How Taxes Can Really Reduce Inequality

Mar 29, 2012Mark Schmitt

The progressive argument on taxes shouldn't focus exclusively on marginal rates. We need to rethink all the harmful incentives in our tax code to fight inequality.

Just out in the Boston Review this month is a forum on inequality -- not just the problem, but what to do about it, featuring Roosevelt Institute Fellow Mike Konczal among the participants. The lead essay by David Grusky argues that progressives have rushed to assume that redistributive tax policy (that is, tax rate increases on the very rich) are the obvious remedy for inequality, neglecting the structural distortions -- what he calls, confusingly, "rents" or "market failures" -- that allow the very rich to build up an even greater share of wealth before taxes than after. Grusky argues that rather than hoping for redistributive taxes to ameliorate pre-tax inequality, we should address the structural forces. He mentions two: high CEO pay and profound inequalities in educational opportunity.

Grusky is right that there is a limit to what modest changes to the progressivity of tax rates at the high end can do. Even assuming that economists Thomas Piketty, Emanuel Saez, and Stefanie Stancheva are correct in their contribution to the forum that the top individual income tax rate could go as high as 83 percent without adverse economic impact, there is a political limit which is no less real than an economic limit. Even progressives are reluctant to talk about raising marginal rates higher than 39.6 percent (the pre-Bush top rate) or the low 40s, and then only on those with incomes more than five times the median. Tax rate increases, absent a radical political transformation, will adjust for inequality only at the edges.

Other than Piketty et al, the respondents don't disagree with that point, but doubt Grusky's basic assumptions about inequality from a variety of angles. Konczal, for example, points out that it's not just inequality of pure income we should be concerned about, but radical inequalities of voice and political power.

But there's an important point that none of the respondents make, which is that there's more to taxes than marginal rates. The structure of taxation itself affects the "rents" or distortions that benefit the very wealthy and burden the working poor. Both of Grusky's alternatives show this. Take, for example, high CEO pay. Grusky argues that a higher tax rate would do little to change the structural incentives (captive boards, for example) that have driven up CEO pay. That may be right. But the tax code has created its own incentives for companies to overpay CEOs. For example, the limit of $1 million on the amount of executive pay that can be deducted as a business expense can be avoided if the pay is linked to performance. This not only permits high pay packages, it encourages CEOs to focus on short-term performance, which is often not in the long-term interest of the company or its employees.

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Favorable tax treatment of stock options also encourages high CEO pay. And many economists believe that the 1986 Tax Reform Act, which brought the top individual income tax rate lower than the corporate tax rate, encouraged corporate executives to take profits as pay rather than let it stay in the corporation where it would be taxed at a higher rate. There is certainly a strong correlation, as the sharp climb in CEO pay begins at exactly that point.

Which is to say, we can do more with the tax code than just fiddle with rates. We can change incentives in the corporate tax or the individual income tax to change the incentives on executive pay. We could even vary the corporate tax rate based on CEO or top executive pay, or the ratio of the CEO pay to average-worker pay, benefitting corporations like Whole Foods that both pay their CEOs less and average workers more.

Grusky's other proposal is to radically broaden access to higher education, by "increasing the number of slots in higher education and committing to fair and open competition for them." He's not very specific about how to do that. But, again, the tax code provides some examples of how we already structure access to higher education in ways that benefit the better-off. Tax benefits -- deductions and credits -- form an ever-larger share of how we pay for higher education, totaling $14.7 billion in 2012. While one program, the (temporary) American Opportunity Tax Credit, is refundable, so that even families that pay no income tax can benefit, the majority are not, and programs such as 529 accounts for college savings benefit almost exclusively the well-off. A study by the College Board showed that households with incomes over $100,000 receive 26 percent of the benefits of higher education tax expenditures. Pell Grants, on the other hand, overwhelmingly benefit students from families with incomes below $50,000. Pell Grants are scheduled to be cut under last summer's budget deal. A shift from some of the tax expenditure programs to Pell Grants would preserve college opportunity for millions of low- and moderate-income students.

There's more to the tax code than marginal rates. In many ways, the code's complex web of incentives and preferences represents the deep structure of our national priorities, one that often seems to benefit the middle class while largely benefiting the wealthy. Tax reform that looks at much more than the top rate can address economic inequality in exactly the way Grusky proposes.

Mark Schmitt is a Senior Fellow and Director of the Fellows Program at the Roosevelt Institute.

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