Why the Tax System Is Doing Less About Growing Inequality

As we have explained, the joint congressional “supercommittee” — and any future efforts at deficit reduction — should raise significant revenues, and do so progressively.  A recent Congressional Budget Office (CBO) report highlights why.

It shows not only that income inequality has dramatically increased in recent decades (a point that we have previously discussed), but also that “the increase in inequality of after-tax income was greater than the increase in inequality of before-tax income.”  That is, the federal tax system as a whole did less to equalize the distribution of income in 2007 than it did in 1979.

There are three reasons why:

1. The share of federal revenues coming from regressive payroll taxes has gone up. The federal tax system is progressive — meaning that higher-income taxpayers pay more of their income, on average, than low- and moderate-income taxpayers.  But the report explains that “[v]irtually all of the progressivity of the federal tax system derives from the individual income tax.  And the share of federal revenues coming from income taxes fell between 1979 and 2007, while the share coming from payroll taxes — which low- and middle-income families generally pay at a higher rate than high-income households — rose.  This shift from income taxes to payroll taxes made the tax system as a whole less progressive.
2. The payroll tax has become slightly more regressive, but the income tax has become only slightly more progressive at the same time. The payroll tax has become slightly more regressive because lower-income households derived a greater share of their income from earnings that are subject to the payroll tax in 2007 than in 1979.
3. Federal tax revenues have fallen as a share of total household income. While the federal tax system is, as we have said, progressive, its ability to alleviate the widening income gap has weakened over the last three decades as federal revenues levels have shrunk as a share of household income.

Given how extreme inequality has become, Congress needs to reverse course and make the tax code more progressive.

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