Friday, October 23, 2015

How Raising the Top Tax Rate Won't Much Alter Inequality

"Would a significant increase in the top income tax rate substantially alter income inequality?"  William G. Gale, Melissa S. Kearney, and Peter R. Orszag ask the question in a very short paper of this title published by the Economic Studies Group at the Brookings Institution. Their perhaps surprising answer is "no."

The Gale, Kearney, Orszag paper is really just a set of illustrative calculations, based on the well-respected microsimulation model of the tax code used by the Tax Policy Center.  Here's one of the calculations. Say that we raised the top income tax bracket (that is, the statutory income tax rate paid on a marginal dollar of income earned by those at the highest levels of income) from the current level of 39.6% up to 50%. Such a tax increase also looks substantial when expressed in absoluted dollars. By their calculations, "A larger hike in the top income tax rate to 50 percent would result, not surprisingly, in larger tax increases for the highest income households: an additional $6,464, on average, for households in the 95-99th percentiles of income and an additional $110,968, on average, for households in the top 1 percent. Households in the top 0.1 percent would experience an average income tax increase of $568,617."

In political terms, at least, this would be a very large boost. How much would it affect inequality of incomes? To answer this question, we need a shorthand way to measure inequality, and a standard tool for this purpose is the Gini coefficient. This measure runs from 0 in an economy where all incomes are equal to 1 in an economy where one person receives all income (a more detailed explanation is available here). For some context, the US distribution of income based on pre-tax income is .610. After current tax rates are applied, the after-tax distribution of income is .575.

If the top tax bracket rose to 50%, then according to the first round of Gale, Kearney, Orszag calculations, the Gini coefficient for after-tax income barely fall, dropping to .571. For comparison, the Gini coefficient for inequality of earnings back in 1979, before inequality had started rising, was .435.

As a follow-up calculation, how about if we took the $95.6 billion raised by this tax increase and distributed it to the bottom 20% of the income distribution: "Increasing the top rate to 50 percent .. would bring in an additional $95.6 billion in revenue, leading to an additional $2,650 in post-tax income for the bottom fifth of households." This calculation includes at least two fairly heroic assumptions: there would be no reduction in the income-earning behavior of taxpayers as a result of the higher tax rates, and the US political system would focus the revenue raised on those with the lowest income levels (rather than the middle class or other spending priorities). Even so, this redistribution would only reduce inequality as measured by the Gini coefficient to .560.

The authors also offer a simulation that assumes a chance in income-earning behavior from the higher tax rate: "We redo the simulation assuming that households with more than $100,000 in pre-tax income reduce their pre-tax income in response to an increase in the income tax rate, with an income elasticity of .4." (This elasticity implies, for example, that a 10% rise in the tax rate would lead to a 4% fall in taxable income earned.) This makes only a small difference in the overall reduction ion inequality from a tax-and-redistribute plan. As the authors explain explain: "The highest income households reduce their pre-tax income, which would amplify the reduction in income inequality, but that leaves less revenue to redistribute."

This paper is really just a set of calculations. It's doesn't recommend the higher tax rate, nor does it not recommend the higher rate. In that spirit, what lessons might one take away from this calculation?

To me, it emphasizes how very large the rise in inequality has been. Even a substantial increase in the top tax rate has a fairly small effect on after-tax inequality--precisely because the before-tax rise in inequality has been so very large. Indeed, trying to address income inequality by raising tax rates on the highest incomes would require some VERY high rates, far above the 50% level considered here.

Just because this rise in tax rates would have a quite modest effect on after-tax inequality of incomes, even when combined with redistribution, it might be worth considering for other reasons, like as part of an overall deficit-reduction package or to fund certain kinds of high-priority spending.  On the other side, raising the tax rate on those with high incomes will not be transformative for the US budget situation. Raising the top income tax rate to 50% brings in less than $100 billion per year. Total federal spending in 2015 seems likely to run around $3.8 trillion. So it would be fair to say that raising the top income tax rate to 50% might increase total federal revenues by about 2%.