US Income Inequality: Taxes Aren’t the Problem

A few weeks ago I wrote a post about the ineffectiveness of the minimum wage to reduce poverty, in response to President Obama’s proposition, in his State of the Union address, to raise it. Obama was addressing a concern of his, as well as many others’, that the poor aren’t getting what they deserve in America, while the rich are getting much, much more.

While I believe strongly in free markets and opportunities to prosper, there’s truth to this characterization. Real income appears to have stagnated for the poorest 40% over the last few decades, while the top 20%, and especially the top 1%, have made incredible gains.

There’s a new kind of culture war in the United States, and it’s about money. The Occupy movement wasn’t a group of economists promoting more progressive taxes or expanded social programs–it was mostly indignant young people, expressing their outrage at the misdeeds of the wealthiest 1%. In the Occupiers’ view, this isn’t an academic issue; this is a moral struggle, with lines clearly drawn between the greedy and the just.

I do not share the Occupiers’ worldview, but the feelings that motivate them are at some level universal. You might experience the same moral horror when you hear how much more CEOs are paid than their employees, or when it is reported that very wealthy investors seem to pay so little in taxes. People don’t necessarily want everyone to be equally rich, but we are averse to inequality–and when inequality appears to violate our expectations of just reward for effort and ability, we want an explanation.

The best simple measure of income inequality is probably the Gini coefficient. The higher a country’s Gini coefficient, the less equitable the distribution of income. The OECD (a group of wealthy industrialized countries) publishes Gini data for its member countries, using income before taxes and transfers, and after. Because taxes and transfers (transfers are government programs that transfer money to people, usually the poor) are designed to redistribute income to some degree, the Gini coefficient is higher before they are applied. Here’s the data for OECD countries in the late 2000s, minus a few of the countries less comparable to the United States, and Ireland, which didn’t have pre-tax data.

init

The first observation to make is that before taxes and transfers, the US is among the least equitable countries. But it is not the worst. Perhaps surprisingly, Italy, the UK, Israel and Germany all have higher pre-tax, pre-transfer Gini coefficients. I won’t get into the reasons for the United States’ high pre-tax inequality in this post. After taxes and transfers, however, the US is the least equitable. Here’s a graph of the difference between pre- and post-tax and transfer Gini coefficients for each country:diff

It appears from this data that tax policy and social spending in the US is relatively ineffective at reducing poverty compared to other countries. While this isn’t a perfect measure of the power of fiscal policy to bring about equality, it’s probably a good clue. Most of the discussion around income inequality in the US has centered around taxation. A relatively mundane effort to raise the top marginal income tax rate in the US recently became a major political battle.

But inequality probably isn’t a taxation story. The US has the highest corporate tax rate in the developed world (and among the highest when average effective rates are considered), relatively high capital gains taxes and a progressive income tax system. By some measures, the US actually has the most progressive tax system in the world, because such a high proportion of its tax revenue comes from rich people. Since the Bush tax cuts, the average effective tax rate paid by the lowest 20% of income earners has fallen to 1%. The next lowest 20% pay just under 7%. Most of the taxes the poor pay are payroll taxes; it’s been well reported that just under half of Americans don’t pay any federal income taxes.

This suggests that much of the inequality problem in the US can be explained by government policy on transfers. Historically, the US has had significantly lower public social expenditures than other countries. Since 2008, however, public expenditures on social programs have risen to be in line with other OECD countries. Including private social spending, the US now spends more per person than nearly every other OECD country. The data can be found here.

The biggest trouble, in my very informal analysis of US social spending, is probably in the way the money is spent. Whereas many OECD countries have established forms of basic income or direct transfers, most of US social spending is in the form of health spending and old age spending (ie. Medicare, Medicaid, and Social Security). More recently, there has been a great deal of money spent on unemployment benefits. Without getting into lengthy detail, there’s evidence that these programs are relatively inefficient at alleviating poverty, partly because so many of their funds are directed to recipients who aren’t rich, but also aren’t poor.

One alternative to these old-fashioned programs is direct cash transfers (ie. giving money to poor people). Historical experience, however, tells us that Lyndon B. Johnson-style welfare programs did very little to alleviate poverty and reduced economic incentives. In my minimum wage post, I suggested that the negative income tax or a similar scheme might be a way to establish a basic income while preserving incentives to work. A negative income tax system might sound like an almost socialist idea (although it was originally proposed by famously capitalist Milton Friedman), but with its administrative simplicity and fiscal efficiency, it’s one of the few major anti-poverty proposals I’ve heard that would not require tax rises.

2 thoughts on “US Income Inequality: Taxes Aren’t the Problem

  1. Tom,

    Why should we want income equality? You say “People don’t necessarily want everyone to be equally rich, but we are averse to inequality”. You’re basically saying that you don’t want people to be equally rich but you don’t like it that they aren’t equally rich.

    What constitutes equality? By what standard do you judge that CEOs make too much compared to their employees?

    These questions need to be answered before you decide how to go about making people equal through social policy.

    Regards,

    Andy

    • Andy, thanks for the comments. I’m not saying that we “should” want income equality. My policy proposals are mostly based on the observation that most people do, in fact, want relative income equality. I’m dealing (mostly) with “positive” as opposed to “normative” politics. Personally, I’m not overly concerned about income equality, but I recognize that most people are, and often it’s because of life experiences they’ve had that I haven’t.

      There’s no “ideal” standard of equality (unless you’re looking at maximizing utility, assuming diminishing marginal utility). The current levels of CEO pay might be completely justified by market conditions and their marginal products of labor. I really don’t know. What I’m sure of is that most people in the US think that the playing field is unfair. The fact that inequality has risen so much as opposed to both international levels and to historical levels suggests that maybe this is the case. Without a complicated analysis I can’t say for sure.

      In the meantime, given that people want something to be done about inequality, I’m offering what I think is the most effective and efficient option. It would do me very little good to try to convince people not to care about inequality.

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