Understanding the income tax and its impact requires distinguishing the statuary rate from the actual rate. The statutory rate from the New Deal to Reagan reached a high of 94%, but the actual rate- the percent paid after deductions and credits was much lower. When Reagan lowered the rate first to 50% then to 28%, he also removed many personal deductions such as consumer interest. The drop in the rate of actual taxes paid was much less severe than the drop in the statutory rare, yet rarely in the discussion of tax fairness is the distinction made.
In terms of the impact on economic behavior the marginal rate is most important; the rate on the incremental dollar of earnings. A high statutory rate becomes a high marginal rate when the deductions and credits expire or are exhausted.
A citizen receiving $30,000 worth of benefits in the forms of food stamps, housing subsidies, health care, etc. may lose these benefits if he earns $30,000 in income. The effective marginal rate in this case is 100%, a huge disincentive to move into the work force.
We can trace the increase in income inequality to the Reagan tax cuts, but that may be more of a correlation than a cause. The tax code has become much more progressive during that time, yet inequality grew. The left thinks it should become more progressive, but that may be doubling down on a failed solution.
The high maximum statutory rates did not stop us from the lost decade of the 1970’s. Without the temporary demand of a war economy and the industrial devastation of our overseas competitors we were unable to support the bloated welfare state of the New Deal and the Great Society.
Just as we should clarify the tax rates, we should clarify inequality. Measuring equality after taxes and transfer payments flattens the curve substantially. If the inequality is caused by a very large increase in a very small upper income elite, policy should proceed carefully. If the solution to disproportionate wealth among the upper one tenth of one percent ends up affecting the upper five percent, then the outcome may be counterproductive and could even increase inequality.
An income of $1.5 million puts you in the top 1/10%, $35 million puts you in the top 1/100 %. But only $480,000 is needed to enter the top 1% and only $300,000 puts you in the top 5%. These only measure income, not wealth.
It is much easier to attack the wealthy if you never define it. It is a delusion to think that a heavy tax to fund a generous welfare state can be funded by a tax on a tiny percent of the tax payers. There just are not enough of them; the middle class inevitably gets the bill. Europe has already recognized this; we have not.
There are many factors that affect inequality and the progressiveness of the tax code is only one. As Michael Tanner wrote in his recent The Inclusive Economy many of our laws make it more difficult for the poor to exit their dependency. The criminal justice system, poor educational system, housing costs, policies that prevent the lower income from participating in the financial system, and unnecessary licensing to start businesses make that first rung on the ladder to success much harder. Voluminous and complex regulations favor larger companies with the infrastructure to meet these costs.
The more regulations businesses face the more they fund lobbyists to influence these regulations to their advantage. Much of the financial and business interests influencing political power that caused such alarm to early progressives have simply been registered and institutionalized in the form of lobbyists. Increased complexity of regulations may have more influence on inequality than the progressiveness of our tax code.
One aspect of the tax code escapes scrutiny and it is most infuriating to those it affects most. Businesses are chastised by political leaders for being too short term oriented, but the greatest reason for that is the short-term focus of our tax policy. Taxes are one of the greatest expenses of a business and yet taxes are constantly threatened to change anytime a politician is near a microphone.
We should consider that the dynamics of a new economy creates dislocations rarely understood until the period has past. Many of our new industries and economies were not predicted and evolved quicker than the government was capable of understanding or addressing. Any attempt at regulating under this new dynamic is fraught with unforeseen risk and consequences.
We must be careful how we measure taxes and inequality and we need a much more stable policy. We should be skeptical of simple solutions extracted from a past era under very different conditions. We should also learn the lesson of Hong Kong’s success noted in Architect of Prosperity: Sir John Cowperthwaite and the Making of Hong Kong by Neil Monnery. If you prioritize economic growth over social spending, you will have a great measure of both: if you prioritize social spending over growth you will have less of both.