Consider the Evidence

Income inequality in the United States has increased sharply since the 1970s. How much of this is due to reduced tax progressivity?

A key element of the rise in inequality has been the dramatic jump in incomes among the top 1% of the population. According to calculations from IRS data by Thomas Piketty and Emmanuel Saez (available here), this group’s share of total income more than doubled during the 1980s and 1990s.

This is due in part to the fact that in recent decades taxes have done less to reduce the top 1%’s income share. The following chart shows the pretax and posttax income share of this group from 1960 to 2001, according to the Piketty-Saez calculations. Between 1960 and 1979, its posttax income share was 70% of its pretax share. In the period from 1980 to 2001 that increased to 84%.

(Note: The Piketty-Saez data end in 2001, so they don’t reflect the Bush tax cuts. Calculations by the Congressional Budget Office suggest that from 2002 to 2005 the top 1%’s posttax income share was 85% of its pretax share, very similar to what the Picketty-Saez data indicate for 1980-2001. I don’t use the CBO data here because they go back only to 1979.)

What effect has this had on inequality?

The chart makes clear that most of the rise in the top 1%’s posttax income share is due to the increase in its pretax share rather than to changes in tax progressivity. The next chart offers another way to see this. The solid line in the chart shows the top 1%’s share of after-tax income since 1960. The dashed line shows what the top 1%’s share of income would have been had taxes reduced it to the same degree as in the 1960s and 1970s. It’s lower, but not massively so. Changes in taxation have mattered, but they have not been the main reason for the rise in the top 1%’s income share.

If reducing inequality is an aim of the next administration, increasing the progressivity of our tax system would surely help. But this is only one piece of the puzzle.

A parable about the virtue of low tax rates for the rich has circulated on the web for a number of years. It apparently originated as a letter to the editor in the Chicago Tribune in 2001. Here is a recent version:

Suppose that every day, ten men go out for beer and the bill for all ten comes to $100. If they paid their bill the way we pay our taxes, it would go something like this:

The first four men (the poorest) would pay nothing.
The fifth would pay $1.
The sixth would pay $3.
The seventh would pay $7.
The eighth would pay $12.
The ninth would pay $18.
The tenth man (the richest) would pay $59.

So, that’s what they decided to do.

The ten men drank in the bar every day and seemed quite happy with the arrangement, until one day the owner threw them a curve. “Since you are all such good customers,” he said, “I’m going to reduce the cost of your daily beer by $20.” Drinks for the ten now cost just $80.

The group still wanted to pay their bill the way we pay our taxes so the first four men were unaffected. They would still drink for free. But what about the other six men — the paying customers? How could they divide the $20 windfall so that everyone would get his “fair share”? They realized that $20 divided by six is $3.33. But if they subtracted that from everybody’s share, then the fifth man and the sixth man would each end up being paid to drink his beer. So, the bar owner suggested that it would be fair to reduce each man’s bill by roughly the same amount, and he proceeded to work out the amounts each should pay. And so:

The fifth man, like the first four, now paid nothing (100% savings).
The sixth now paid $2 instead of $3 (33%savings).
The seventh now pay $5 instead of $7 (28%savings).
The eighth now paid $9 instead of $12 (25% savings).
The ninth now paid $14 instead of $18 (22% savings).
The tenth now paid $49 instead of $59 (16% savings).

Each of the six was better off than before. And the first four continued to drink for free. But once outside the bar, the men began to compare their savings.

“I only got a dollar out of the $20,” declared the sixth man. He pointed to the tenth man, “but he got $10!”

“Yeah, that’s right,” exclaimed the fifth man. “I only saved a dollar, too. It’s unfair that he got ten times more than I!”

“That’s true!” shouted the seventh man. “Why should he get $10 back when I got only two? The wealthy get all the breaks!”

“Wait a minute,” yelled the first four men in unison. “We didn’t get anything at all. The system exploits the poor!”

The nine men surrounded the tenth and beat him up.

The next night the tenth man didn’t show up for drinks, so the nine sat down and had beers without him. But when it came time to pay the bill, they discovered something important. They didn’t have enough money between all of them for even half of the bill!

And that, boys and girls, journalists and college professors, is how our tax system works. The people who pay the highest taxes get the most benefit from a tax reduction. Tax them too much, attack them for being wealthy, and they just may not show up anymore. In fact, they might start drinking overseas where the atmosphere is somewhat friendlier.

The parable is misleading in several ways. (For more commentary see this, this, and this.)

First, though it doesn’t matter much, the numbers aren’t right. See here (table 1b) for the actual shares of federal taxes paid by various groups.

Second, and more important, if the government (the bar owner in the story) reduces tax rates (the price of beer) it usually must do one of two things to compensate for the lost revenues. One option is to reduce its expenditures. In the context of the parable, this means the bar owner lays off a bartender or a bouncer; or perhaps she has the bar cleaned less often or forgoes needed repairs. Some customers won’t care, but others will find the bar a less attractive place to spend time in. They might be happy to pay a little more for beer if it means faster service, nicer surroundings, and fewer bar fights. The same applies to government services such as police, military, schools, roads, bridges, subways, and parks.

The other option is that the government borrows money to finance the tax rate (beer price) reduction. If the bar owner does this and it results in a substantial debt, as was the case for our federal government in the 1980s and in the 2000s, a larger share of her revenues will go to her lenders as interest payments. Eventually she may decide it makes sense to raise prices (taxes) again, as did the first president George Bush in the early 1990s — even though it meant reneging on his “read my lips: no new taxes” pledge.

But set these issues aside. The most important point is this:

The claim made by proponents of equal-percentage tax cuts is that the rich man (the tenth) will stop coming to the bar and paying for a large share of the tab if he doesn’t get the same percentage price (tax) reduction as the others. (Forget about the others beating him up; that’s a distraction from the real point the parable aims to make.) This could conceivably be true. Or it might not be. Many advocates of tax cuts for the affluent believe it’s true. But that doesn’t mean they’re correct.

In my view it’s equally plausible to hypothesize that the tenth man would keep showing up even if he were asked to continue paying $59 — in other words, even if the others get a beer price (tax) cut while he doesn’t. After all, he wouldn’t be paying any more than before. And he could probably afford it; according to Congressional Budget Office data — see table 1c here — average pretax income among households in the top tenth was $340,000 as of 2005.

How the tenth man will react is an empirical question. There’s some discussion of relevant evidence in previous posts of mine here, here, and here.

Stories resonate with us far more than do impersonal statistics. But in some instances, such as this one, the reason a story resonates is simply that it affirms prior beliefs, rather than because it offers genuine insight.

For most left-of-center Americans, the paramount concern with respect to taxes is progressivity. The aim: reduce income inequality. The means: raise income tax rates for the rich and/or lower them for the poor.

A look at the experiences of other affluent nations suggests consideration of an alternative — though by no means antithetical — strategy.

The following chart shows the amount of inequality reduction achieved by taxes and by government transfers (social security payments, unemployment benefits, the Earned Income Tax Credit, and so on) in the United States and nine other rich countries. The calculations are mine, using data from the Luxembourg Income Study database, which provides the best available comparative data on incomes. Inequality is measured using the Gini coefficient. I calculate inequality in each country using household incomes before and after taxes are subtracted; the difference between the two is the amount of inequality reduction achieved by taxes. I do the same for government transfers. Being farther to the right in the chart indicates greater reduction of inequality.

None of these countries achieves much inequality reduction via taxes. Instead, to the extent inequality is reduced, it is mainly transfers that do the work.

The chief contribution of taxes to inequality reduction is indirect. Taxes provide the money to fund the transfers that reduce inequality. The next chart shows this. On the horizontal axis is a measure of the quantity of taxation: tax revenues as a share of gross domestic product (GDP). On the vertical axis is the measure of inequality reduction via government transfers used in the first chart above. Not surprisingly, countries that significantly reduce inequality via transfers tend to tax more heavily.

The comparative experience thus suggests that for inequality reduction, it is the quantity of taxes rather than the progressivity of the tax system that matters most. Affluent countries that achieve substantial inequality reduction do so with tax systems that are large but no more progressive than ours.

What lesson should Americans draw for tax reform? In my view, the key one is that a national consumption tax — as a supplement to the income tax, not a replacement for it — is worth serious consideration (see more here and here and here).

The drawback is that consumption taxes tend to be regressive; because the poor (by necessity) spend a larger fraction of their income than the rich, they pay a larger share of that income in consumption taxes. Yet the degree of regressivity is a political choice. It can be greater or lesser, depending on whether certain items, such as food, are exempted.

A national consumption tax (we currently have state and local sales taxes) would help to raise revenue. As the following chart shows, one way other affluent nations generate more tax revenues than the United States does is by making greater use of consumption taxes.

One possibility to consider: a national consumption tax on the order of 5% that is earmarked to fund universal health care, universal preschool, and/or high-quality child care. This would reduce the progressivity of the tax system somewhat, but the payoff might well be worth it.

“When you cut the highest tax rates on the highest-income earners, government gets more money from them.”

This sounds like an argument by Arthur Laffer, probably on the Wall Street Journal op-ed page circa 1978. Actually, it is by Arthur Laffer … in the Wall Street Journal … but in 2008 rather than 1978. The piece is titled “The Tax Threat to Prosperity” (here). In it, Laffer reiterates his famous, and famously-influential, claim about the detrimental impact of tax rates on incomes and therefore on tax revenues.

But the argument has changed. The notion at the heart of the original “Laffer curve” argument was that higher marginal tax rates on those making the most money discourage them from investing, starting new businesses, and working hard. The result is less income growth, and hence lower tax revenues. Laffer now argues that the problem with high marginal tax rates is that they encourage high earners to hide and shelter their income. The “supply-side” problem now is said to be tax avoidance.

What is the evidence? Laffer notes that while the top marginal income tax rate has been significantly altered over the past generation, the effective tax rate — the share of income actually paid in taxes — for the top 1% of households has been fairly stable. The chart below shows this. (The data on effective tax rates are from the Congressional Budget Office here.) This, he says, is because when the top marginal rate is increased, high-income taxpayers reduce their taxable reported income via “tax shelters, deferrals, gifts, write-offs, cross income mobility, or any of a number of other measures.” When the top marginal rate is reduced, they increase their taxable reported income.

This is certainly plausible. But it is equally plausible that the effect on tax avoidance, while real, is quite small. Suppose the top marginal tax rate is reduced by 10 percentage points. Is it likely that most of those in the top 1% will call their accountants and instruct them to go easy on the exemptions and deductions?

If changes in the top marginal tax rate in fact have little impact on tax reporting by those with high incomes, what accounts for the fact that the effective rate on the top 1% is far less variable than the top marginal rate? Two things. First, the top marginal rate applies to only the top portion of these households’ incomes. Second, and more important, when Congress and the president have altered the top marginal rate they frequently also have changed the rules about loopholes, exemptions, deductions, and tax compliance.

There are have been four noteworthy changes in the top marginal tax rate since the late 1970s. Let’s consider them in turn.

1. Tax reform in 1981 reduced the top marginal rate from 70% to 50% beginning in 1982. Few exemptions and loopholes were closed. The fact that the effective income tax rate on the top 1% of households fell only slightly in the ensuing years appears to support Laffer’s argument.

But there are two important qualifications. First, the drop in the top marginal rate is misleading. As Eugene Steurle points out in his book, Contemporary U.S. Tax Policy, “Even before 1981, high-income individuals often avoided a top tax rate of 70 percent through a special provision of the tax code that limited the tax rate on earnings, or income from labor, to a maximum of 50 percent.” Furthermore, in 1982, 1983, and 1984 additional tax reforms were enacted that reduced loopholes and enhanced tax compliance and collection via expanded reporting requirements and heightened penalties.

2. Tax reform in 1986 reduced the top marginal rate from 50% to 39% in 1987 and 28% beginning in 1988. The effective rate on the top 1% actually increased slightly in the following years. This, however, is fully explained by the fact that the 1986 reform dramatically reduced loopholes and exemptions. This wasn’t a case of high-income households deciding to hide less of their income because the top marginal tax rate had been lowered. They had no choice.

3. Tax reform in 1993 raised the top marginal rate from 31% to 40%. The effective rate on the top 1% increased from 21% in 1992 to 24% in the latter part of the decade. Did the hike in the marginal rate of 9 percentage points encourage tax avoidance? Possibly, but if tax avoidance increased, it was more likely due to the massive rise in incomes among the top 1% that occurred in the second half of the 1990s. The next chart shows this. Average pretax income in this group nearly doubled between 1993 and 2000, soaring from $750,000 to $1,450,000.

4. Tax reform in the early 2000s reduced the top marginal rate by four percentage points, from 39% in 2002 to 35% in 2003. In this case the effective rate on the top 1% of households fell by exactly the same amount, from 24% in 2002 to 20% in 2003.

None of this is to suggest that tax avoidance doesn’t occur or isn’t worth worrying about. Far from it. But the notion that lowering the top marginal tax rate dramatically reduces such avoidance appears to be wishful thinking.

In a post last week — “Taxes at the Top” — I suggested that higher tax rates on the richest Americans very likely would increase government revenues. Austan Goolsbee has a closely related discussion in Sunday’s New York Times (here; comment by Mark Thoma here).

Goolsbee addresses the “supply-side” argument that lower tax rates on top earners will produce a rise in their earnings and pretax incomes, due to greater investment or work effort. That might increase tax revenues. Goolsbee argues, and shows, that the evidence doesn’t support this claim. He focuses on the effect, or lack thereof, of changes in the top marginal tax rate:

“My calculations show that in the four years after top marginal rates were cut in 1981 and 1986, and in the three years after the rate cut of 2003, average real salaries (subtracting inflation) for the top 1 percent of earners grew 18.8 percent, 22.5 percent, and 17.4 percent…. A supply-sider might see this as evidence of the growth power of cutting top rates. But the data also show that incomes at the top have been growing rapidly regardless of what happened to tax rates. In the four years after the increase in top marginal rates in 1993, average salaries grew 18.7 percent among the top 1 percent of earners…. Seeing the same pattern when taxes rose as when they fell indicates that tax cuts weren’t responsible.”

The effective tax rate on the top households is more meaningful than the marginal rate. The chart below shows trends in the effective rate and in the pretax income of the top 1% of households. The data are from the Congressional Budget Office (here).

Goolsbee’s conclusion holds. The effective tax rate on the top 1% was reduced from 37% to 28% between 1979 and 1982. In the ensuing five years the average pretax income of the top 1% jumped sharply. But between 1990 and 1994 the effective rate on the richest was raised from 29% to 36%, and in subsequent years pretax incomes at the top rose even more dramatically.

For many progressives it is an article of faith that tax rates on the richest Americans should be higher than they currently are.

Why? One reason is that it would be fairer. In the 1950s the top marginal income tax rate was 90%, and it was 70% as recently as 1980. These days the top rate is only 35%.

That’s misleading, however, because prior to the mid-1980s the tax system had a lot more loopholes and deductions than it does now. The meaningful tax rate is the “effective” rate — the share of their income that people actually pay in taxes. The following chart shows the top marginal rate and the average effective rate on the top 1% of taxpayers since World War II. The latter is from calculations by the Congressional Budget Office (here) and is only available beginning in 1979. (As of 2005, a four-person household in the top 1% had a pretax income of $600,000 or more.) The effective rate is lower now than it was in the late 1970s and in the mid-1990s.

Some opponents of higher tax rates for the rich argue that fairness in taxation requires that everyone’s income be taxed at the same rate. Taxation should be proportional rather than progressive. Not many people seem to share this view, however. Most feel that because they can afford to, the richest should pay not only more dollars but also a larger share of their income.

A second rationale for higher taxes on the most well-to-do is that it would increase government revenues, which could be used to help improve opportunity and outcomes for those less fortunate. Health care for all, a more generous Earned Income Tax Credit, and subsidized preschool and child care are among the many good ideas currently on the table.

The taxes paid by those at the top matter a great deal for government finances. As of 2005 the top 1% accounted for 28% of federal government tax revenues. That isn’t because they are taxed at an outlandish rate; an effective tax rate of 30-40% is hardly confiscatory. Instead, it’s because they get a very large share of the country’s income — 18% as of 2005.

The following chart shows federal government tax revenues as a share of GDP by the effective tax rate on the top 1%. The data points represent each year for which data are available. Although the correlation is far from perfect, tax rates on the richest are positively associated with the portion of GDP collected in taxes. This is as we would expect. It suggests that steeper tax rates at the top are likely to bring in more revenue.

But not so fast. It is commonly objected that higher tax rates on the affluent will reduce incentives for saving, investment, entrepreneurialism, and hard work. Economic growth will slow. Thus, taxes will be collecting a larger share of a less-rapidly-growing economy. In the end, higher tax rates will yield no increase (and perhaps a reduction) in government revenues.

Is this true? A lot of research has been done on this question, but there is little agreement about the answer. (For a helpful overview, see Joel Slemrod and Jon Bakija, Taxing Ourselves.)

The next chart shows the growth rate of per capita GDP by the effective tax rate on the top 1%. The effective tax rate on the richest appears to have had no noteworthy impact on economic growth. Averaging growth over several years does not change the picture.

What about the effect of tax changes? As the first chart above indicates, the effective tax rate on the top 1% fell sharply between 1979 and 1982. In the five-year period beginning in 1982 the growth rate of per capita GDP averaged 2.6%. By contrast, the effective rate on top incomes jumped appreciably between 1990 and 1995. Yet over the five-year period starting in 1995 the average rate of economic growth was virtually identical: 2.7%.

There have been several smaller changes in the high-end effective tax rate since the late 1970s. In the late 1980s the rate increased slightly, and in the late 1990s it declined slightly. In both of these instances, however, assessment is complicated by the fact that recessions occurred fairly shortly afterwards. More recently, between 2000 and 2005 the top rate was reduced from 33% to 31%. Per capita economic growth in the mid-2000s has been relatively weak for a non-recession period, at just a little more than 2% per year, but it is too early to fairly judge the impact.

To sum up: The effective tax rate on the incomes of the top 1% of Americans is substantially lower now (31%) than it was in the late 1970s (37%) and in the mid-1990s (36%). When the rate is higher, the federal government tends to collect a larger share of the national economy in taxes. And the experience of the past several decades suggests that higher rates have had no adverse impact on growth of the economy.

This evidence is by no means conclusive. But it lends credence to progressive hopes that a somewhat higher rate of taxation on the richest Americans would not only be fairer but also enhance the government’s ability to provide valuable services and benefits.