Six Tax Based Ways to Tackle US Inequality

Three years ago, Donald Trump’s victory in the United States’ presidential election triggered a search for explanations of what is still a shocking outcome. One immediately came to dominate: his Democratic opponents had been insufficiently aware of the problem of income inequality or had neglected to propose effective solutions.

That is presumably the logic behind the radical proposals to tackle inequality coming from some of the leading candidates for the 2020 Democratic presidential nomination. Senator Elizabeth Warren, for example, has proposed an annual tax (originally of 2%, but now up to 6%) on the richest Americans’ wealth.

The problem with the wealth tax is not that it is radical. Like many economists, I would support a high carbon tax – also a radical policy, but the most economically efficient way to respond to the global problem of climate change. A wealth tax, however, simply is not the most efficient way to address the problem of inequality.

In fact, there are at least six practical policy changes that could make the US tax system more progressive. They have all been proposed by mainstream Democrats such as President Barack Obama – who also advanced the Patient Protection and Affordable Care Act and other inequality-reducing policies – but in most cases were blocked by Republicans.

These proposals are practical in two senses. For starters, if adopted, they would be more enforceable than a wealth tax and less likely to have costly unintended side effects. Moreover, studies of recent US congressional elections have found that the traditional median-voter approach still holds. Although radical-left economic proposals do attract new voters on the left, they repel substantially more voters on the right. That suggests US political candidates are more likely to get elected by proposing moderate policies than by advocating radical measures.

The first policy proposal would be to reinforce the estate tax. The US might begin by restoring the tax on all estates worth, say, $5 million. More important, however, is to eliminate the “step-up” of the valuation of the assets in the estate, which currently allows generations to pass on capital gains without ever paying tax on them. It would be far easier for the Internal Revenue Service to place a dollar value on assets on a once-a-lifetime basis (that is, on the estate, before it passes to the heirs) than to try to do so every year under a wealth tax. And doing this would accomplish the same objective as the wealth tax: putting some friction into the inter-generational accumulation of dynastic wealth that, as it stands, never gets taxed.

Second, policymakers should give the IRS the resources it needs to collect taxes that are owed. Natasha Sarin and Larry Summers recently noted that the IRS currently fails to collect nearly 15% of total tax liabilities – primarily to the benefit of those with high incomes. It is impossible to close the gap completely. But giving the IRS more resources, Sarin and Summers argue, would have a high benefit-cost ratio and generate more than $1 trillion in net additional revenue over the next decade.

Third, expanding the Earned Income Tax Credit (EITC) would help to “make work pay.” Incentives do matter. But it is those Americans trying to lift themselves out of poverty and up into the middle class – not the rich – who often face the steepest effective marginal tax rate (taking lost benefits into account). Extending the EITC to more households would enlarge the economic pie while also sharing it more equally, thereby enhancing both efficiency and equity.

Fourth, the payroll tax should be made more progressive. The US social security system is not as progressive as many think. Even workers who don’t earn enough to pay federal income tax must nonetheless pay a payroll tax. The threshold for this tax should be raised, with the lost revenue recouped by raising the ceiling (currently $118,500 in wages) above which Americans no longer pay it.

Fifth, the US government also should make the income tax more progressive – for example, by cutting the gap between the tax rates on investment income and wages. And, clearly, it should abolish the carried-interest loophole.

Finally, Congress should revisit the December 2017 corporate-tax cut to make it revenue-neutral. There were good arguments for reducing the US corporate tax rate to bring it closer to that of other countries. But all Republican senators voted for the tax cut in the declared belief that it would boost income growth so much as to be revenue-neutral. Unsurprisingly, this has not happened: firms turned their windfalls over to shareholders in the form of dividends and share buy-backs, rather than investing in the capital as intended. As a result, revenue fell. US firms now pay virtually the lowest level of tax as a percentage of GDP among major advanced economies.

The solution is not to limit firms from buying back their shares, as Senators Bernie Sanders (another leading Democratic presidential contender) and Chuck Schumer have proposed. Rather, the key is to close loopholes to bring overall corporate-tax revenue back to its pre-reform level. The biggest potential revenue-generator is to curtail the tax-deductibility of interest payments – another proposal that could be good for both GDP and income distribution. If there is to be a successor to the 2007-2009 financial crisis, it is now more likely to come from an excess of corporate debt – especially of the so-called “covenant-lite” variety – than from too much housing debt. Curtailing the interest-rate deduction could motivate firms to strengthen their financing structure.

Fortunately, few of the Democratic presidential candidates have committed themselves irrevocably to extreme policies. It is not too late for Warren or others to adopt further proposals to address the inequality that is more practical than the wealth tax and would naturally precede it.