Report | Budget Taxes and Public Investment Rising Income Inequality and the Role of Shifting Market-Income Distribution, Tax Burdens, and Tax Rates
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In the decades following World War II, the United States experienced robust economic growth, and the gains were shared fairly equally across the income distribution. But this era of shared prosperity came to an end in the 1970s, and since then a sharp divergence in the distribution and growth of market-based income has skewed gains toward the very top of the income distribution and away from the bottom (Bivens 2011).
Income inequality in the United States"”already well above that experienced in other advanced economies"”has surpassed Gilded Age levels, and the Great Recession and ongoing jobs crisis will exacerbate this trend until full employment is restored (Bivens, Fieldhouse, and Shierholz 2013). While market forces are the primary driver of rising inequality, recent economic research suggests that tax policy has contributed as well, both by exacerbating after-tax income inequality since the late 1970s and by spurring a shift of pretax income toward high-income households. To be sure, government policy has surely contributed to inequality growth through other, more hard to quantify channels: policies related to labor protections, collective bargaining, minimum wage erosion, and trade"”or lack thereof, what political scientists Jacob Hacker and Paul Pierson refer to as "political drift"� (Hacker and Pierson 2011).1
But to the degree that policymakers are interested in pushing back against the growth of inequality, it is critical to understand the impact and scope of tax policy, one of the more concrete policy levers affecting inequality.
This paper reviews empirical trends in pre- and post-tax income inequality since 1979 and summarizes recent empirical and theoretical research on the role of tax policy in exacerbating market-based income inequality. It finds that increasing top marginal tax rates could yield potentially large results in slowing the growth of income inequality, and as shown in Fieldhouse (2013a), do so without substantially reducing productive economic activity:
Between 1947 and 1979, within each family income quintile average annual income grew more than 2 percent, with the largest average gains of 2.5 percent accruing to the bottom fifth of households.3 The top 5 percent of households by income experienced slightly smaller average gains of 1.9 percent. But between 1979 and 2007, the top 5 percent saw average annual income growth of 2 percent, compared with 0.6 percent growth for the middle fifth of households and zero growth for the bottom fifth.4 Looking at cash, market-based income (defined as excluding noncash income and government transfers), the top 5 percent of tax units by income captured 80.9 percent of average income growth between 1979 and 2007 (Mishel et al. 2012).5
Income growth has also become grossly unequal within the top 5 percent, with the distribution of market income most heavily concentrated within the top 1 percent of households by income. Between 1979 and 2007, real income rose cumulatively by 240.5 percent among the top 1 percent of households by comprehensive income (which includes government transfers and employer-provided benefits), versus 71 percent for the 95th"“99th income percentiles, 55.3 percent for the 90th"“95th percentiles, and 40.6 percent for the 80th"“90th percentiles. This compares with cumulative income growth of just 19.2 percent for the middle fifth and 10.8 percent for the bottom fifth of households.
Congressional Budget Office (CBO) data measuring comprehensive household income show that the top 1 percent of households captured 38.3 percent of total income growth between 1979 and 2007, more than the collective income gains of the bottom 90 percent of earners (36.9 percent).
The figures in this paper are available in an interactive format on epi.org. Users can obtain specific data points by hovering a cursor over a line or bar, view the figure as a data table, and copy data into Excel.
This trend of lopsided income growth is true of both labor income (i.e., wages and salaries) as well as broader measures that include investment income"”capital gains, dividends, and business income from S corporations and partnerships. And the rise of capital income as a share of total income"”at the expense of labor income"”has greatly contributed to the rising income share of the top 1 percent of households by income. Capital income is heavily concentrated at the top of the income distribution, with roughly 75 percent of the benefit of the preferential rates on long-term capital gains and qualified dividends accruing to the top 1 percent of households ranked by income (Toder and Baneman 2012).6
The share of overall income (as opposed to income growth) accruing to the top 1 percent of earners rose from 9.6 percent in 1979 to 20 percent in 2007; of this 10.4 percentage point increase, 3.4 percentage points, or roughly one-third of the increased share, would not have occurred without the shift toward capital income away from labor income (Mishel et al. 2012).
During the period from 1979 to 2007, government tax and transfer policy did not effectively push back against this sharp market-based rise in inequality, and by many measures the tax and transfer system has actually exacerbated pretax inequality trends, creating even less equitable growth in post-tax, post-transfer income.
Changes in post-tax, post-transfer income shares generally track changes in market income shares.7 CBO data for the post-1979 period show that both market income and post-tax, post-transfer income shares have risen for the top 5 percent of households and fallen for the bottom 95 percent of households (Mishel et al. 2012). For the top 1 percent of households, a 9.7 percentage-point rise in market income share is closely tracked by a 9.6 percentage-point rise in post-tax, post-transfer income share. For the 40th"“95th income percentiles, changes in the tax and transfer system have, on average, cushioned the declining shares of market income, whereas post-tax, post-transfer income shares have fallen by even more than market-based income shares for households in the bottom two-fifths of the income distribution.
That changes in post-tax, post-transfer income shares are driven, at least in direction, by changes in market income suggests that meaningfully curbing inequality growth would require more than increasing the progressivity of tax and budget policy; policies would need to directly or indirectly slow the rising share of market-based income accruing to the top 1 percent of households.
Accounting for the effects of taxes and transfers, U.S. income inequality, as measured by the Gini index, rose 33.2 percent between 1979 and 2007 (see Figure A). Â In terms of only market income the index rose 23.2 percent, meaning that roughly 30 percent of the rise in post-tax, post-transfer inequality between 1979 and 2007 can be attributed to changes in the redistributive nature of tax and budget policy. It is still the case, however, that shifts in the market distribution of income are the primary factors driving the rise in inequality.
Note:Â The Gini index is a commonly used measure of inequality, ranging from 0 (perfectly equitable income distribution) to 1 (perfectly inequitable income distribution).
Source: Author's analysis of CBO (2011)
The data underlying the figure.
The data below can be saved or copied directly into Excel.
On net, the federal tax and transfer system reduced the Gini index by 17.1 percent in 2007, down from a 23.4 percent reduction in 1979. CBO data show that the tax and transfer system had less of a tempering effect on inequality, as measured by the Gini index, in 2007 than in any other year from 1979 to 2007 (see Figure B). Again by broad measures, the federal tax and transfer system offers less of an equalizing effect on the distribution of income than it did in the late 1970s.
Government transfers, which account for nearly two-thirds of the total reduction in inequality from the tax and transfer system, exerted an 11.2 percent reduction in the Gini index in 2007, the smallest relative reduction over this period, down from 15.0 percent in 1979. In itself, the decline of transfer progressivity accounts for 4.5 percent of the overall rise in inequality, as measured by the Gini index, since 1979. In terms of tax policy, the federal tax system lowered the Gini index by 6.7 percent in 2007, down from 9.9 percent in 1979. The decline of tax progressivity singlehandedly accounts for 3.6 percent of the overall rise in inequality, as measured by the Gini index, since 1979. The net effect of declining tax and transfer system progressivity (including interaction effects) was an 8.2 percent increase in the post-tax, post-transfer Gini index, relative to holding the equalizing effects fixed from 1979.
Source: CBO (2011)
The data underlying the figure.
The data below can be saved or copied directly into Excel.
While income tax cuts and expanded tax preferences for capital income since 1979 assuredly made the tax code less progressive, the progressive income tax can have an offsetting equalizing 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"� (Hungerford 2013). Thus, the 3.6 percent increase in the post-tax, post-transfer Gini index relative to holding the equalizing effects fixed from 1979 is the net effect of deliberate and on-net regressive tax policy changes less the offsetting effects of bracket creep spurred largely by inequality growth.
Perhaps the greatest opportunity for tax policy to reduce post-tax, post-transfer income inequality is for the lower two-fifths of households by income, for whom tax and transfer policy has exacerbated a decline in market-based income share since 1979. Overall, the federal tax and transfer system boosted comprehensive income for the bottom income fifth by 28.3 percent in 2007, down from 37.2 percent in 1979 (Mishel et al. 2012).
While both tax and transfer policy have scope to reduce or exacerbate inequality growth, the remainder of this paper will focus exclusively on the relationship between tax policy and inequality, for several reasons.
First, the progressivity of the tax and transfer system can be increased within the top 1 percent of households more easily by changing tax policy than by restricting transfers, say by increasing Medicare premiums for upper-income households. Tax policy can more easily be fitted to the skewed distribution of income by adding additional tax brackets at higher taxable income thresholds and marginal rates or by reducing preferential tax preferences for investment income, which are by far the most regressive tax expenditures (Toder and Baneman 2012).
Second, the 112th Congress prioritized deficit reduction, an objective that could be substantially advanced by increasing the progressivity of the tax code (e.g., raising effective tax rates for upper-income households), whereas there is considerably less scope for deficit reduction through means-testing transfers to upper-income households; in other words, there is vastly more market-based income than transfer income at the top of the income distribution. As noted above, the income share of the top 5 percent, particularly the top 1 percent, of households by income is high and rising; realistically, this is the major tax revenue base for the progressive income tax code. And as will be discussed below, this is where progressivity of the federal tax code has fallen most sharply since the 1960s. Increasing the progressivity of transfers or taxes at the lower end of the income distribution would, on the other hand, add to budget deficits; this creates a substantial political barrier regardless of policy merits.
Third, changes in tax policy can be implemented faster than changes in many transfer benefits, as some benefits are accrued based on lifetime earnings, and politicians are reluctant to change retirement benefits for those approaching retirement (typically taken to mean individuals within a decade of the normal retirement age).
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