Essay on Income Inequality and Tax Distribution

The last few decades have seen a substantial increase in income inequality in most countries around the world. In the United States, income inequality has been on the rise since the late 1970s with class warfare becoming the mainstay of liberal politics during this period. Income inequality is a measure of the extent to which the incomes of households differ and is driven by different growth rates in different household income cadres. The rapid increase in income inequality in the country over the last few decades is arguably one of the most important social and economic issues in modern America (Fieldhouse). The rapid growth in income inequality in the last three decades or so has been largely driven by relatively rapid income growth at the top of income distribution in this country.

To understand the full scale of income inequality growth in the United States, one only needs to compare the disparity between the top and bottom quintiles regarding income. For example, in 1975 the average annual household income for households in the top quintile of the income distribution was about 10.3 times the average annual income for households in the lowest quintile of income distribution in the country. In 2015 the average income for households at the top of the distribution was about 16.3 times that of households at the bottom (Labonte and Donovan 3). The pattern of distributional change during this period, however, was not constant. From the late 1970s to about the year 2000, incomes grew steadily for households in all quintiles. Income inequality snowballed during this period because incomes for households in the top quintile grew faster than the others. Between 2000 and 2015, there was modest growth for households in the top two quintiles and a decline in income for households in the bottom three quintiles (Labonte and Donovan 4). The net effect was a sustained increase in income inequality in the country.

There is a complex relationship between income inequality and taxation policies in this country. While taxation has a central role in mitigating economic inequality, less progressive tax codes have often been blamed for widening the gulf between the rich and the poor. Studies in the past have found that non-redistributive tax and budget policies played a massive role in exacerbating wealth and income inequality in this country. That view is backed by the fact that income growth in the top 1% of households almost invariably correlates with tax cuts (Fieldhouse). Therefore, while market dynamics are mostly to blame for the gulf between the rich and the poor in the United States, the government, through taxation policies, bears the responsibility for exacerbating it. Other ways the government is responsible for widening the wealth gap include minimum wage erosion, labor protection, trade-or the lack thereof- and other harder to quantify ways. To justify tax cuts for people and households in the top percentiles of income distribution, it has been claimed that a tax reprieve on the wealthy results in an increase in economic growth. It has also been argued that increasing taxes for the wealthy has the effect of reducing their productivity. Recent research, however, has discounted that showing that increasing taxes on the wealthy only causes them to shift their income to categories that are taxed relatively lower, like investment income (Fieldhouse)

The value of taxation in reducing inequality, on the other hand, is a little more complex. It is commonly believed that income tax structures have a tradeoff between equity and efficiency. Conventional wisdom in public finance literature holds that efficiency is best attained by using lump-sum taxes that do not influence the choices people make. Vertical equity, however, requires graduated taxation policies containing individual specific deductions and allowances which, to a good extent, distort the choices people make. In that regard, taxes that are equitable are thought to reduce efficiency while those that are geared towards efficiency are thought to reduce equity. Underlying the presumption that these two objectives are somewhat always in conflict is the presupposition that high levels of tax progressivity play a role in the reduction of income inequality (Duncan and Sabirianova Peter 12). That view, however, is significantly undermined by tax evasion. Given the correlation between tax evasion and tax rates, it is possible that tax progressiveness could end up reducing the levels of both equity and efficiency. The possibility of progressive tax schedules reducing both equity and efficiency arise where they have a differential effect on false or observed income inequality as in reported income, and actual income inequality as obtained from true income in the presence of tax evasion. The effects of tax reforms on equity are therefore dependent on some factors, and it is, therefore, important for any work undertaken to study that to keep in mind the differential effect of progressive tax schedules on actual vs. observed income inequality (Duncan and Sabirianova Peter 16).

Purpose of the study

This paper will attempt to determine the effects of taxation on income inequality in the United States. It will attempt to determine the underlying mechanisms affecting income inequality. It will identify the factors that play a primary role and those that play a secondary role in expanding income inequality. Such an analysis will provide the necessary information to guide policy changes in the future to curtail the soaring levels of income inequality. The paper places special emphasis on the effect of income tax and related policy changes on the level of income inequality in the country for the last three decades.

Methodology

This paper analyses the empirical trends in pre- and post-tax household income levels for the last three decades. It summarizes both theoretical and empirical research on the role of income taxation policy on household income. The main sources of the information presented in the paper are data and tax history.Data

Several data sources have been utilized in studies querying the impact of taxation on income inequality with particular emphasis on tax return data and direct household surveys like the Current Population Survey (CPS) (Labonte and Donovan 8). These sources of data both have pros and cons. For instance, it is common knowledge that while tax returns are immensely beneficial in helping calculate income distribution, they typically do not contain any information on non-filling household which usually constitute the bottom tiers of income distribution ( (Bargain and Dolls 11). While the CPS is an indispensable source of data for the distribution of housed income in the United States and the main source of government statistics, the information it contains is not in respect to itemized deductions which might affect the results of this paper. Additionally, the Census Bureau codes all income sources because of confidentiality considerations with the methods changing every year. There is a need, however, to devise ways to overcome the shortcomings of the methods selected to obtain data for this study. One way to overcome the shortcomings is by using data from the Internal Revenue Service for the imputation of itemized deductions

Sample Selection

This paper focuses on a sample that solely includes non-elderly households. These are households where at least one member of the family is of working age, i.e., between 18 and 69. That sample section is motivated by the fact that this paper is focused solely on tax policy and it does not take into consideration transfers for the elderly (Bargain and Dolls 12). The focus of this paper is on pre- and post-tax income whose definitions are like commonly done in literature. Pre-tax income is obtained from data and is in accordance to the census definition of money income that measures income and poverty. Pre-tax income was computed as the summation of all forms of market income including pretax wages and business income etc. with private and public transfers. Public transfers include such things as welfare payments, social security, and unemployment benefits. Post-tax income, on the other hand, comprises pre-tax income minus all the simulated deductions of the income tax system applicable to the individual.

Tax History

Here, the paper briefly provides an overview of the major US Federal tax system changes for the last three decades. The focus is mostly on major legislative changes with major effects on the tax policy. Some of the most important tax reforms include the Revenue Act of 1978, The Tax Reform Act of 1986, The Taxpayer Relief Act of 1997, the Economic Growth and Tax Relief Reconciliation Act of 2001, the Jobs and Growth Tax Relief Reconciliation Act of 2003 and the American Recovery and Reinvestment Act of 2009 (Bargain and Dolls 13). The Revenue Act of 1978 aimed to expand GDP growth by broadening tax brackets and reducing individual taxes. The Tax Reform Act of 1986 also saw the widening of the tax base and a reduction in marginal taxes in a bid to make the taxation system more conducive to sustained growth (Bargain and Dolls 14). Tax reforms in the 1990s introduced more tax credits and reduced capital gains tax rates. Tax reforms between 2000 and 2010 ranged from reducing tax rates to attempting to counter the economic contraction during the global recession.

Literature Review

Growth in income inequality in the United States has simulated a significant body of research querying the underlying driving factors. A lot of empirical literature examines the cross-sectional evolution of income inequality in the United States since the 1970s. Intense interest in the effects of tax schedules in income distribution can be traced back to the hypothesis by Meltzer and Richard, that when there is an increase in average income relative to median income in the wage distribution, a good number of those in the lower cadres of income distribution will support higher taxes preferably in the form of direct progressive taxes as opposed to indirect taxes (916). There is a lot of applied research on tax incidence whose findings allocate tax burdens among different wage groups according to common assumptions related to tax shifting. These assumptions as found in the literature on tax incidence include; personal income tax is regarded to be progressive. Additionally, social security taxes and payroll are assumed to be regressive and are shifted to the worker. Taxes on goods and services including value-added tax and custom duties are considered to have been shifted to the customer and are therefore regressive.

While most empirical studies indict the role of tax structure in reducing income inequality in most developing and developed countries, the case for the United States is slightly different. Li and Sarte found that the progressivity change associated with the Tax Reform Act of 1986 had far-reaching effects in reducing income inequality in the United States (1708). According to their research, the Tax Reform Act reduced income inequality in the United States by as much as four percentage points of the Gini Coefficient. The Gini coefficient, also known as the Gini Index is a measure of inequality that quantifies income dispersion. Duncan and Sabirianova Peter also undertook to assess the effects of tax progressivity on income distribution (14). Using sophisticated measures of metrics of progressivity, they found that while progressivity in national ta systems markedly reduces disparities in observed inequality based on reported gross and net incomes, as calculated using Gini coefficients from that data, its effect on true inequality based on actual gross and net wages is a lot smaller. What they may have failed to take into account, however, is the fact that the relative effect of p...