Blame the Economy for Widening Inequality – And Washington for Doing Little about It

Blame the Economy for Widening Inequality – And Washington for Doing Little about It

October 3, 2017

America’s widening income inequality has become a subtext across most debates in domestic policy.  GOP plans to repeal and replace Obamacare failed in large part because virtually every expert warned that the changes would end coverage for millions of people with modest incomes and cut taxes for high-income people.  President Donald Trump’s push to cut business taxes will likely meet a similar fate.  He shouldn’t be surprised: The populist revolt that helped elect him has been fueled by popular anger over Washington’s incapacity to do anything about how the economy skews its rewards towards those at the top and away from most everyone else.

Ask the right questions, and the income data reveal a great deal about how this inequality took hold over the last 40 years.  It is given that the American economy and politics both changed dramatically over this period.  But how did each of those forces affect the distribution of incomes? In a new study just issued by the Center for Business and Public Policy at the McDonough School of Business at Georgetown, I used statistical analysis to explore this question.  It turns out that we can track the economy’s role in growing inequality by following the changing distribution of all pre-tax income, and then track the role of politics and the government by following the changing distribution of all post-tax income.

It also turns out that the new populists, or at least their feelings, are justified:  As economic changes have produced widening income inequality, the government has remained largely though not entirely on the sidelines.

To begin, the data show that rising inequality in the United States began in 1977, and the same data series ends with 2014, giving us 37 years of income information on both a pre-tax and post-tax basis.  Over those years, the share of pre-tax national income going to the bottom 50 percent of Americans – that is, not taking account of changes in taxes and government transfers – slumped from 20 percent to 12.5 percent.  This was the doing of a changing economy as globalization and technological advances steadily squeezed the wages and working hours of tens of millions of low, moderate and middle-income Americans.

Over the same years, the share of all pre-tax income going to the top one percent of Americans soared from 10.7 percent to 20.1 percent.  The economic drivers were the same.  In their case, the rapid progress of globalization and new technologies boosted both the returns on capital – think of soaring stock markets – and the compensation of millions of American business executives and professionals.

“Income shares” are economist-speak, so let’s translate them into the average incomes for each group.  The results are sobering.  The average pre-tax income of the bottom 50 percent of Americans, in 2014 dollars, inched up from $15,948 in 1977 to $16,216 in 2014, for a raise of $268 or 1.7 percent over 37 years.  The top one percent lived in a different economy:  Their average pre-tax income in 2014 dollars jumped from $424,631 in 1977 to $1,305,301 in 2014, a raise of $880,670 or more than 207 percent.

To see what the government did about all this, we shift the analysis to the two groups’ income shares and average incomes on a post-tax basis.  The data show, first, that the government took some steps to soften the blow for the bottom 50 percent of the country and were modestly effective.  After taking account of changing tax and spending policies since 1977, the share of all post-tax income going to the bottom half of the country fell from 25.6 percent in 1977 to 19.4 percent in 2014.  So, their income share dropped 24.2 percent on a post-tax basis, compared to 37.5 percent on a pre-tax basis.

The difference tells us what the government actually accomplished:  Washington managed to offset a little over one-third of the adverse impact of globalization and new technologies for the bottom 50 percent of Americans [1 – (24.2 / 37.5) = 0.355].  Their relief came mainly from government steps to expand the earned income tax credit, broaden access to Medicaid, and provide subsidies for health insurance under Obamacare.  Other tax changes made the federal income tax moot for most of this group, but increases in payroll tax rates offset those gains.

Turning to actual incomes, we find that the average post-tax income of the bottom half of the country increased over this period, in 2014 dollars, from $20,390 in 1977 to $24,925 in 2014.  That signifies a raise of $4,535 or 22 percent over 37 years – not much, but better than the 1.7 percent gains in average pre-tax income.

Washington has been more solicitous of the top one percent of the country.  After taking account of changes in tax and spending policies, their share of all post-tax income jumped from 8.6 percent in 1977 to 15.6 percent in 2014.  So, the income share going to the top one percent of Americans increased 81.4 percent on a post-tax basis, compared to 87.8 percent on a pre-tax basis.

Once again, the difference tells us what Washington did: 37 years of tax changes and spending offset about 7 percent of the fast-rising income gains claimed by the top one percent [1 – (81.4 / 87.8) = 0.073].  In more concrete terms, the average post-tax income of the top one percent of Americans increased, in 2014 dollars, from $342,328 in 1977 to $1,012,429 in 2014.  That’s a sweet raise of $670,101 or 196 percent over 37 years.

Over nearly four decades, then, Washington demonstrated moderate concern about the declining position of the bottom half of the country while affirming the rising position of those already at the top.

This record tells us it is time to address the real drivers of widening inequality:  Shift our focus from half-hearted redistribution to serious economic reforms — aggressive anti-trust for all concentrated industries, for example, and universal access to free retraining at community colleges — that can put average Americans in a better positions to capture the rewards of globalization and technological change.



The Three Choices for Tax Reform

September 13, 2017

Trump administration officials and GOP leaders in Congress are still putting together their tax plan. Nevertheless, the early signs point to decisions that could sink the project or produce changes that would jeopardize economic growth.

Congress can approach changing the corporate tax in one of three ways. It can try to simplify the code, it can reform it, or it can cut it back. The GOP’s current approach appears to start with simplification. Simplifying the corporate tax normally means phasing out a package of tax preferences for particular industries or business activities, and using the revenues to bring down the current 35 percent tax rate to 28, 25 or even 20 percent. This model shifts the burden of the tax among industries but not among income groups, since shareholders continue to bear most of the burden. Such simplification can also attract bipartisan support and produce real economic benefits. At a minimum, it lowers tax compliance costs for most businesses; and if it’s done thoughtfully, it can increase economic efficiency. To be sure, any efficiency benefits will be marginal unless the simplifications are fairly broad and sweeping.

The record also shows that serious tax simplification is very hard to achieve. Support from President Obama and congressional GOP leaders wasn’t enough to advance it in 2014, for the simple reason that most companies prefer their tax preferences to a lower tax rate. They’re not wrong economically: The Treasury calculated in 2016 that tax preferences lower the average effective corporate tax rate to 22 percent, and companies in many industries pay substantially less. Why give up those preferences for a 28 or 25 percent rate? A 20 percent rate could solve the problem for most industries, if anyone had a plausible way to pay for it. Of course, financing a deep rate cut was the border adjustment tax promoted by Speaker Paul Ryan, and which the White House and big importers and retailers quickly squashed.

The second option is genuine reform, where Congress changes the structure of the corporate tax. Economically, the most promising reform would give U.S. companies a choice of tax treatments when they invest in equipment. They could deduct the full cost of those investments in the year they make them (“expensing”) while giving up the current deduction for interest on funds borrowed to finance the investments. Or they could stick with the current depreciation system for their investments, including the deduction for interest costs. If enough companies choose the first route, as they likely would, this reform would spur investment and sharply reduce the tax code’s nonsensical bias towards financing business growth with debt rather than equity. Such a structural reform would make sound economic sense. It also seems as unlikely as serious simplification, because it foregoes the pixie dust of marginal tax rate cuts that GOP supply-siders demand.

That leaves the Trump administration and Republican leaders with option three: Cut the corporate tax rate without paying for it. The President seems to favor this approach. He has called repeatedly for slashing the corporate rate to 15 percent, a multi-trillion dollar change, and paying for a small piece of it by limiting a few personal tax deductions for higher-income people. It’s also catnip for GOP supply-siders who continue to proclaim that a deep rate cut will boost economic growth enough to pay for itself. We’ve tried this t several times already, so we now have hard evidence to evaluate those claims. The actual record shows, beyond question, that such turbo-charged dynamic effects do not occur. The most recent example is George W. Bush’s 2001 personal income tax cuts. His “success” enacting them produced huge deficits and ultimately contributed to the financial collapse that closed down his presidency.

A largely-unfunded cut in the corporate tax rate in 2018 would boost corporate profits as well as budget deficits, but it won’t increase business investment, productivity or employment. Prime interest rates in this period have been lower than at any time since the 1950s, so companies have had easy and cheap access to funds for investment for years. At a minimum, this tells us that there’s no real economic basis to expect businesses to use their windfall profits from a big tax cut to expand investment.

Instead, they’re likely to use some of their additional profits to fund stock buy-backs. The rest will flow through as dividends and capital gains, mainly for the top one percent of Americans who hold 49.8 percent of stock in public companies, and the next nine percent who own another 41.2 percent of all shares. Those lucky shareholders will use much of their windfall gains to buy more stock; and coupled with the corporate stock buy-backs, the boost in demand for stocks will pump up the markets. To be sure, those shareholders will also spend some of their unexpected gains, which will modestly stimulate growth. Once that stimulus dissipates, as it will fairly quickly, the ballooning budget deficits will drive up interest rates and slow the economy for everyone else.

The worst scenario is that large, deficit-be-damned cuts in the corporate tax rate could produce a stock market bubble that could take down the economy when it bursts. The good news is that the current Congress would never enact it. The odds of Democrats supporting Donald Trump on a tax plan to make shareholders richer are roughly the same as winning the Powerball; and the certainty of soaring budget deficits should scare off enough conservative Republicans to sink the enterprise.



Trump’s Tax Plan is Aimed at the 2018 and 2020 Elections, Not U.S. Competitiveness

April 26, 2017

President Trump wants to cut the tax rate for all American businesses to 15 percent, and damn the deficit. If you believe him, any damage from higher deficits will be minor compared to the benefits for US competitiveness, economic efficiency, and tax fairness. The truth is, those claims are nonsense; and the real agenda here is the 2018 and 2020 elections. Without substantial new stimulus, the GOP will likely face voters in 2018 with a very weak economy – and tax cuts, especially for business, are the only form of stimulus most Republicans will tolerate. Moreover, if everything falls into place, just right, deep tax cuts for businesses could spur enough additional capital spending to help Trump survive the 2020 election.

Let’s review the economic case for major tax relief for American companies. It’s undeniable that the current corporate tax is inefficient – but does it actually make U.S. businesses less competitive? The truth fact is, there’s no evidence of any such effects. In fact, the post-tax returns on business investments are higher in the United States than in any advanced country except Australia, and the productivity of U.S. businesses is also higher here than in any advanced country except Norway and Luxembourg.

The critics are right that the 35 percent marginal tax rate on corporate profits is higher than in most countries. But as the data on comparative post-tax returns suggest, that marginal tax rate has less impact on investment and jobs than the “effective tax rate,” which is the actual percentage of net profits that businesses pay. On that score, the GAO reports that U.S. businesses pay an average effective tax rate of just 14 percent, which tells us that U.S. businesses get to use special provisions that protect 60 percent of their profits from tax (14 percent = 40 percent of 35 percent).

Tax experts are certainly correct that a corporate tax plan that closed special provisions and used the additional revenues to lower the 35 percent tax rate would make the overall economy a little more efficient. But lowering the rate alone while leaving most of those provisions in place would have almost no impact on the economy’s efficiency – and the political point of Trump’s plan depends on not paying to lower the tax rate.

Finally, would a 15 percent tax rate on hundreds of billions of dollars in business profits help most Americans, as the White House insists, since 52 percent of us own stock in U.S. corporations directly or through mutual funds? The data show that most shareholders would gain very little, because with 91 percent of all U.S. stock held by the top 10 percent, most shareholders own very little stock.

Moreover, the proposed 15 percent tax rate would cover not only public corporations but also all privately-held businesses whose profits are currently taxed at the personal tax rate of their owners. So, Trump’s plan would slash taxes not only for public corporations from Goldman Sachs to McDonald’s, but also for every partnership of doctors or lawyers, every hedge fund and private equity fund, and every huge family business from Koch Industries and Bechtel, to the Trump Organization..

There is no doubt that the President’s tax plan would provide enormous windfalls for the richest people in the country. Beyond that, it may or may not sustain growth through the next two elections, since even the best conservative economists commonly overstate the benefits of cutting tax rates. But the truth is, there aren’t many other options that a Republican Congress would accept.