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Attacking Inequality
Tax Reform Has the Greatest Potential To Narrow the Gap

By Sebastian Mallaby
Monday, September 4, 2006

By now almost everyone agrees that inequality is serious. Economic growth no longer seems to help the majority of workers; the proceeds flow to the top fifth or so of the workforce, and the top within the top has done especially handsomely. But the tough debate is what to do about this trend. The surprising answer is: tax reform.

Start with a few other proposals. Trade protection could help workers in the heavily traded manufacturing sector by shielding them from competitive pressure on their wages. But the cost to economic growth would be severe, and even if you don't care about growth, protectionism is a blunt tool for reducing inequality. Many of the poorest U.S. workers are employed in non-traded service jobs -- hotel workers, retail workers and so on. These workers benefit from trade, which puts little downward pressure on their wages but a lot of downward pressure on the price of goods they purchase.

Is unionization a more promising response to inequality? The old argument against organized labor is that the market can be trusted to align wage gains with productivity gains, making unions unnecessary. But over the past half decade productivity has shot up while real wages have stagnated. The case for unionization appears better than it has in a generation.

But unionization can't be the main answer. There's little that unions can do to protect wages in traded parts of the economy, since tough wage bargaining in these sectors will send jobs to other countries. And the traded sector accounts for most of the gap between rising productivity and stagnant pay; in other words, unionization may not be able to affect the parts of the economy that arguably most need it. Meanwhile, unionization imposes costs as well as benefits -- as when it obstructs business innovation.

What about raising the minimum wage, another popular remedy for inequality? There's a long-standing debate about whether a higher minimum wage causes employers to create fewer jobs or perhaps to recoup the cost by allowing work conditions to deteriorate: Wages for factory workers go up, but management spends less on air conditioning. It seems reasonable to argue that, in an economy where jobs are plentiful, a higher minimum wage represents a good trade-off. But this can't be the central answer to inequality either. The current push to raise the minimum wage to $7.25 per hour would directly benefit fewer than 6 million workers.

At this point the left begins to seethe: I've poured tepid water on trade protection, unionization and increasing the minimum wage so what the heck am I proposing? Increasingly even moderate Democrats believe that you can't be serious about helping workers unless you embrace organized labor's agenda. In the view of many in the party, the centrist, "Republican-lite" playbook has been tried and found wanting.

Actually, that's nonsense, and a good place to see the redistributive potential in centrist policies is tax reform. Many popular provisions in the tax code are both ineffective and regressive. Repealing them would liberate billions that could be used to help workers.

Take mortgage-interest relief, a policy that's supposed to boost home ownership. More than half of this subsidy flows to the top 12 percent of households with incomes over $100,000; the poor get very little. This absurdly regressive policy doesn't even promote its objective, since affluent families would own their own homes anyway. The U.S. home ownership rate is no higher than Britain's or Australia's, two countries that have no mortgage-interest tax relief.

Tax incentives to promote savings are equally regressive. Half of the subsidies for IRAs, 401(k)s and other retirement accounts are pocketed by the richest tenth of households; the bottom two-fifths get only 3 percent of the benefits. Again, this absurdly unfair system doesn't even promote its objective, since the rich tend to save anyway, whether or not they get tax subsidies. Meanwhile, poor families that are not saving don't get the incentive to do so, because so much of the tax break is funneled to the rich. A chance to boost national savings is wasted.

The same argument holds for tax incentives to buy health insurance. Just over a quarter of this subsidy is swallowed by households in the $100,000-plus bracket; far from promoting the wider dissemination of health insurance, it may even reduce it. Affluent Americans use the subsidy to buy all-inclusive health plans, which in turn causes them to throw money at health services; health inflation goes up, making insurance too expensive for poor families. The Treasury estimates that the ranks of the uninsured could be reduced by at least 1 million if the tax deduction for health insurance were capped at a reasonable level.

Fixing these egregiously regressive programs could yield really juicy benefits. On a back-of-the-envelope calculation, raising the minimum wage might transfer $10 billion a year to poor workers; call it $20 billion if you want to stretch the assumptions generously. But if you eliminated just a quarter of the subsidies in the tax code, you would liberate about $180 billion a year -- enough to finance a big expansion in the earned-income tax credit plus a cut in the regressive payroll tax. And this sort of redistribution would not risk higher unemployment or compromise economic growth at all. Democrats on the left and right ought to be embracing it.

smallaby@washpost.com

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