Is Taxing the Rich the Solution to America’s Financial Problems?

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Should our government tax the rich to reduce income inequality? Image by cohdra

Should our government tax the rich to reduce income inequality? Image by cohdra

Most of us recall the tense, bitter standoffs that characterized the ‘fiscal cliff’ negotiations; a high-stakes political drama that played out just over one year ago. The battles were over the triple-whammy of the expiration of the Bush tax cuts, automatic spending cuts, and an impending debt ceiling deadline, all of which threatened to damage the U.S. economy, if not wreak havoc.

At the 11th hour, politicians struck a deal, and although neither side got exactly what they wanted, one significant event happened that had not previously been seen in a generation: Individual marginal tax rates went up.

Could the populist-pleasing mantra of  taxing the rich actually be the solution to income inequality and budgetary problems of the United States?

Income Inequality: Understanding The Issue

As I wrote several months back, income inequality in the United States is widening to levels not seen since before the Great Depression. In 2012, the top 1% saw their income rise sharply (20%), with the remaining bottom 99% seeing virtually no increase (1%). Looking at the data over a longer time period, the percentage of overall wealth enjoyed by the top 10% increased from 33.2% to 48.2% between 1982 and 2012, after remaining virtually flat over the previous 40 years.

There is no doubt that income inequality exists, and in a capitalist society, always will. The opinion of whether or not that should be accepted as axiomatic to such a system, however, depends on one’s politics.  President Obama labeled it the “defining challenge of our time,” whereas Congressman Paul Ryan decried the falling “makers versus takers” ratio. Politics notwithstanding, the question is whether or not our nation’s income inequality rises to the level of being a macroeconomic problem, one which increasing taxes on the rich could help solve.

What Does ‘Rich’ Mean in the United States?

In order to understand the potential impact, one must first determine what the definition of ‘rich’ is. Much like President Clinton’s hilariously infamous “it depends on what the meaning of the word ‘is’ is” testimony, we can also parse the definition of “rich.”

In 2012, the top 1% of American households earned over $394,000, while the top 10% earned income in excess of $114,000. By comparison, the average American household earned $51,017.

Few would debate that personal income over a certain level — say, for example, $1 million — would fit the bill. Whether or not a family making $114,000 or even $394,000 should be considered rich, on the other hand, has been hotly debated. When the ‘fiscal cliff’ deal was signed and the government finally implemented the tax increase (technically, it was the expiration of the Bush tax cuts on upper-tier income), the line for the rich was set at $450,000 for a family and $400,000 for individuals. For those taxpayers, the highest tax bracket increased from 35% to 39.6%. As stated above, it was the first such increase since the Clinton administration.

Plans to Tax the Rich Continue to Grow

No doubt capitalizing on Obama’s themes and the outcome of the ‘fiscal cliff’ negotiations, New York City Mayor Bill De Blasio outlined a progressive agenda in his inaugural address, calling for new taxes on residents who report greater than $500,000 of income to help pay for them. The details aren’t important in this discussion; what is key is the liberal philosophy of using government to train, educate and otherwise lift the masses, versus the conservative approach of reducing the size and scope of government, thereby decreasing the very need for taxes.

As further evidence of the trend toward taxing the rich, the recently-passed budget signed by Obama includes closing tax loopholes and reduced tax benefits for the wealthiest Americans.

Political Parties Cannot Agree Upon a Unified Economic Approach

Conservatives generally favor the political policies of Reaganomics, which favor supply-side principles to grow the economy. The net result is lower taxes for investors and job-creators, which provides significant incentives to both invest and produce. This produces a ‘trickle-down’ effect that lifts the entire economy. This approach appeals to their base of voters, which (generally speaking) has higher income, not to mention a more hands-off philosophy with respect to government.

Liberals prefer a managed economy that utilizes Keynesian principles as necessary to smooth out economic rough patches. Their core philosophies appeal to their base as well, which is weighted toward more modest income-earners, as well as those who approve of more active government involvement.

The inability of the two parties to reconcile their philosophies except for during periods of perceived crisis explains why little progress has been made toward long-term solutions for the nation’s economic woes.

Will Taxing the Rich Help Decrease Income Inequality and Balance the Budget?

Obviously, there is no clear answer one way or the other. That being said, there is substantial data to support the argument for increasing taxes on the rich in order to reverse the negative trends of income inequality as well as shrink budget deficits.

Historical information shows that when the top marginal tax brackets were much higher, income inequality was far less pronounced. During the 1960s, the highest tax brackets regularly topped 70%, with income inequality at its lowest ebb in nearly eighty years. Inequality remained stable until the top bracket was decreased in the early 1980s. At that point, the percentage of wealth owned by the top 10% began its steady upward climb.

With respect to economic growth and budget deficits, both were (on average) significantly better during the 1950s, 1960s and even the stagflation-suffused 1970s then they have been during the past thirty years. One can even draw a circle around the sweeping Reagan tax cuts as the trigger point toward the current era of burgeoning budget deficits, as relatively small deficits ballooned to record levels shortly thereafter. These deficits were briefly eliminated during the Clinton administration when — you guessed it — top-tier marginal tax rates were last increased.

It’s not rocket science. As upper-income individuals pay a higher percentage, tax revenues increase. Greater tax revenues equate to smaller budget deficit. In addition, there is an indirect transfer of wealth when marginal tax rates change, which flow up or down depending on which brackets are adjusted. Higher tax brackets for the rich, naturally, prompt a certain amount of wealth to flow downward, thereby improving income inequality.

The correlations are by no means perfect, but decades of data support them. The average growth rate of GDP between 1952-1982 was nearly double what it achieved the following 30 years, deficits were (even as a percentage of GDP) substantially smaller, and income inequality remained stable. Having said that, supply-siders argue lower-income individuals actually benefit when the rich pay fewer taxes, and there is evidence to support the argument as well. However, over the long-term, the evidence favors the theory that revenues need to be increased in order to solve the nation’s financial problems, with the lion’s share of the wealth transfer necessarily coming from richer Americans.

Solving Income Inequality

Even if presented with the data in an impartial and apolitical fashion, the two parties still wouldn’t likely agree upon the time of day, much less come up with a solution that both sides could live with. As Benjamin Franklin once said, “In this world, nothing can be said to be certain except death and taxes.” Add political bickering to that list.

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