Do low taxes on the rich leave the middle-class with lower wages?

Raising taxes on the rich often gets proposed as a way of combating the rise of financial inequality. But how important is tax policy, really?

Andrew Fieldhouse, a federal budget policy analyst at the Economic Policy Institute and the Century Foundation, has a new paper out of EPI that does a great job of illustrating the limits of tax policy in this area. Take this chart:

The top line is inequality of market income — that is, income before taxes and transfers such as Social Security or the Earned Income Tax Credit. That income inequality has widened steadily over the past quarter-century.

The middle line represents inequality of income after taxes and transfers. That percentage always been lower than inequality of market income because taxes and transfers are progressive overall and reduce inequality. Still, this income inequality gap grew at roughly the same rate as market income and tracked it fairly well. There are a few exceptions. Income inequality rose in the early to mid-1990s, but post-tax/transfer inequality fell, indicating that government policy was offsetting the rise in inequality in that period. Generally, however, the two move together.

But most intriguing is the bottom line in the chart. That's how inequality would have changed if the United States had kept 1979-level taxes and transfers in place. That's a very different policy situation, given how much that tax rates on upper-income Americans have fallen over the period in question, a point nicely illustrated by another chart in the Fieldhouse's paper:

So, would we have avoided the increase in inequality over the period in question? Not even remotely. The 1979 scenario lines shows inequality rising a bit more slowly than what actually happened, but the underlying pattern is the same.

"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," Fieldhouse concludes. "It is still the case, however, that shifts in the market distribution of income are the primary factors driving the rise in inequality."

It's interesting, however, that the relative roles of taxes and transfers changed over that period. In 1979, taxes and transfers were about equally important to reducing inequality. By 2007, however, transfers had come to "account for nearly two-thirds of the total reduction in inequality from the tax and transfer system." That's not because we've shifted to a European approach in which regressive consumption taxes are used to finance progressive welfare states. Both taxes and transfers grew less progressive over the period in question, but the progressivity of taxes fell more:

So the system has become significantly less progressive, even if that doesn't explain the bulk of the increase in inequality. But, as Fieldhouse notes, the pre-tax rise in inequality may actually be attributable, in part, to tax policy.

The theory comes from a paper by economists Emmanuel Saez, Thomas Piketty and surprise guest star Stefanie Stantcheva. They hypothesized that lowering marginal tax rates increases the incentive for high earners to bargain up their wages -- and pocket more of their raise. Moreover, because the higher earners are bargaining for greater pay without actually becoming more productive, the additional money they're taking in is coming form other workers, generally those lower down the income scale.

Sure enough, Saez, Piketty, and Stantcheva found that there's a strong correlation between the size of countries' tax cuts on the rich and increases in the income shares of the rich, even before taking taxes into account. That is, the rich are getting richer even before you take into account that they're paying less in taxes:

What's more, increases in the rich's income share didn't coincide with increases in the rate of GDP growth. That fits the Saez/Piketty/Stantcheva theory that the rich aren't getting more productive; they're just getting better at bargaining because lower tax rates give them the motivation to get better at bargaining.

Much more research has to be done before we can accept the Saez/Piketty/Stantcheva findings as proven. But their research does point to a plausible way that lowering income tax rates for the wealthy — and in particular lowering rates on capital income — could worsen pre-tax inequality without any economic benefit.

Fieldhouse's study, then, demonstrates how income taxes matter both more and less for inequality than is commonly thought. They matter less in the sense that their declining progressivity still can't explain the bulk of the massive increase in inequality in recent decades. But they matter more in that taxes could have other effects, besides the measure of their progressivity, that in turn affect inequality.

In any case, it's a reminder that we should be talking a lot more about policies, including tax policies, that could reduce inequality before the country even starts spreading the wealth around.

Read more:

-- If you want to know more about the non-tax causes of the rise in inequality, read Timothy Noah's Slate series evaluating all the alleged culprits, including immigration, trade policy, technology, the decline of organized labor, changes in education and more. That's an order. If you're the type of person who reads blog posts like this, you need to go read Noah. Better yet, read his book.

-- In December, I looked at several non-tax policies that would reduce inequality.

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