidence suggesting that Washington’s dominant framework for tax reform is divorced from economic research and needs serious reevaluation.
1. The Gini index is a commonly used measure of inequality that quantifies the dispersion of income between 0 (perfectly equitable income distribution) and 1 (perfectly inequitable income distribution).