The Top Takes Off

Sunday, May 7, 2006

THE QUEST for ways to reduce inequality begins with taxation. Unlike spending programs, redistribution through taxation is administratively simple; besides, putting money directly into people's pockets allows them to spend it on whatever they need most. But the tax tool has been wielded badly. Rather than using it to offset rising inequality, politicians have contrived to do the opposite.

The Bush administration refuses to acknowledge this extraordinary fact. It argues that the tax system has grown more progressive because the rich provide a larger share of government revenue than in the past. But this isn't because tax rates for the rich are higher; it's because the pretax earnings of the rich have taken off. While the income of the families in the middle fifth of society has grown 12 percent since 1980, the income of the top tenth has grown 67 percent, and the income of the top 1 percent has more than doubled. In short, the rich have grown a whole lot richer: That's why they pay a larger share of total tax.

The administration also argues that the federal income tax is already progressive enough. Thanks to the earned-income tax credit and Mr. Bush's refundable child credit, almost a third of tax filers pay either zero income tax or less than zero -- meaning that they take money out of the system. But it's nonetheless true that the income tax is less progressive than it used to be. People still have to pay the regressive payroll tax. And changes to the estate tax must be factored in as well.

Our chart shows the combined effect of the Bush tax cuts. It leaves no doubt that the tax system has become less progressive, even as the need for progressivity has grown. Over the past quarter of a century, the tide of the American economy has failed to lift the bottom half of society, damaging the faith on which capitalism depends. Seven out of ten say the nation is headed in the wrong direction even though economic growth is galloping, and many are hostile to trade, immigration and big business. But rather than crafting a tax policy that responds to those sentiments, the administration has done the opposite.

The chart makes a second point. The loss of tax progressivity has not occurred in the middle of society; it's not as though someone a quarter of the way down the income scale is doing better at the expense of someone three-quarters of the way down. Rather, it's the top tenth who have benefited, and the top within the top has done fabulously well. According to Thomas Piketty of the École Normale Supérieure in Paris and Emmanuel Saez of the University of California at Berkeley, the top 0.01 percent of households has seen its tax bite fall by 6 percentage points since 2000 and by an astonishing 25 percentage points since 1980.

It's clear that some of these changes should be rolled back. Yes, raising taxes on the rich can mean more evasion and duller incentives. Some footloose financiers might leave the country. Some managers might spare themselves the heartache of restructuring companies if their performance-linked bonuses were subject to high taxes; they might prefer to coast along comfortably -- as many do in Europe or Japan and as many did in the United States of 30 years ago. But the risks of raising taxes have to be weighed against the risks of not raising them. Inequality is not only bad in itself; it also will intensify pressure for bad policies that threaten growth more acutely than higher taxes would.

Economics cannot predict how high taxes can be raised before they reach counterproductive levels. But it would almost certainly be safe to increase taxes on the top 1 percent by 5 percentage points, restoring the level of the mid-1990s -- hardly a period of lethargic chief executives. This tax hike would raise $85 billion annually or perhaps a bit less if it spurred some extra tax evasion; sharing that revenue among the bottom three-fifths of households would give each family $970 a year. That would be a big help to families at the bottom, but it would deliver a boost of less than 3 percent to the median household.

To remedy stagnant middle-class living standards, more radical tax hikes would be necessary. But given that taxes will have to increase anyway because the budget deficit is running at around $300 billion, raising more than $85 billion for the purpose of redistribution is possible only if it's part of a wide-ranging tax reform.

Which brings us to the possibility of closing loopholes in today's tax system. Closing loopholes that allow people to shelter income does not dull incentives, because it does not raise tax rates on the additional income people earn by putting in an extra effort. Meanwhile, closing loopholes does reduce the time Americans devote to gaming the tax code, freeing their energy for more productive things. Since the rich make greatest use of loopholes, closing them is good for equality and good for efficiency. The next editorial in this series will explore some of these win-wins.

This is the fifth editorial in an occasional series on inequality. Previous editorials in the series may be found at

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