Entitlements not tax cuts widen income gap

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Article Highlights

  • Federal income taxes lowered income inequality between 1979 & 2007; federal payroll taxes that fund Social Security & Medicare raised it.

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  • Federal transfer payments have done more to increase income inequality than federal taxes.

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  • We should limit future increases in transfer payments to affluent households and cap deductions for home mortgage interest taxes.

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What should be done about income inequality? That basic question underlies the arguments hashed out in the supercommittee and promises to be a central issue in the presidential campaign.

Supercommittee Democrats argue that income inequality has been increasing and can be at least partially reversed by higher tax rates on high earners. They refused to agree on any deal that didn't include such tax increases.

"Keeping entitlements as they are and raising tax rates on high earners is a recipe for Europe-style stagnation. [Paul] Ryan and the supercommittee Republicans point toward a better way." --Michael BaroneSupercommittee Republicans offered a plan to eliminate tax preferences and reduce tax rates, as in the 1986 bipartisan tax reform. They argued that high tax rates would squelch economic growth.

They didn't make the case that their proposals would also address income inequality. But House Budget Committee Chairman Paul Ryan, in a 17-page paper based largely on a Congressional Budget Office analysis of income trends between 1979 and 2007, has done so.

Ryan, a Republican from Wisconsin, makes the point that the government redistributes income not only through taxes but also through transfer payments, including Social Security, Medicare, food stamps and unemployment benefits. The CBO study helpfully measures income, adjusted for inflation, after taxes and after such transfer payments.

Many may find the results of the CBO study surprising. It turns out, Ryan reports, that federal income taxes (including the refundable Earned Income Tax Credit) actually decreased income inequality slightly between 1979 and 2007, while the federal payroll taxes that supposedly fund Social Security and Medicare slightly increased income inequality. That's despite the fact that income tax rates are lower than in 1979 and payroll taxes higher.

Perhaps even more surprising, federal transfer payments have done much more to increase income inequality than federal taxes. That's because, in Ryan's words, "The distribution of government transfers has moved away from households in the lower part of the income scale. For instance, in 1979, households in the lowest income quintile received 54 percent of all transfer payments. In 2007, those households received just 36 percent of transfers."

In effect, Social Security and Medicare have been transferring money from low earning young people (who don't pay income tax but are hit by the payroll tax) to increasingly affluent old people.

The Democrats, perhaps following the polls and focus groups, have been protecting these entitlement programs that have done more to increase income inequality than the Reagan and Bush tax cuts put together.

Ryan makes three more points that may strike many as counterintuitive.

First, reductions in some transfer payments haven't hurt the living standards of most low earners. The prime example is the welfare reform act of 1966 that reduced transfers to single mothers, but induced many of them to find jobs that left them better off economically and, probably, psychologically.

Second, Americans aren't trapped in one segment of the income distribution. A Tax Journal analysis of individual income tax returns found that 58 percent of those in the lowest income quintile in 1996 had moved to a higher income segment by 2005. This comports with common experience. We move up and down the income scale in the course of a lifetime.

Finally, the inflation adjustment used in the CBO analysis was the Consumer Price Index. But that tends to overstate inflation (as any indexes tends to do, since it measures the cost of a static market basket of goods and services). A study by Chicago economist Christian Broda found that prices for goods purchased by low earners have been rapidly decreasing, while prices for goods of high earners have increased. Kids' school clothes may be cheaper at Walmart than they were years ago, while prices at Neiman Marcus keep increasing.

So if the question is how to compensate for increasing income inequality, higher tax rates on high earners won't do much -- and could be counterproductive if they diminish economic growth.

A better way is suggested by the supercommittee Republicans: Limit future increases in transfer payments to affluent households and cap deductions for home mortgage interest and state and local taxes that are hugely lucrative for high earners and worthless for low earners who don't pay income tax.

These proposals won't reduce income inequality altogether. Much of the increased inequality comes from the huge increases for those in the top 1 percent of earners. But we wouldn't be better off if Steve Jobs had never existed.

Keeping entitlements as they are and raising tax rates on high earners is a recipe for Europe-style stagnation. Ryan and the supercommittee Republicans point toward a better way.

Michael Barone is a resident fellow at AEI.

 

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