One way to make some progress in reducing income inequality is to significantly increase redistributive transfers and public services. I’ve suggested that it will be difficult to fund that solely by heightening taxes on those at the top of the income distribution. Robert Waldmann asks, quite reasonably: Where’s the math?
Here’s an answer. I’ll use numbers for 2006, since that’s the most recent year for which we have good income and tax data from the Congressional Budget Office.
Suppose we need to increase tax revenues’ share of GDP by 5 percentage points. As the following chart shows, that would still leave us near the bottom among the world’s rich countries. But if the money were used well, it would be a notable advance.
GDP in 2006 was approximately $13 trillion; 5% of that is $0.65 trillion ($650 billion). President Obama has pledged to not increase taxes for the bottom 95% of Americans, so let’s presume the added revenue will come from the top 5%. In 2006 this group, 5.9 million households, had an average pretax income of $564,200. Their total pretax income was thus $3.3 trillion. The $0.65 trillion needed in order to boost tax revenues by 5% of GDP amounts to 20% of that $3.3 trillion in income. Thus, the effective tax rate (taxes paid as a share of pretax income) on the incomes of the top 5% of households would need to be increased by 20 percentage points.
The following chart shows the effective federal tax rate on the top 5% of households going back to 1960. The data from Piketty and Saez begin in 1960; the CBO data begin in 1979. I use the federal rate not only because data are available, but also because these taxes — mainly individual and corporate income — are the ones most likely to enhance the progressivity of the tax system (also included are payroll and excise taxes).
Incomes are higher in the top 1%, so what if we focused on that group? In 2006 the average pretax income among those 1.1 million households was $1,743,700. Their total income was thus $1.9 trillion. The effective federal tax rate on this group would have to be raised by 34 percentage points in order to increase tax revenues by $0.65 trillion, or 5% of GDP. Here’s what that would look like in historical context.
Whether desirable or not, increases of this magnitude strike me as unlikely. It’s worth thinking about additional potential sources of revenue.
Let me emphasize that my aim isn’t to discourage increases in taxation of the richest. I favor doing that. Rather, it’s to encourage the American left to think beyond heightened tax progressivity when considering strategies for inequality reduction.
Note: I’ve corrected an error in the earlier version of this post.