WHILE FEW QUESTION the fact that income inequality has risen in the United States over the past three decades, there is plenty of dispute about why. Some argue that the upward shift in after-tax income reflects a high-tech society’s increasing rewards to highly skilled workers, or the rise of super-paid “superstars” in everything from finance to sports, or the decline of labor unions and the minimum wage.
Another concern is that the lighter federal taxation of capital gains and other investment income relative to ordinary income has skewed income distribution upward. This is related to the so-called “Buffett Rule,” whereby the Omaha billionaire (and former Washington Post Co. board member) Warren Buffett pays income tax at a lower effective rate than his secretary does, largely because so much of his income comes from investments.
Now comes evidence that this is, indeed, at least part of the story. A report by the nonpartisan Congressional Research Service shows that, between 1996 and 2006, the share of total after-tax income attributable to dividends and capital gains grew by 40 percent, faster than any other category. Earned mostly by the well-to-do, investment income was the largest contributor to the increase in income inequality between 1996 and 2006, according to CRS.
The tax cuts enacted at the urging of President George W. Bush magnified what CRS calls the “disequalizing” impact of this shift. The 1986 tax reform eliminated the gap between the ordinary and capital gains rates. The gap began to widen again during President Bill Clinton’s second term, but the Bush tax cuts of 2003 blew it wide open by slicing the top rate on dividends and long-term capital gains from 28 percent to 15 percent. The tax code as of 2006 was still progressive, in that top earners paid a greater share of their income to Washington than everyone else. But thanks largely to the more favorable treatment of investment income, the code was significantly less progressive in 2006 than it was in 1996, CRS found.
True, the study does not account for the impact of the Great Recession, which hit top earners hard. The top 1 percent’s share of total income (before taxes) dropped from 23 percent in 2007 to 17 percent in 2009. That group’s average income fell to $957,000 in 2009 from $1.4 million in 2007. A plunging stock market is probably the cause.
Yet it remains true that the top ordinary income rate of 35 percent is 20 points higher than the 15 percent rate on dividends and capital gains. Not only does this foster inequality, it also creates an incentive to seek investment income rather than the ordinary kind, either through productive investment that creates jobs or through tax shelters and other gimmicks.
There is a case to be made that capital gains and dividend taxes are a second tax on earnings that have been subject to the 35 percent corporate income tax; the report acknowledges that this argument has merit.
But it shouldn’t be impossible to resolve this dilemma. One approach would be to lower corporate rates to compensate for increasing rates on individual filers’ dividends and capital gains. A 2007 CRS report suggested that Congress could cut four percentage points from the corporate rate if it eliminated the Bush tax cuts on dividends and capital gains, and that the code’s overall efficiency would improve in the process. When Congress turns to tax reform, it will have to keep equality as well as efficiency in mind.