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Taxes and Inequality

Posted on Oct. 9, 2017
Henry Banta
Henry M. Banta

Henry M. Banta is of counsel with Lobel Novins & Lamont LLP. He previously served as counsel to the Senate Judiciary Committee.

In this article, Banta discusses the increasing problem of economic inequality in the United States.

Thomas Piketty’s monumental work, Capital in the Twenty-First Century, had an enormous impact on political discourse. Economic inequality has been established as a subject that cannot be ignored. Having said that, most of the public discussion is hopelessly superficial, contributing more to confusion and misunderstanding than to useful political debate.

First, we need public awareness of the historic scale of the transfer of wealth and income to the very top of the population. Second, we need an understanding of the relationship of income inequality to the massive increase in the wealth (as distinguished from, or rather in addition to, income) of an infinitesimal fraction of the public. Third, although many complex factors have certainly contributed to economic inequality, there are some conspicuous causes for the massive inequality we now face. At least for the short run, any effort to deal with inequality largely involves tax policy.

Public awareness is in many ways the most important issue. Virtually every politician at some point talks about inequality. That talk rarely gets beyond a vague idea that some people make and have more money than others. Most of the discussion, in some form, reflects the decline of the working class and the increasing insecurity of the middle class. To many it reflects the forces of global trade and the effects of technological change. To others, it reflects racial or gender discrimination. Those issues are important, but focusing on them keeps attention on the periphery of the inequality problem. For example, almost all politicians would rather deal with the need for increases in the minimum wage than address the massive shift in wealth and income from lower- and middle-income taxpayers to a tiny fraction of the population at the very top of the economic ladder. As a result, the most enormous transfer of economic resources since the 1920s occurred with surprisingly little public understanding about it.

The Washington Post in 2015 cited a recent National Bureau of Economic Research paper by two economists surveying what people in several countries, including the United States, knew about inequality.1 The paper concluded that ordinary people knew little about inequality and a lot of what they thought they knew was wrong.

The shift of wealth and income to the top 10 percent is deeply significant, but more troubling is the growth of wealth and income of the top 1 percent and even the top 0.01 percent. Indeed, it can be argued that this growth of economic power and resources at the very top should not be called inequality at all. In its economic and political implications, it bears little resemblance to the income and wealth differentials between the top and bottom of the middle class. The political effects of this shift to the top, although hard to measure, have had consequences that are impossible to ignore. Those effects represent a change in the nature of our democracy. While the scale of this change gets attention from academics and wonkish pundits, politicians and their disciples approach it with the utmost caution — strong evidence of its immense importance. The obvious reason for this caution, even on the part of progressives, is that the issue deeply touches the economic class that the political world depends on for its lifeblood — campaign contributions, and perhaps even more important, the services of conservative “think tanks.” Of course, the political world knows well the difference between the economic resources of the super-rich and everyone else. But no politician wants to talk about what must be done to make the donor class grateful and more generous. Even hardcore liberals prefer to keep the discussion vague.

It is worthwhile to take a quick look at some of the numbers. They are by any standard quite staggering. In December 2016, Piketty, Emmanuel Saez, and Gabriel Zucman reported that “the bottom half of the income distribution in the United States has been completely shut off from economic growth since the 1970s.”2 Since 1980, the pretax income of the top 10 percent rose 121 percent, for the top 1 percent it rose 205 percent, and for the top 0.001 percent it rose 636 percent.

The share of the country’s income going to the top fractions continues to grow. Late last year Saez reported that “the income (adjusted for inflation) of the top 1 percent of families grew from $990,000 in 2009 to $1,360,000 in 2015, a growth of 37 percent.” In the same period the share of everyone else grew “only 7.6 percent — from $45,300 to $48,000.”3 This means that more than half (52 percent) of the total real income growth went to the top 1 percent of families. The rest of the growth, the remaining 48 percent, went to the 99 percent. This is consistent with the increasing inequality that began in 1980.

Taxes play a large role in this. As The New York Times reported in late 2015, the 400 highest-earning taxpayers paid almost 27 percent of their income in federal taxes when Bill Clinton was elected president.4 By 2012, according to data from the IRS Statistics of Income division, that number had fallen to less than 17 percent — slightly more than the percentage paid by a typical family making $100,000 annually. To make it onto the list of the top 400 required an income of about $336 million, The Times reported, describing the implications:

Operating largely out of public view — in tax court, through arcane legislative provisions and in private negotiations with the Internal Revenue Service — the wealthy have used their influence to steadily whittle away at the government’s ability to tax them. The effect has been to create a kind of private tax system, catering to only several thousand Americans.

Perhaps the most ignored part of Piketty’s book is his finding that the largest factor in the creation of inequality in the United States is the compensation of the top managers of large corporations. He concluded that the wage inequality was mainly the result of “increased pay at the very top end of the distribution: the top 1 percent and even more the top 0.1 percent.”5

That observation is consistent with the AFL-CIO’s finding that in 2016, the CEOs of companies in the Standard & Poor’s 500 index received on average $13.1 million in total compensation. On average, the CEO-to-worker ratio was 347 to 1.

More recently, the Economic Policy Institute, using a different method, found that the CEOs of the 350 largest corporations made an average of $15.6 million in 2016 — 271 times more than the average worker, down a bit from 2015, when the ratio was 286 to 1.6 But more importantly, the institute concluded that the fact that CEO pay has grown faster than the pay of the top 0.1 percent of wage earners indicates that the CEO pay growth “does not simply reflect the increased value of highly paid professionals” but reflects the power of CEOs to extract substantial “economic rents.”

A 2015 Washington Post article cited a Harvard Business School study on the pay gap between CEOs and workers.7 In the year of the study, the average Fortune 500 CEO in the United States made more than $12 million per year, or more than 350 times the pay of the average worker. The study compared that pay gap with those of 15 other countries. It found that the United States had the highest CEO-to-worker ratio (350 to 1), Switzerland had the second highest (148 to 1), Germany had the third highest (147 to 1), and Spain had the fourth highest (127 to 1). Those international comparisons do considerable violence to the notion that CEO compensation is driven by market forces.

Regarding the general public’s ignorance about inequality, the Harvard Business School study found that Americans believe that CEOs make roughly 30 times what the average worker makes. As The Post commented, “Americans might think they know how bad inequality is, but it turns out they actually have no idea.”8

A related problem is the increasing concentration of management compensation — a result of declining competition in an economy dominated by a small number of large corporations. A growing body of literature points to the decline in competition as a major factor in the overall growth of inequality. In a world where competition was a serious discipline, no corporation would be able to afford to compensate its management on the scale that has become common. There have been many calls for greater antitrust enforcement.9 Perhaps the most significant came from the Obama administration’s Council of Economic Advisors.10 While saying little about specific policy, it noted that fewer competitors meant “increasing rents, in the form of higher returns on invested capital across a number of industries.” (“Increasing rents” is wonkish talk for making the rich richer.)

It should also be noted that a recent study by two economists at New York University found that the increasing concentration of market power in fewer corporations provides an explanation for the decline in new investment.11

The second issue that escapes public attention is the growth in the share of the country’s wealth held by the very top percentile of the population. For our purposes, wealth can be described as what one owns, in contrast to what one is paid. And there are increasing concerns about the concentration of wealth. As with income, the massive growth in wealth at the very top has been quite recent. Saez and Zucman found:

By our estimates, the share of wealth owned by the top 1 percent of families has grown since the late 1970s and reached 42 percent in 2012. Most of this increase is driven by the top 0.1 percent, whose wealth share grew from 7 percent in 1978 to 22 percent in 2012, a level comparable to that of the early 20th century.12

The relationship between the distribution of income and the distribution of wealth is a central issue in Piketty’s book. His controversial thesis is as follows:

When the rate of return on capital exceeds the rate of growth of output and income, as it did in the nineteenth century and seems quite likely to do again in the twenty-first, capitalism automatically generates arbitrary and unsustainable inequalities that radically undermine the meritocratic values on which democratic societies are based.13

Translation: When the rich get more from their investments than others get for working, the rich will get richer relative to others. This idea was expressed as r > g, with “r” representing the return on investment and “g” representing the rate of growth. That formula had a brief moment of fame. Stated in terms of wealth earning more than work, it had some popular appeal and was even emblazoned on some T-shirts.

The basic point — that the ratio of the growth of investment to the general growth of earnings in the economy determines the level of inequality in the economy — has provoked an academic debate of breathtaking proportions. It is that thesis that casts an aura of inevitability about the increasing wealth and income of the very rich — an inevitability that Piketty rejects. In any event, it argues for aggressive countermeasures dealing with both income inequality and wealth inequality.

The problem of income inequality is something we have faced before, and based on long experience, we know how to deal with it — at least since the passage of the 16th Amendment. The remedy is an increase in top brackets of the income tax. Of course, the income tax as it now stands is a mess. It has irrational exemptions and loopholes. It is both a cause and a consequence of the growth of income inequality. It purports to be progressive and is not. This is not because we don’t know how to make an income tax work; it’s because we just haven’t wanted to do it. The massive shift in wealth and income was largely the result of deliberate political action. Hedrick Smith’s Who Stole the American Dream provides an encyclopedia of the political distortions in our economic system. It identifies who promoted them, the politicians who implemented them, who benefitted from them, and who paid the costs. The account destroys any notion that somehow inequality is merely the byproduct of an efficient market.

The question of corporate taxes is equally confounding because, like income taxes, they are both a cause and a result of the shift in economic power. Again, Smith provides a comprehensive history of what happened.

Like the increases in income, the growth of wealth at the top has drawn relatively little attention. Incremental changes in economic statistics are not big news. It’s the same dynamic that makes a single airplane crash big news and 30,000 highway deaths no big deal. But in the face of this indifference, we are increasingly hearing a small chorus of knowledgeable commentators calling for a wealth tax. The appeal is considerable. Daniel Altman, an adjunct associate professor of economics at New York University’s Stern School of Business, wrote in The New York Times:

Trends in the distribution of wealth can look very different from trends in incomes, because wealth is a measure of accumulated assets, not a flow over time. High earners add much more to their wealth every year than low earners. Over time, wealth inequality rises even as income inequality stays the same, and wealth inequality eventually becomes much more severe.14

However appealing a tax on wealth may be, implementing it would not be simple. David Kamin has identified the challenges in using taxation to address inequality.15 He finds taxing wealth problematic. For example, there may be a constitutional issue. In the final analysis, the issue may not be fatal to a wealth tax, but it could be sufficiently credible to deter any casual reliance on that tax. And careful analysis reveals that even something as simple as increasing the capital gains rate would be less effective than it at first appears. Moreover, options as appealing as the Buffett rule would raise much less revenue than expected. Kamin lists as “more promising options” such easily administered measures as an increase in the estate or gift tax and an increase in the ordinary income tax rate.

Zucman’s The Hidden Wealth of Nations addresses the problem of tax havens. According to his estimates, offshore tax evasion costs the United States about $35 billion annually. He finds that eliminating the U.S. tax revenue losses from tax havens would be equivalent to an average tax increase of about 20 percent for all taxpayers within the top 0.1 percent income group. That makes a strong case for a global corporate income tax that would prevent corporations from avoiding taxes by transferring income to another country with a low or no corporate tax.

In sum, the problem of inequality is immense. In its sheer size, it is far beyond what the public understands and beyond what the political leadership is willing to recognize, much less deal with. Yet what is at stake is our very democracy. Over the last 30 years the United States has permitted the growth of a monstrous super-class that is more than capable of pursuing its own interests over those of the country. Although some in the media and government understand how serious a threat we face, their voices have yet to affect our politics — at least not on the scale necessary to confront the problem.

Ganesh Sitaraman, in The Crisis of the Middle-Class Constitution, reminds us how much the United States’ constitutional democracy has always depended on a middle class that values economic equality. A law professor at Vanderbilt University, Sitaraman argues that a large, stable, and prosperous middle class is essential to the survival of our basic values and that the viability of the U.S. constitutional system cannot be separated from a more egalitarian economy.

In the current political environment, there is virtually no chance of an assault on inequality. Few Democrats appear to have clear economic principles. To even mention the size of the problem is beyond most of them. Offending the wealthy donor class is something they want to avoid at almost any cost. In the age of Trump, all that the Republicans have left is their alliance with the ultra-rich and the devotion of their followers to the neoliberal ideology.

But even now there is reason for hope. In the end, the debate over the Affordable Care Act was essentially an argument over taxes. The ACA provided healthcare to millions who otherwise could never have afforded it. But because it depended on a very progressive tax, it drew the opposition of the wealthy and many of the law’s political enemies. The Center on Budget and Policy Priorities estimated that repeal of the ACA would give each of the 400 highest-income households an average tax cut of about $7 million a year. It took a while for the rest of the electorate to recognize their own interest and stand up to the rich and powerful. When repeal failed, the result was an improbable victory for ordinary people. With any luck, it won’t be the last.

FOOTNOTES

1 Emily Badger, “People Have No Idea What Inequality Actually Looks Like,” The Washington Post, May 18, 2015 (citing Vladimir Gimpelson and Daniel Treisman, “Misperceiving Inequality,” NBER working paper no. 21174 (May 2015)).

2 Piketty, Saez, and Zucman, “Economic Growth in the United States: A Tale of Two Countries,” Washington Center for Economic Growth (Dec. 6, 2016).

3 Saez, “U.S. Top One Percent of Income Earners Hit New High in 2015 Amid Strong Economic Growth,” Washington Center for Equitable Growth (July 1, 2016).

4 Noam Scheiber and Patricia Cohendec, “For the Wealthiest, a Private Tax System That Saves Them Billions,” The New York Times, Dec. 29, 2015.

5 Piketty, Capital in the Twenty-First Century 314 (2013).

6 Lawrence Mishel and Jessica Schieder, “CEO Pay Remains High Relative to the Pay of Typical Workers and High-Wage Earners,” Economic Policy Institute (July 20, 2017).

7 Drew Harwell and Jena McGregor, “This New Rule Could Reveal the Huge Gap Between CEO Pay and Worker Pay,” The Washington Post, Aug. 4, 2015 (referencing Sorapop Kiatpongsan and Michael I. Norton, “How Much (More) Should CEOs Make? A Universal Desire for More Equal Pay,” 9 Persp. Psych. Sci. 587 (2014)).

8 Roberto Ferdman, “The Pay Gap Between CEOs and Workers Is Much Worse Than You Realize,” The Washington Post, Sept. 25, 2014 (referring to Oliver P. Hauser and Norton, “(Mis)perceptions of Inequality,” 18 Current Op. Psych. 21 (2017)).

9 See, e.g., Matt Stoller, “The Return of Monopoly,” The New Republic, July 13, 2017; “The Superstar Company: A Giant Problem,” The Economist, Sept. 17, 2016; Jonathan B. Baker and Steven C. Salop, “Antitrust, Competition Policy, and Inequality,” 104 Geo. L.J. 1 (2015); and Einer Elhauge, “Horizontal Shareholding,” 129 Harv. L. Rev. 1267 (2017).

10 Council of Economic Advisers, “Benefits of Competition and Indicators of Market Power,” Issue Brief (Apr. 2016).

11 Max Ehrenfreund, “Researchers Have a New Theory for Why Companies Are Sitting on Ungodly Piles of Cash,” The Washington Post, July 21, 2017 (citing Germán Gutiérrez and Thomas Philippon, “Declining Competition and Investment in the U.S.,” NBER working paper no. 23583 (July 2017)).

12 Saez and Zucman, “Wealth Inequality in the United States Since 1913: Evidence From Capitalized Income Tax Data,” 131 Q. J. Econ. 519 (2016).

13 Piketty, supra note 5, at 1.

14 Altman, “To Reduce Inequality, Tax Wealth, Not Income,” The New York Times, Nov. 18, 2012.

15 David Kamin, “How to Tax the Rich,” Tax Notes, Jan. 5, 2015, p. 119.

END FOOTNOTES

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