Can tax reform really fix the income gap?
Because many other factors influence income inequality besides tax policy, tax reform's ability to combat the problem is limited, but its potential shouldn't be entirely counted out.
In this file photo, a woman drops her federal tax return in the mail slot at a post office in Palo Alto, Calif. Bernstein argues that income inequality isn't entirely caused by the tax code, but it can have a major effect.
Paul Sakuma/AP/File
Based on a spate of recent posts (see and links therein), a commenter (HT: Greg) asks a good, tough question of yours truly: on the one hand, I鈥檝e argued long and hard that while we definitely need more progressive tax policies, the fact that the growth of inequality is largely a pretax phenomenon implies that tax changes alone won鈥檛 reverse the trend.
Yet, in this post reviewing the recent CRS inequality report, I point out that a) the increase in capital gains plays a large role in driving inequality trends, and b) if we taxed such gains as regular income (instead of at much reduced rates), that would help to reduce inequality.
So how can I argue on the one hand that tax policy is inherently limited as a tool against rising inequality, and on the other, that we should employ tax policy to push back on inequality?
I could invoke Walt Whitman: 鈥淒o I contradict myself? Very well, then I contradict myself, I am large, I contain multitudes鈥濃�攁nd leave it at that.
But better yet, let me explain.聽 First, the evidence as shown in the chart shows that increased inequality is a pretax story. 聽Whether it鈥檚 the increase in earnings or wealth inequality, the latter including outsized gains from assets, that鈥檚 all occurred in the so-called primary distribution of income, before taxes and transfers get into the mix.
Now, that doesn鈥檛 mean that more progressive taxes and transfers can鈥檛 help offset higher inequality.聽 They can, they should, and they do.聽 Unfortunately, as I stress , they鈥檝e become less effective in that regard over time.
But there鈥檚 another policy constraint here鈥攊t鈥檚 the 鈥渂uilding-a-dam-against-an-ever-rising-river鈥� problem.聽 As long as market outcomes become increasingly unequal almost every year, whatever redistribution we鈥檙e accomplishing through the tax code will have to be constantly ratcheted up.聽 That鈥檚 tough even in a rational political environment鈥攊t鈥檚 impossible in the current one.
Then there鈥檚 the question of how much of a direct difference we could make in the growth of inequality by just depending on taxes (the word 鈥渄irect鈥� is important, as I鈥檒l聽 show in a moment).聽 Using table B-1 from the CRS , I can simulate what the Gini index might have been in 2006 if the tax system hadn鈥檛 become less progressive.聽 And the answer is: it wouldn鈥檛 have directly changed measured inequality much at all鈥攊t lowered the Gini by only 0.005 compared to its actual 2006 level.*聽 More progressive taxation will help, but at the end of the day, you can鈥檛 bring a knife to a gun fight.
There are, however, very good indirect reasons to think that taxes matter a lot more in terms of moving inequality than the above rap would suggest, and I should be more careful to reflect this insight. 聽Important work on this question by Saez et al (see ; paper ), for example, shows strong correlations across time and place between higher marginal tax rates and reduced income concentration.
With higher taxation, they argue, there鈥檚 less 鈥渞ent seeking鈥� (economese for rich people figuring out ways to claim more riches鈥攚ays that don鈥檛 lead to better overall economic outcomes).聽 As Saez et al put it, 鈥淟ower top tax rates induce top earners to bargain more aggressively for higher pay鈥� and bargaining here mean using their clout, power, friends on the board, etc., to claim pay packages that go well beyond their productive contributions to the firm鈥檚 output. 聽This is a classic zero-sum outcome鈥搕he execs鈥� gain is someone else鈥檚 loss.
Of course, the notion that there鈥檚 separable independence between the primary distribution (market outcomes) and the secondary (post-tax and transfer) is wrong.聽 Tax policy itself affects market outcomes, for better or worse.
The trickle-downers have way overdone this for decades, arguing, against evidence to the contrary, that tax cuts unleash torrents of growth.聽 What Saez et al are identifying is a new pattern that looks like it has a lot to do with inequality: trickle-up economics.
*I did this by substituting the 1996 terms for taxes into the 2006 table and recalculating the Gini index.聽 One wrinkle here is that you have to rescale the income shares so that they sum to one.