Time For a New Approach to Taxes and Inequality

In the final presidential debate last Wednesday night, both candidates echoed longstanding partisan talking points on tax policy. Donald Trump voiced the standard Republican theme of low taxes, stating, "We are going to cut taxes massively." Hillary Clinton sounded the standard Democratic theme of tax progressivity, promising "to have the wealthy pay their fair share." The candidates made similar remarks at the earlier debates and throughout the campaign.

The two parties' steadfast insistence on these themes has given the United States a tax system different from most other industrialized countries. Republicans have kept the total tax burden lower than in many other countries. Democrats have kept the tax system more progressive than in other countries, with more of the tax burden on the rich and less on the middle class. But this small, progressive tax system may not be what the United States needs.

Recent data from the Organisation for Economic Cooperation and Development (OECD) show that the United States has the second-most progressive tax system among OECD countries, with the rich paying a larger share of taxes relative to their share of income. At the same time, our tax system is smaller than in other countries. Federal, state, and local taxes in the United States amount to 25.4 percent of GDP, compared to the OECD average of 34.2 percent.

Our choice of a small progressive tax system has important policy implications. The relatively steep progressivity of our tax system tends to reduce income inequality by redistributing income from rich to poor. But the small size of our tax system pushes in the opposite direction, limiting the amount of redistribution that it can induce.

To see this, suppose the United States switched to a tax system in which the richest person paid one dollar and nobody else paid anything, with the dollar transferred to the poorest person. This tax system would be highly progressive because the richest person would bear the entire tax burden. But, with only one dollar changing hands, the tax system would be too small to make a dent in income inequality. On the other hand, a larger tax system could significantly reduce inequality even if it was not very progressive, particularly if the taxes were used to finance larger benefit payments to those with lower incomes. In general, the same volume of redistribution can be achieved with a smaller, more progressive system or with a larger, less progressive system.

Our smaller, more progressive tax system has emerged as a compromise between the two parties. Republicans would probably prefer a smaller and less progressive fiscal system. That approach would promote economic growth by imposing smaller penalties on earning income, saving, and investing, but it would also reduce redistribution and harm those with lower incomes. Democrats would probably prefer a larger and more progressive tax system with larger benefit payments. That approach would reduce income inequality, but it would also impede economic growth. Neither of these extreme combinations is likely to be politically feasible.

Faced with these tradeoffs, Republicans have focused on reducing the size of government, promising tax cuts for everyone. Democrats have focused on increasing progressivity, demanding that the rich pay their "fair share." The resulting compromise, as we recently discussed in two Tax Notes articles (part 1, part 2), is our small but progressive tax system. As it turns out, even though our tax system is among the most progressive in the OECD, our fiscal system induces less redistribution than most other OECD countries due to our smaller taxes and benefit payments.

But, with the federal budget under pressure from an aging population and rising health care costs, we may need to start thinking about a larger, less progressive, tax system. A larger tax system would provide the revenue needed to avoid deep cuts to Social Security and Medicare. Making the tax system less progressive would keep its larger size from choking off economic growth.

Such a tax system might strike a better balance between Republicans' growth objectives and Democrats' distributional objectives. It could maintain the transfers needed to help those on the bottom rungs of the economy while avoiding heavy tax burdens on the saving and investment needed to fuel economic growth.

Such a move would not be easy. It would require a step that both parties currently oppose - tax increases on people making less than $250,000. But a larger, less progressive tax system may be what we need to face the fiscal challenges ahead.