Despite Rising Inequality, Tax Code is at Most Progressive in Decades

January 3, 2014

One of the persistent themes in all of the news reports and editorials about inequality is that the rising incomes of the 1% are in some way the result of a repeated tax cuts for the rich and a tax system that is rigged in favor of the wealthy.

While it is true that scores of tax breaks favor high-income taxpayers, the irony is that the the tax system has become increasingly progressive as inequality in America has grown. Indeed, a recent Congressional Budget Office report finds that the overall federal tax system is more progressive today than it has been over the past 35 years. And the biggest growth in progressivity has been in the income tax, which is nearly twice as progressive today as it was in 1979 at the end of the Carter Administration.

These seemingly contradictory events raise some serious questions:

  • Are there factors driving inequality that have nothing to do with the tax code?
  • Is the tax code the right tool to combat inequality?
  • Is it possible that the way we are trying to use the tax code to combat inequality is actually undermining the factors that could close the gap between rich and poor?

All worthy questions, but let’s look at the facts first.

The chart below compares the changes in the inequality of income to the progressivity of both the income tax and the overall federal tax system. It is easy to see that all three metrics are at a higher level today than at virtually any point since 1979. [The data is drawn from CBO’s supplemental workbook tab #7].

In this example, inequality is measured by what is known as the Gini Index, which tells us how far from perfect equality is the current distribution of household income. A value of zero indicates that income is distributed evenly across all groups, while a value of 1 indicates complete inequality (that one household or group receives all the income). Market income, in this example, is a broad measure of income that includes employer-provided health insurance, payroll taxes, and capital income. According to CBO, in 1979, the Gini Index stood at 0.476 and has been growing gradually ever since. It now stands at 0.586.

We can also see that the progressivity of the overall tax system has grown at roughly the same pace in recent years as has the inequality index. However, much of this growth is being driven by the rapid increase in the progressivity of the income tax system.

The chart shows that tax progressivity did decline after the 1981 tax cuts, which lowered the top marginal tax rate from 70 percent to 50 percent. However, progressivity jumped following the passage of the Tax Reform Act of 1986 and has grown steadily ever since.

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While the ’86 Act lowered the top marginal tax rate from 50 percent to 28 percent, it also increased the value of the standard deduction, personal exemption, and Earned Income Tax Credit; each of which provided a considerable amount of tax relief to lower-income taxpayers and took millions of filers off the tax rolls.

Since then, lawmakers have been making the income tax system even more progressive by successively increasing top tax rates while enacting and expanding various credits—such as the child credit, the Earned Income Tax Credit, and the temporary Making Work Pay tax credit. Many of these credits were made refundable so that taxpayers received a check back from the IRS even if they have no tax liability. The effects of these credits, plus the recession, are seen in the spike in progressivity after 2007.

Interestingly, while the Bush tax cuts are often cited as a cause of today’s rise in inequality, the progressivity of the income tax system remained far higher after the enactment of those tax cuts than at any time during the Clinton administration.

The lesson here is that the tax code may not be the best tool to combat inequality. While tax credits can provide temporary relief to low-income families, attempting to redistribute the wealthy’s income with higher tax rates—especially on capital and business income—ultimately hurts the poor by undermining the factors that can boost economic growth and increase living standards.

Thus, the smart way to close the gap between rich and poor is to reform the tax code in a way that lowers the cost of capital, makes workers more productive, and makes the American economy more competitive.

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