[*PG993]THE MATTHEW EFFECT AND FEDERAL TAXATION

Martin J. McMahon, Jr.*

For whosoever hath, to him shall be given, and he shall have more abundance; But whosoever hath not, from him shall be taken away even that he hath.

—Matthew 25:29

Abstract:The “Matthew Effect” is a synonym for the well-known colloquialism, “the rich get richer and the poor get poorer.” This Article is about the Matthew Effect in the distribution of incomes in the United States and the failure of the federal tax system to address the problem. There has been a strong Matthew Effect in incomes in the United States over the past few decades, with an increasing concentration of income and wealth in the top one percent. Nevertheless, there has been a continuing trend of enacting disproportionately large tax cuts for those at the top of the income pyramid. Neither economic theory nor empirical evidence supports the argument that these tax cuts increase incentives to save, invest, and work. A growing body of economic literature supports the thesis that economic inequality impedes economic growth instead of fostering it. Furthermore, in a modern industrialized democracy, most of what everyone earns is attributable to infrastructure created by society acting through government. Paradoxically, public concern with increasing economic inequality is not matched by opposition to tax legislation that delivers vastly disproportionate benefits to the super-rich. This Article suggests that future tax legislation ought to mitigate the Matthew Effect rather than enhance it.

Introduction

The term, the “Matthew Effect,” was coined by sociologist Robert K. Merton in 1968 based on the passage from the Gospel of Matthew [*PG994]in the epigram.1 “Put in less stately language, the Matthew Effect consists in the accruing of greater increments of recognition for particular scientific contributions to scientists of considerable repute and the withholding of such recognition from scientists who have not yet made their mark.”2 The Matthew Effect is not limited to the context in which Robert Merton first coined it. More generally, it is a synonym for the well-known colloquial aphorism, “The rich get richer and the poor get poorer.” This Article is about the Matthew Effect in the distribution of incomes in the United States and the failure of the federal tax system to address the Matthew Effect.

Over twenty years ago, economist Paul Samuelson observed, “If we made an income pyramid out of a child’s blocks, with each layer portraying $1000 of income, the peak would be far higher than the Eiffel Tower, but most of us would be within a yard of the ground.”3 Things have changed a lot since then, and things have changed little since then. The peak is higher, but most people are still in essentially the same place. During the last two decades of the twentieth century, the distribution of incomes and wealth in the United States reached levels of inequality that have not been seen since the Roaring Twenties. Although the “Roaring Nineties,” as the decade was labeled by Joseph E. Stiglitz, might have been “the world’s most prosperous decade,”4 the prosperity was not spread around. The data indicate that a very small number of people garnered an overwhelming amount of the increase in incomes and wealth in that decade, as well as in the prior decade.

Between 1947 and 1997, median family income (in constant dollars) grew by 122%.5 Ninety-one percent of this growth, however, occurred before 1970. Between 1979 and 1997, average household before-tax income grew by nearly one-third in real terms, but that growth was shared unevenly across the income distribution. Average income for households in the top quintile rose by more than one-half, while average income for the middle quintile increased by only 10% [*PG995]and average income for the lowest quintile decreased slightly.6 Income growth at the very top of the distribution was even greater. Average before-tax income in 1997 dollars for the top 1% of households more than doubled, rising from $420,000 in 1979 to more than $1 million in 1997. Inequality continued to increase in the late-1990s.7

During the 1950s and 1960s, family income inequality decreased, but the tide changed after 1969, and through the last three decades of the twentieth century income inequality increased.8 Nevertheless, the federal tax system did little to ameliorate the increasing economic inequality. Prior to 1982, high marginal rates at the top had some redistributive effects. Redistributive effects were reduced as a result of the rate reductions in the Economic Recovery Act of 1981 (the “1981 Act”), and after the Tax Reform Act of 1986 (the “1986 Act”), the redistributive effect of the income tax was relatively low.9 Adoption of the 39.6% bracket in 1993 increased the redistributive effects of the income tax, but redistribution decreased again as a result of the reduction in capital gains rates in 1997. As of 2000, the redistributive effect of the income tax was somewhat less than it was in the early 1980s, although it was somewhat greater than it was in the early 1990s.10 As we move into the new millennium, however, recent changes in the federal tax system presage a decreasing role not only in redistribution, but in mitigation of vast disparities in income and wealth. Since the inauguration of the Bush Administration11 in 2000, there have been three major tax acts, which have reduced significantly the tax burden of the super-rich, while handing out small change to everyone else.

Part I of this Article examines in detail the increasing concentration of income and wealth in the top 1%, and particularly within much narrower cohorts near the top of the top 1%, that has occurred [*PG996]over the past twenty-five years.12 This Part demonstrates the strong Matthew Effect in incomes in the United States over that period. The super-rich are pulling away from everyone by so much and at a rate so fast that the fact that incomes of many households at the bottom and in the middle have stagnated, or even fallen in constant dollars, has been obscured by ever increasing per capita income—a false talisman of progress because it obscures distributional issues.

Part II discusses the distribution of after-tax income and wealth in the United States in recent years.13 Wealth and income levels are highly correlated. This Part describes the increasing disparity in after-tax incomes, particularly the rate at which the amount and share of total after-tax income of the top 0.5%, and even of smaller cohorts further toward the top of the income pyramid, are growing relative to everyone else. Moreover, the share of wealth owned by the super-rich is growing even faster than its share of income. This Part demonstrates that the federal tax system has failed to respond adequately to take into account ever increasing income inequality.

Part III examines changing effective federal tax rates over the last two decades of the twentieth century, examining with more precision the aspects of the federal tax system that have failed to respond adequately to ever increasing income inequality.14 After first discussing the various major legislative changes in this period, the Part then examines the shifting burdens, measured by effective tax rates on different income cohorts, of the various federal taxes individually and collectively. Part IV then reviews the economic literature on the effect of these changes on the progressivity of the tax system. It concludes that by the close of the twentieth century the tax system was not raising revenue as fairly and was doing less to mitigate inequality than it had in the middle of that century.

Part V describes the Republican tax policy agenda for the new millennium, as embodied in tax legislation enacted in 2001 through 2003 and discusses the projected distribution of the benefits of the massive tax cuts enacted in that brief period.15 The projections show that the tax cuts disproportionately favor those at the top of the income pyramid with very small tax cuts going to everyone else, even the upper middle class and the merely rich, in contrast to the super-rich.

[*PG997] Part VI deals with economic issues.16 It starts by demonstrating that theory does not support the argument that the tax cuts were necessary to spur incentives to save, invest, and work, and that the empirical evidence of the effect of tax cuts on savings and investment clearly contradicts the claims made by supporters of the tax cuts. Next, this Part examines the rapidly growing body of economic literature supporting the thesis that economic inequality impedes, rather than fosters, economic growth. Thus, not only do the tax cuts not spur economic growth, but because they increase inequality, they probably impede economic growth. This Part then examines empirical data that debunk the notion that “a rising tide lifts all boats,” by demonstrating that increasing incomes for the few and decreasing incomes for the many can occur even though the economy is “growing,” that is, the national GDP is increasing. Distribution thus counts. Finally, the Part briefly notes the disastrous long-term economic effects of the massive federal budget deficits largely attributable to the Bush tax cuts.

Part VII discusses the philosophical basis for a highly redistributive tax system, arguing that in a modern industrialized democracy, most of what everyone earns is attributable to infrastructure created by society acting as a whole, principally through government.17 It rejects the notion that individuals have the first claim to everything that they earn, and although it does not label it as such, adopts a more communitarian approach.18 This Part then briefly discusses the deleterious effect of increasing concentrations of wealth on the future health of democratic institutions.

Part VIII examines the paradox of public concern with increasing economic inequality, thinking it undesirable, while simultaneously supporting tax cut legislation that in fact delivers vastly disproportionate benefits to the very wealthy—the super-rich.19

The Conclusion suggests that it is time for the tax system to address these problems by substantially increasing progressivity at the top of the income pyramid. Marginal tax rates should be increased for incomes in excess of $500,000, and as incomes increase to progres[*PG998]sively higher levels, additional rate brackets should be added to impose substantially higher marginal rates on incomes in excess of $1 million and particularly on incomes that exceed $5 million. Future tax legislation ought to mitigate the Matthew Effect rather than enhance it.

I.  The Distribution of Before-Tax Income

F. Scott Fitzgerald was right when he had a character quip, “Let me tell you about the very rich. They are different from you and me.”20 Both income and wealth in the United States are highly concentrated in a very small percentage of the population, and wealth is somewhat more concentrated than income. Although the data from various sources often use slightly different measures of the relevant unit and the precise measurement of income or wealth, the pattern is consistent. One percent or less of the population is remarkably different than everyone else. Compared to everyone below them, the top 1% are in a class by themselves. But that is not all. Although the data are not as complete for subgroups within the top 1%, there are enough data to indicate that even the top 1% is not a homogenous group. The cr�me de la cr�me—the top 0.01%, or even smaller subgroups—have so much income and wealth that these groups merit separate consideration in any analysis.

There are several methods for comparing income distributions, including actual money incomes for different income classes, incomes for different groups with reference to an index number, for example, as a multiple of the poverty rate, household income ratios, the percentage of national income received by different income classes, and the Gini index.21 These are all valid measures of income inequality [*PG999]and changes in income inequality.22 A wealth of data is available on income distributions, and it reveals very unequal distributions no matter which method is chosen.

A.  The Rich Are Getting Richer

1.  The “Merely Rich” Are Running Away from the Pack

Recent data from the Congressional Budget Office (the “CBO”) provide the best perspective on the phenomenal growth of the income of those households in the highest income cohorts and the ever increasing income inequality over the past two decades. Other data are available from the Census Bureau and the Internal Revenue Service (the “IRS”), but the CBO data provide the more comprehensive perspective.23 Although the Census Bureau data are available for a number of definitions of income, they do not generally include capital gains and do not adequately break out those households within cohorts smaller than the top 5%.24 IRS data, which are based primarily on adjusted gross income (the “AGI”) shown on tax returns, do not adequately reflect economic income, do not consistently identify the top 1% and top 5% cohorts, and are available with respect to taxpayers rather than households. One important piece of information from the Census Bureau data, however, is that between 1979 and 2001, the income ratios—the multiple of the average income of the lower percentile that is the average income of the higher percentile—for every income percentile above the fiftieth percentile increased relative to lower income percentiles, whereas the income ratio of the tenth to [*PG1000]fiftieth percentile was the same in 2001 as it was in 1980.25 The data thus demonstrate that although those in the middle of the income distribution did not gain relative to the poor, the households in the top half pulled away from households below them. Furthermore, within that top half, households relatively higher in the income distribution pulled away from households relatively lower in the income distribution at an increasing rate.

The most recent CBO data show not only that the income inequality inexorably increased throughout the last two decades of the twentieth century, but that income inequality—particularly with respect to the rate at which those at the very top of the income pyramid pulled away from everyone else—increased in the 1990s more than in the 1980s.26 In 2000, before-tax income was more concentrated in the top 1% than at any time since 1929.27 The increasing income disparities between the top 40% and the bottom 60% between 1979 and 1993 was attributable to the combination of a decline in real income of the bottom 40% and stagnation of the income of the middle quintile, coupled with modest income growth for the fourth quintile and significant income growth for the top quintile, particularly for the higher cohorts within the top quintile. From 1993 to 2000, the three lowest quintiles experienced a not insignificant increase in real incomes. Nevertheless, due to dramatic increases in their incomes, the upper income quintiles—particularly the top 10%—actually pulled away from the lower income quintiles at a much greater rate in the mid-to-late 1990s than they did in the period from 1979 to 1993, as is demonstrated in the following table.

This table vividly demonstrates that the real incomes of the top cohorts—the top 5% and the top 1%—grew dramatically more than did the incomes of all of the other cohorts.30 The top 5% saw its average income increase at nearly nine times the rate of increase for the mid[*PG1002]dle quintile and at nearly five times the rate of increase for the fourth quintile. The top 1% saw its average income increase at nearly fifteen times the rate of increase for the middle quintile and at nearly eight times the rate of increase for the fourth quintile. The bottom 60% saw two decades of nearly stagnant or very modest real income growth.31

Nevertheless, the manner in which the CBO data are presented masks the real disparity between the top 1% and the remainder of the top 5% and top 10%. Because the average income grows at an increasing rate, the averages for large cohorts, including the top 1%, are distorted. The data more accurately present the true picture if they are recalculated separately to state the average pre-tax income of the 81st to 90th percentiles, the 91st to 99th percentiles, and the top 1%.

The data in this table clearly illustrate that the top 20% is not a group that can be lumped together meaningfully when discussing income distribution and the role of taxes in effecting redistribution. The average income of the 81st through 90th percentiles is closer to the average income of the fourth quintile than it is to the average income of the 91st through 95th percentiles. Even the average income of the 91st through 95th percentiles is closer to the average income of the fourth quintile than it is to the average income of the 96th through 99th percentiles. And the average income of the 96th through 99th percentiles, although not even twice the average income of the 91st through 95th percentiles is dwarfed by the average income of the top [*PG1003]1%. More significantly, the top 1% saw its average income increase at six times the rate of increase for the 81st through 90th percentiles and at more than three times the rate of increase for the 96th through 99th percentiles. The top 1% is leaving everyone else in the dust.

2.  The “Super-Rich” Are Soaring Above the Merely Rich

Just as the aggregate data for the top quintile hide the extraordinary differences between the top 1% and the remainder of the cohort, the aggregate data for the top 1% hide extraordinary differences within that select group. Data for smaller cohorts within the top 1% are difficult to obtain, and when they are available they often are based on different income measures, different statistical descriptions, and a different base year for measuring changes in constant dollars. The preceding data—mostly CBO data—were based on an expanded income concept and described mean income for the respective cohorts. Another measure of differences between income classes is the threshold income for each income cohort. The greater the difference between the threshold income necessary to be included in the cohort and the average income of the cohort, the greater the income inequality within the cohort itself. The threshold incomes necessary to enter each quintile, and smaller cohorts within the top quintile in 1979 and 2000, using a comprehensive money income calculation starting from AGI (including capital gains, but excluding in-kind receipts), measured in constant 1982 through 1984 dollars, were as follows:33

According to these data, between 1979 and 2000, the threshold to climb out of the bottom 60% fell in real dollars, meaning that this [*PG1004]group would have fallen in relative terms even if the top of the income pyramid had no increase in real income. But the top 20% realized increasing real incomes. Even the threshold for the top 20% increased by only 8.2% in real terms. At the same time, the thresholds for the top 1% and top 0.5% roughly doubled, which is significantly more than the increase in thresholds for the top 10% and top 5%. The threshold for the top 0.25% increased by 153%, and the threshold for the top 0.1% roughly tripled, indicating that the super-rich are pulling away from the nearly super-rich at an astonishing rate.34

The increasingly elite status of the super-rich can be put in the perspective of the earlier CBO data by examining the thresholds for entry into the top cohorts in current 2000 dollars, which facilitates a comparison with the CBO data on average incomes. According to the CBO data, the average income of the top 1% in 2000 was $1,290,800. The threshold for entering the top 1%—albeit using a different, less comprehensive, income definition based on IRS data—was $354,035.35 The threshold for the top 0.5% was $554,335; for the top 0.25%, it was $902,317, and for the elite top 0.10%, it was $1,696,322.36 Within the top 1%, so much of the income was concentrated in the top 0.10% that even those at the threshold for the top 0.25% had an income of roughly only two-thirds of the average for the top 1%.37

[*PG1005] The story of super-elites does not stop with the top 0.10%. Within the top 0.10% is another ultra-elite, dubbed the “Fortunate 400.”38 Based on IRS data, in 2000, the threshold income for joining this group, constituting the top 0.00031% of tax returns, was an AGI of $86.8 million, and the average AGI was $173.9 million.39 To qualify for this group requires an income more than fifty times the threshold income for joining the top 0.10%. This jump within a cohort of less than 0.10% exceeds the gap between the credentials for entering the top one-tenth of 1% and entering the top 40%—the $1,696,322 annual income necessary to join the top 0.10% was forty-seven times more than the $36,014 annual income necessary to join the top 40% in 2000.

The Fortunate 400, however, is a fluid group that changes significantly from year to year—over the nine years from 1992 through 2000, a total of 3600 returns were identified as belonging to this group, with fewer than 25% of taxpayers within this group appearing twice and fewer than 13% appearing more than twice. Furthermore, incomes of the members of this club consist largely of capital gains—over 70% of the group’s total AGI in each of 1998, 1999, and 2000 was net capital gains.40 Nevertheless, it is worth noting that if the lowest income member of this elite group, with an income of $86.8 million, realized the group’s average percentage of AGI as capital gains in 2000, that taxpayer’s capital gains would have been nearly $62 million. If that were averaged over even a thirty-year holding period, annual income from capital gains alone would have exceeded $2 million in 2000 constant dollars, which would have put the taxpayer substantially above the threshold for the top 0.10% in every year.41 Thus, even the lumpiness of capital gains realizations does not affect the status of members of this [*PG1006]ultra-elite group as members of the super-rich class. Those who have made the Fortunate 400 even once are in an elite class.

Although the key to joining the Fortunate 400 may be capital gains, this is not true with respect to the remainder of the top 1%. The percentage of income realized as capital gains increases as the percentile of the income cohort increases, but recent observations indicate that wage and entrepreneurial income is the dominant form of income for all income cohorts. Only for the top 0.5% do capital gains approach or exceed 20% of the income.

The percentage of the income of the top 5% realized in the form of wages (including stock options), in contrast to capital gains and periodic income from capital, has increased steadily over the last half of the twentieth century, and the percentage of income realized as wages has grown dramatically for the smaller cohorts at the very top.

This change in income composition of the top 1% is not attributable, however, to changes in the pattern of realization of capital gains and periodic income from capital; both remain highly concentrated in the highest-income cohorts.43 Rather, the change in income composition is attributable to dramatic increases in the wage level of top earners relative to everyone else—the phenomenon of the winner-take-all market economy of the United States at the turn of the millennium.44 More than half of the “very top” taxpayers derived the major part of their income in the form of wages and salaries.45 The “working rich” dominate the smallest measured percentile cohorts, if [*PG1007]not the Fortunate 400. Part of this might be attributed to athletes and other entertainers, many of whom earn astronomical salaries,46 although there also is evidence to the contrary.47 But most top 1% income earners—admittedly in this context a group that include the “wannabes” as well as the truly “income-rich” are engaged in business or professions.48 The dramatic increases in the compensation of the chief executive officers (and certain other officers) of publicly held corporations also play a part. CEO pay has risen astronomically in the past forty years. Whereas the average CEO made forty-one times as much as the average worker in 1960, by 2001 the average CEO made 411 times as much as the average worker, and that was a decrease— possibly temporary due to a decline in the stock market—from the levels in the immediately preceding years, in which average CEO pay was as much as 531 times the level of the average worker.

What kind of pay are we talking about here in dollars? According to BusinessWeek’s “52nd Annual Executive Pay Scoreboard,” the average CEO’s pay in 2001 was $11 million—many times the multiple necessary for entry into the top 0.10%—and that was a 16% decrease from the 2000 average.50 As do all averages, however, the 2001 average presents a somewhat distorted picture. Lawrence J. Ellison, the CEO of Oracle, earned so much due to pocketing $706 million from exercising stock options, that the rest of the CEOs averaged only $9.1 mil[*PG1008]lion, a low not seen since 1997.51 Many, of course, made far less than even that average. To break into the top 40 required annual compensation of over $40 million.52 But one does not even have to be a CEO to garner such munificent compensation. At least ten executives below the CEO level made between $58 and $128 million in 2001,53 and annual pay of more than $1 million is common for the second banana in publicly held corporations.54

3.  The Super-Rich Are Taking a Substantially Bigger Slice of the Pie

So far, we have been examining relative average incomes of various percentile cohorts of the population. Another perspective on the distribution of incomes is to examine the percentage of total personal income realized by the various income cohorts. Over the final two decades of the twentieth century, the top 5% increased its share of national before-tax personal income at the expense of virtually every other group, including much of the top quintile. This small subset of the top quintile increased its share of incomes dramatically, and even most of that increase accrued to the top of the top of the pyramid. The data as presented by the CBO illustrate that the higher income cohorts gained at everyone else’s expense.

[*PG1009]The picture of income distribution in the last years of the twentieth century is stunning. In both 1997 and 2000 the top 20% of the households had more income than everyone else combined, as well as in all of the intervening years.58 The top 5% had more income than the bottom 60%. And the top 1% had nearly one-half as much as the bottom 40%. Expressed slightly differently, in 2000, the 1.1 million richest households measured by income had nearly one and one-half times more money than the 44.2 million poorest households measured by income.59

Again, the CBO presentation of the top quintile masks the difference between the top 1% and everyone else in the top quintile. Breaking down the top quintile into cohorts that exclude higher level cohorts reveals that the bottom half of the top quintile joined the bottom 80% in transferring a slice of the pie to those who were better off, and that within the top 10%, only the top 5% made any significant gains from 1997 through 2000, with most of those gains going to the top 1%.60

Significantly, in the late 1990s, the pattern of increasing income shares differed from earlier years. Unlike earlier periods, from 1997 to 2000 it was not the top 20%, or 10%, or even the top 5% that was gaining income share at everyone else’s expense. From 1997 to 2000, [*PG1010]the only income cohort that increased its share of total income was the top 1%.

Although the CBO data do not address the share of economic income realized by smaller cohorts within the top 1%, some such data are available, and they parallel the data regarding increased dollar incomes. As any income cohort is broken down into increasingly smaller cohorts, the share of incomes realized by each successive higher level income cohort increases at an increasing rate. A somewhat more precise view of the pattern within the top 1% is revealed by calculations by Thomas B. Petska, Michael I. Strudler, and Ryan Petska from IRS Statistics of Income data based on AGI—a very different base than that used by the CBO. Although the percentages differ somewhat, the pattern is consistent. Their data show that almost one-half of the share of income realized by the top 1% is realized by the top 0.10%.62 Thus, the top 0.10%—roughly 110,000 households out of nearly 110 million households in the Untied States at that time—had roughly the same income as the 1.9 million households immediately below them near the top of the pyramid. Their analysis of the data also shows that this elite 110,000 households realized a greater share of income than the 44.2 million households in the bottom 40%.63

B.  Income Mobility and the Fallacy of the Horatio Alger Myth

Americans believe in the Horatio Alger myth. They love, and believe in, rags-to-riches stories.64 Opponents of progressive taxation use such anecdotal stories of income mobility to fight progressive taxation [*PG1011]on the grounds that income inequality merely reflects life cycle differentials. But the data tell a different story.

Examination of available data leads to the inescapable conclusion that the Horatio Alger myth is exactly that, a myth. Although some Americans experience “significant” income fluctuations from year to year,65 the data do not support the conclusion that many households frequently move between broadly defined income classes.66 An Urban Institute study found that in both the 1970s and 1980s, about half of the people in either the lowest or highest quintile at the beginning of the period were in the same quintile ten years later.67 Another study found that about half of the young adults (ages twenty-two to thirty-nine) who were in the bottom quintile of the income distribution in 1968 still were in that quintile twenty-three years later, in 1991.68 More significantly, three-quarters of those who were in the bottom quintile in 1968 were in the bottom 40% in 1991.69 According to another study, only 13.8% of those who are in the bottom 30% for any given year have lifetime income in the top 30%, and only 2.6% of those who are in the top 30% for any particular year have lifetime income in the bottom 30%.70 Both top to bottom mobility and rags-to-riches mobility are thus quite rare.

Focusing on the top of the income pyramid, 90% of those in the top decile for their age cohort at age forty-nine were in the top two deciles at age seventy-nine, and only 2% of individuals in the top decile for their age cohort at age forty-nine had fallen below the top three deciles by age seventy-nine.71 At the top, then, almost all of the [*PG1012]mobility is up, not down.72 This finding is confirmed by other studies which show income mobility within one or two deciles, but not much income mobility across more dispersed deciles, within any particular age cohort.73 Furthermore, because the percentage of people changing income category from one year to the next declined somewhat between the late 1960s and the early 1990s, income mobility diminished. Thus, the sharp increases in income disparities reflect true growth in disparities and not merely a reshuffling of the income distribution.74

All of this implies that increasing “income inequality within a single year is mirrored by a similar increase in inequality over Americans’ lifetimes.”75 The data on income mobility support, rather than impugn, the case for graduated progressive taxation, both on the grounds of fairness and to effect redistribution.

II.  The Distribution of After-Tax Income and Wealth

A.  After-Tax Dollar Incomes

When all is said and done, what is most important is the distribution of after-tax income.76 By this measure, despite its progressivity, the federal tax system really has done little to ameliorate the increasing disparities in income over the last two decades of the twentieth century. The CBO data show increasing after-tax income disparities.

Mirroring the changes in before-tax income,79 calculations based on the CBO data show each successive income class climbing up the income distribution pyramid realized a greater percentage increase in after-tax income than the income group below it. The second and third quintiles pulled significantly ahead of the lowest quintile, while the fourth quintile pulled ahead of the middle quintile by more than the middle quintile pulled ahead of the lowest quintile. And the top quintile appears to be in a class by itself. The percentage increase in its after-tax income outpaced the fourth quintile by four times as much as the increase for the fourth quintile exceeded that of the middle quintile.

[*PG1014] As with before-tax incomes, the CBO’s presentation, which does not adequately break out the smaller income cohorts within the top quintile, masks the extent to which increases in averages for the top quintile, top 10%, and top 5% actually are attributable largely to enormous increases in income of the top 1%.

The rate of after-tax income growth of all of the top quintile, except the top 1%, more nearly resembled the rate of income growth of the third and fourth quintiles than it did the top 1%. The after-tax income of the top 1% increased by nearly 150 percentage points more than the percentage by which the after-tax income of the 96th through 99th percentile increased, whereas the after-tax income of the 96th through 99th percentile increased by only 38 percentage points more than the percentage by which the after-tax income of the middle quintile increased.

The differences between the increases in before-tax income and the increases in after-tax income from 1979 to 2000 illustrate the special status of the super-rich. On the one hand, because tax rates generally fell during the period from 1979 to 2000, the first four quintiles saw their after-tax income increase at a higher percentage than the percentage at which their before-tax income increased.81 On the other hand, the fifth quintile saw its after-tax income increase by a slightly lower percentage than the percentage at which its before-tax income increased. But this did not necessarily reflect increased progressivity. The tax cuts in the various tax acts in that time period were not distributed evenly across or within quintiles. Many of the tax cuts were effected through increases in the earned income tax credit, af[*PG1015]fecting the first and, to a lesser extent because of its phase-out rules, the second quintile.82 Other tax reductions were effected through items such as the child and education credits, which due to phase-out rules affected primarily the second through fourth quintiles, and the bottom of the fifth quintile.83

Breaking the top quintile down in to smaller income cohorts reveals that the 81st through 90th percentiles saw after-tax income increase at a higher percentage than the percentage at which its before-tax income increased. But the 91st through 99th percentile after-tax income increased by a lesser percentage than the percentage by which its before-tax income increased—a small difference for the 91st through the 95th percentile and a significant amount for the 96th through 99th percentiles. When we get to the top 1%, we discover the big winner. After-tax income grew by 17 percentage points more than before-tax income increased. No other income class saw after-tax income increase by more than 2.5 percentage points more than before-tax income increased.

B.  Shares of Total After-Tax Income

As illustrated in Part II.A, the top of the economic pyramid realizes an extraordinarily disproportionate share of before-tax income.84 Policy makers have not responded to this ever-increasing growth in the disparity of incomes with any changes to the tax system that would reallocate [*PG1016]the tax burden to reflect these significant changes in the relative ability to pay taxes. Instead of increasing the progressivity of the tax system to meaningfully mitigate the rate at which the gulf between the rich and poor is widening, the policymakers have allowed the after-tax gulf to widen dramatically. The CBO data on the shares of after-tax incomes realized by each income class confirm this conclusion.

On an after-tax basis the top 5% has gained a share of income at everyone else’s expense. Even the 91st through 95th percentile has lost income share to the top 5%.86 And within the top 5%, the top 1% has grabbed the biggest share of the bigger slice of the pie, leaving the 96th through the 99th percentile only an additional sliver—at least compared to the top 1%’s extraordinarily increased share of pie.

[*PG1017]C.  Shares of Total Wealth

Wealth is strongly correlated to income.87 Precise measurement of the distribution of wealth is difficult, because the data are difficult to collect.88 Nevertheless, the various sources reveal consistent patterns, although details of the data may differ. Wealth in the United States is even more highly concentrated than income.89 Like incomes, wealth has been becoming increasingly more concentrated,90 but not at the same rate as the rate of growth of the concentration of incomes.91 Wealth, however, is more concentrated at the top of the pyramid than income. By some estimates, for over a decade, the top 1% has held nearly 40% of the total value of net wealth, while the top 5% has held nearly 60% of net wealth.92

[*PG1019]Other estimates show less concentration in the top 1%, offset by a larger share held by the 90th to 99th percentile, but the measure of the difference is not so significant as to change the import of the data.94 In any event, the top 1% alone holds more wealth than the bottom 80% or 90%.95

Although consistent data for smaller cohorts within the top 1% are difficult to obtain, what data there are demonstrate that the same pattern that occurs with respect to income distributions occurs with respect to wealth. The top of the top is different from the bottom of the top. In 1989, the top 1%, by wealth, owned 33.5% of all assets. Of this, the 99th to 99.4th percentile held 7.4%, and the 99.5th to 100th percentile—the top 0.5%—held 26.1%.96 Net worth was even slightly more concentrated.97 More recent data from the Internal Revenue [*PG1020]Service Statistics of Income Division (albeit using a different baseline measure of wealth) indicate that in 1998 the top 0.5% held over three-quarters of the wealth held by the top 1%.98 This is consistent with data from the Federal Reserve Board’s Triennial Survey of Consumer Finances for 1998.99 The data consistently show the top 0.5% holding more than 25% of personal net wealth in the United States.

Furthermore, in examining the distribution of wealth, there is an analogue to the IRS’s Fortunate 400 highest income earners. For wealth, the group is the Forbes 400—a list of the 400 wealthiest Americans published annually by Forbes magazine. From 1989 to 1999 the threshold for joining this elite group grew by 74%, to $609 million, measured in constant 1998 dollars.100 The average wealth of the top ten individuals grew by 611% to nearly $27.1 billion. Some estimates conclude that from 1989 to 1999, the percentage of total wealth held by the Forbes 400 grew from 1.5% to 2.6%. (With the stock market decline in the early 2000s, the Forbes 400’s share of total wealth is estimated to have fallen to 2.2% in 2001.101) Other estimates conclude that this group’s share of total wealth grew from about 1% in the early 1980s to closer to 3% in 2002.102 This growth in wealth was not even, and it was not evenly distributed. Between 1989 and 1995, most measures of the wealth of the wealthiest people grew fairly modestly in real terms, but from 1996 through 1999, there were dramatic increases. But the data indicate that the most significant increases in wealth were at the very top, and they tapered off at lower levels.103

It is true that much wealth in the United States today is newly created. On the one hand, Forbes magazine’s list of the ten wealthiest persons in the country in 2003 includes self-made billionaires Bill Gates, Warren Buffett, Paul Allen, Lawrence Ellison, and Michael Dell. On the other hand, many fortunes are inherited; five of Sam Walton’s heirs—individually, not collectively—also made the top [*PG1021]ten.104 The Walton heirs’ status is just one illustration that much of the wealth in the United States is dynastic.105 Many other members of the club that constitute the Forbes 400 acquired their wealth by inheritance. In 1999, half of the Forbes 400’s fortunes originated with inherited wealth.106 A number of studies indicate that approximately 50% of the wealth in the United States is inherited.107 Thus, although there is churning of identities within this elite group, there is still a high degree of stability of high wealth status.108

Regardless of whether we are considering inherited wealth or self-created wealth, one thing is clear. Because high incomes and high wealth are highly correlated, if the progressivity of the tax system at the high end continues to erode, wealth will become even more concentrated in the future than it is now.

III.  Effective Tax Rates

A.  Individual Taxes

1.  The Individual Income Tax Rate Schedule

Progressivity has always been an essential element of the income tax in the United States, even though progressive income tax rates have always been controversial.109 The 1913 income tax had a low, relatively flat-rate structure with generous exemptions. Although high marginal rates—going to over 90%—were enacted to fund World War [*PG1022]I, those high rates were rolled back in the 1920s. Steeply graduated progressive rates, rising to higher than 90% at the top of the scale, reappeared in the 1940s in response to the need for revenues during World War II. High marginal rates for taxpayers in the top decile continued to characterize the income tax rate schedules until 1981.110 For the most part, however, until the inflation-driven bracket creep of the mid-1960s, the income tax system was largely flat-rate or mildly progressive for the masses, with steeply progressive surtaxes on a relatively small percentage of the population.111

Progressivity went into decline in 1981, partially rebounded in the 1990s, but has never recovered to its pre-1981 level. Between 1981 and 1985, the largest percentage cuts in individual income tax rates went to the highest income groups.112 The decline of progressivity began with the 1981 Act, which eliminated all marginal brackets above 50%.113 The eliminated brackets applied almost exclusively to current yield from capital, but the changes had the important ancillary effect of reducing the maximum rate on long-term capital gains from 28% to 20%. In general, income from capital got a big break. In addition, through adjustments in the remaining rate brackets, taxpayers in al[*PG1023]most every rate bracket received approximately a 10% rate reduction. Every prong of the 1981 Act reduced progressivity. The effect of elimination of the brackets above 50% is obvious, but it was even more anti-progressive than it appears on the surface because it was, to a large extent, tax relief for dividends, the receipt of which is highly concentrated in the highest-income classes.114 That the other two changes reduced progressivity is not quite so facially obvious, but it is equally certain. The benefits of reduction of capital gains rates inure disproportionately to high-income taxpayers because capital gains realizations are highly concentrated in high-income taxpayers.115 Even the 10% across-the-board reduction in rates reduced progressivity. Across-the-board percentage cuts increase inequality in private before-tax income because they reduce taxes of higher-income taxpayers proportionately more than they reduce taxes of lower-income taxpayers.116

Five years later the rate structure was radically changed by the 1986 Act, which reduced the rate brackets to 15% and 28%.117 Because of significant base broadening, the elimination of the preferential treatment of capital gains, and an increase in effective corporate tax rates, the 1986 Act resulted in decreased tax effective rates for all income classes below the top quintile.118 The lowest income classes benefited significantly from the 1986 Act, primarily due to expansion of the earned income credit, but across most of the spectrum, the 1986 Act was to a large extent distributionally neutral. Some analysts [*PG1024]find the changes to have been mildly progressive,119 although others find the changes to have mildly reduced progressivity.120 Nevertheless, because the net effect of most of the changes in the 1986 Act was to lock in the effect of changes in the tax acts in 1981, 1982, and 1983, from the perspective of the top 1% vis-�-vis everyone else, effective tax rates after the 1986 Act were less progressive than they were immediately before the 1981 Act.121

As subsequently analyzed by the House Committee on Ways and Means, the changes in the individual income tax burdens in the 1980s lopsidedly favored those at the top of the very top of the economic pyramid.

These data show the top 1% getting twice as much tax relief as the middle class, and an even higher multiplier of the tax relief than the nearly rich in the 96th through 99th percentiles.

The disproportionate tax cuts accorded to the very highest income class in the 1980s set the stage for the introduction in 1991 of the 31% bracket and in 1993 of the 36% and 39.6% brackets, the lat[*PG1025]ter applying to taxable incomes over $250,000 (indexed for inflation).123 The higher rates enacted in 1993 were intended solely to apply to those who benefited the most from the tax cuts of the 1980s. The new higher brackets initially affected less than 4% of taxpayers— those at the very top of the income distribution.124 Nevertheless, the increased progressivity fostered by those rate increases was somewhat ameliorated four years later when, in 1997, the rates on most long-term capital gains were significantly reduced, from 28% to 20%.125

2.  Payroll Taxes

Important changes in the 1970s and 1980s that dramatically affected the distribution of overall federal tax burdens had nothing to do with the income tax. In addition to income taxes, the federal government levies payroll taxes on wages and self-employment income. Payroll taxes were first introduced in 1935 to fund the Social Security system, but they now also fund Medicare (starting in 1965) and federal unemployment compensation. Payroll taxes are imposed on wages and self-employment income, starting with the first dollar, with no exceptions or exclusions,126 but they are dramatically reduced after wages or self-employment income exceeds an applicable ceiling for the year. Although the payroll tax rate is proportional with respect to its base, the burden of the tax is regressive. Regressivity results from the combined effects of the absence of a floor exempting some income and the imposition of a ceiling on wages subject to the largest portion of the tax.127 Statutory payroll tax rates have risen from 8.8% in 1967 to 15.3% currently.

The payroll tax (excluding unemployment compensation) currently consists of two components. The first component is the 6.2% [*PG1026]Social Security tax on wages below a specific ceiling that increases each year as wages in the economy generally increase. For 2003 the Social Security component of the payroll tax is levied on the first $87,000 of wages, without any exemptions, for a maximum of $5394. The second component of payroll taxes is the 1.45% Medicare tax on all wages, again without any exemptions, but without a ceiling. The payroll tax is collected from both the employer and the employee, so the Social Security component actually is 12.4% (a maximum of $10,788) and the Medicare component is 2.9%, for a total of 15.3%. Self-employed individuals pay these percentages on self-employment income, subject to the same ceiling on the Social Security component. From the employee’s side, payroll taxes are neither deductible nor creditable in computing income taxes, but self-employed individuals may deduct one-half of self-employment taxes in computing income taxes.128 Employers deduct their share of payroll taxes if the wages are paid in a profit-seeking activity.

Although income tax rates—particularly the rates imposed on the top of the income pyramid—have fallen dramatically over the last forty years, both the payroll tax rate and base have increased markedly during that period, dramatically increasing payroll tax receipts. Through 1949, the combined employer and employee Social Security tax was 2% (1% each), which was imposed on wages up to $3000.129 Over the years, as necessary to keep the system solvent, Congress increased both the rate and the ceiling. Starting in 1975, the ceiling was increased for inflation (except from 1979 through 1981 when ceilings were increased ad hoc by Congress).130 Generally speaking, the goal was to collect, in any given year, payroll taxes somewhat more than enough to pay current benefits, but not to fully fund accrued benefits.131 From 1974 through 1982, the combined (employer and employee) payroll tax rate (including Medicare, added in 1965) rose from 11.7% to 13.3%.132 In 1983, spurred largely by the urging of Alan Greenspan to better fund [*PG1027]future accrued benefits,133 Congress revised the Social Security system. The goal was to increase the excess of taxes collected over benefits paid out in order to further increase the balance in the Social Security trust fund.134 Under the Social Security Amendments of 1983,135 the combined Social Security payroll tax rate rose to 12.4% and the combined Medicare payroll tax rose to 2.9%.136 The 1983 legislation also provided a formula to increase the rate at which the ceiling on Social Security taxes was raised. As a result, the payroll tax burden has increased substantially, with higher rates and a ceiling on the Social Security portion of the tax that increases annually for inflation. From the mid-1960s through 2003, payroll tax receipts increased from approximately 20% to about 40% of federal revenues.137 Over the last twenty years, however, the growth of payroll taxes has been attributable to increases in the wage ceiling rather than rate increases. The rates have not been increased since 1990.

Payroll taxes in excess of those necessary to fund the Social Security system and Medicare on a pay-as-you-go basis are “invested” in the “social security trust fund,” which consists solely of a special issue of Treasury bonds.138 The proceeds of the sale of those Treasury bonds to the Social Security trust fund are then used for general governmental expenditures, for example, military, farm subsidies, interest on the national debt, federal payroll, and so forth.139 In other words, increased payroll taxes fund expenditures that generally are thought by most taxpayers to be funded by primarily the income tax. Over [*PG1028]$150 billion was added to the “trust fund” in 2002.140 At the end of 2002, “the trust fund” held approximately $1.4 trillion,141 meaning that cumulatively nearly $1.4 trillion dollars collected by the payroll tax ostensibly to fund Social Security and Medicare had been spent on general government operations. It is estimated that another $1 trillion will be added to the trust funds—that is, spent on general government operations—by the year 2007.142

B.  Effective Tax Rates

One of the most frequently referenced norms for determining progressivity is what is known as “effective tax rates.” An “effective tax rate” is determined by dividing tax liabilities (total or with reference to the allocable burden of a specific tax) by total income.143 This method of analysis generally defines income in a normative manner, including in income many items that are exempt from taxation.144 Tax liabilities taken into account generally include actual taxes paid. Therefore, the method does not employ tax expenditure analysis, under which normative taxes equal the normal statutory rate applied to a normative base, and the difference between the normative taxes so calculated and actual tax liability is treated as an offsetting government subsidy to the taxpayer.145 Because of their differing methodologies, effective rate analysis using actual tax liabilities and tax expenditure analysis are mutually inconsistent and cannot be applied simultaneously.146 Most, if [*PG1029]not all, of the available data relating to tax burdens reflect actual tax liabilities rather than normative tax liabilities, and the data regarding the distribution of tax expenditure benefits are far less refined, even when they are available. Moreover, in the political arena, tax expenditures generally are viewed as “tax relief.” Thus, this Part focuses on effective rate analysis exclusive of tax expenditure analysis.

The CBO has published two major studies on effective tax rates in the past few years, one covering changes in the period 1979 through 1997,147 and a second covering changes in the period 1997 through 2000.148 The CBO studies provide data not only with respect to the overall effective federal tax rates, but with respect to the impact of income taxes, payroll taxes, and corporate taxes on each income quintile, as well as the top 10%, top 5%, and top 1%.

1.  Income Tax

According to the CBO data, from 1979 to 1997, the effective income tax rate fell for the first four quintiles, but increased slightly for the top quintile.149 The CBO also shows that the smaller cohorts within the top quintile, the top 10%, top 5%, and top 1%, saw slight increases in their effective federal income tax rates from 1979 to 1997, after dipping substantially after the 1986 Act and before the institution of the 36% and 39.6% marginal brackets in 1993.150 From 1997 to 2000, the effective individual income tax rates for the lowest income quintile rose (but remained negative due to the refundability of the earned income credit). Effective income tax rates fell for those in the second and middle quintiles, remained constant for households in the fourth quintile, and rose for those in the highest quintile (including all smaller cohorts within the highest quintile).151 These changes [*PG1030]in effective individual tax rates, however, were not due to statutory changes. According to the CBO, the increased individual income tax rates were attributable to bracket creep—inflation-adjusted income growth pushed more households into higher tax brackets—and disproportionately high income growth realized at the very top of the income distribution, which combined to make a larger share of income subject to the highest tax rate.152

How can the CBO data show an increase in effective income tax rates when rates have been cut? Part of the answer lies in changes in the base, because effective rate analysis uses an expanded definition of income, not AGI or taxable income.153 But more importantly, even the CBO studies themselves caution that its methodology and data can “mask or even misrepresent information about subgroups or specific taxes.” The CBO points out that total effective tax rates can rise between any two years, even if effective rates for households in every income quintile fall.154 Likewise, effective tax rates for a quintile can rise even though statutory tax rates for a subgroup remain constant or fall. As shares of income shift upward—that is, the real income of a higher income cohort increases disproportionately to a lower income cohort, a higher percentage of income is taxed at higher rates.155 Finally, because of tax preferences, such as exclusions from taxable income for pension plan contributions, which are counted in total income in the CBO data, and the preferential rate for capital gains, shifting composition of income within an income class can affect the effective tax rate even if statutory rates remain unchanged. This last factor is very important. The data show that in the 1990s a smaller percentage of the income of top income earners was in the form of capital gains than it was in the 1980s and a larger percentage of the income of those earners was wage and other income taxed without any preference.156 In 1998 more than half of the “very top [*PG1031]taxpayers derive[d] the major part of their income in the form of wages and salaries. . . . [T]he ‘working rich’ celebrated by Forbes magazine have overtaken the coupon-clipping rentiers.”157

A study by Thomas B. Petska, Michael I. Strudler, and Ryan Petska has reached a different conclusion than the CBO regarding effective income tax rates.158 Petska, Strudler, and Petska employed a “retrospective income concept,” which uses the income and deduction items available in the 1979 to 1986 period as the base, and found that all income classes, except the lowest class and the top 10%, realized a substantial decrease in average tax rates from 1979 to 2000. In contrast to the CBO, however, they concluded that average tax rates for the top 1% of the income distribution decreased substantially from 1979 to 2000, with the top 0.10% of taxpayers having a 15.7% decrease, from 31.41% to 26.48%, and the remainder of the top 1% seeing a 14.07% decrease, from 27.43% to 23.57%.159 In contrast, the remainder of the top 10% of taxpayers saw less than a 5% decrease in average tax rates.

2.  Other Federal Taxes

Individuals’ overall tax burdens reflect not only the income tax, but also payroll taxes, corporate income taxes, excise taxes, and wealth transfer (estate, gift, and generation-skipping) taxes. Individual income tax receipts constitute slightly less than 50% of total federal tax receipts.160 In the late 1970s, corporate income taxes represented about 15% of federal tax receipts, but in recent years corporate income taxes have dropped to less than 10% of total federal taxes. In addition, various excise taxes collect slightly less than 4% of total taxes.

Payroll taxes are particularly important. In recent years, payroll taxes have risen to an amount equal to nearly 40% of federal tax receipts. Payroll taxes nominally are imposed to finance Social Security and Medicare specifically.161 If earmarking of these receipts for these specific transfer programs is accepted at face value, it might be difficult [*PG1032]to evaluate these taxes without considering the distribution of the benefits they provide. Nevertheless, because federal expenditures apart from the transfer programs for which payroll taxes nominally are earmarked far exceed taxes other than payroll taxes (primarily, individual and corporate income taxes), and payroll taxes far exceed current Social Security and Medicare expenditures,162 payroll taxes are to a large extent financing current general purpose government expenditures.163 Thus, in analyzing tax burdens, payroll taxes should not be considered to be any different than the individual or corporate income taxes.

All of these other taxes, which ultimately are borne by individuals, should be taken into account along with the income tax in determining the progressivity of the federal tax system. The CBO studies have done so by determining the effective rate for each of these taxes for the various income classes.164 In computing the effective rates, the CBO assumed, as do most economists,165 that the employer’s share of payroll taxes is borne by the employees. Thus, the amount of those taxes was included in employees’ income, and the taxes were treated as part of employees’ tax burden. The CBO treated corporate taxes as borne by owners of capital and allocated corporate taxes to households in proportion to their income from interest, dividends, rents, and capital gains.166 Finally, the CBO assumed that excise taxes are borne by [*PG1033]households according to their consumption of taxed goods (tobacco and alcohol) or—in the case of excise taxes that affect intermediate goods—in proportion to overall consumption. Under this analysis, corporate taxes fall more heavily on taxpayers in the higher-income classes; social insurance tax rates are higher for the middle-income classes; and excise taxes fall disproportionately on low-income households.167

a.  Payroll Taxes

Most households pay a larger amount in payroll taxes than in income taxes. As previously explained, economists generally agree that even though the employer nominally pays one-half of total payroll taxes, the entire burden is borne by employees.168 Taking into account both the employers’ and employees’ shares of payroll taxes, 70% or more of households have paid more in payroll taxes than in income taxes, and that has been true for every income category below the top quintile since 1988.169 Payroll taxes are regressive because they are based on a flat rate and for the most part are subject to a ceiling. According to the CBO data, effective wage tax rates are lower for the top quintile than for any other income class.

The overall effective payroll tax rate increased fairly steadily from 1979 to 1994, as Congress increased the levies to deal with financing Social Security and Medicare. Since 1994, however, the overall effective payroll tax rate has been falling, as an increasing percentage of [*PG1034]total income, mostly realized by the highest income households, is not subject to payroll taxes or is above the ceiling for the Social Security portion of the payroll taxes. Effective payroll tax rates for 1979, 1994 (the peak overall payroll tax rate), and 2000 were as shown in the following Table.

Effective wage tax rates have been higher than effective income tax rates for households in the first four quintiles for every year since 1984, and for households in the first three quintiles in all years of the CBO studies, and have continuously risen.171 Because of the inherent structure of the payroll taxes, the highest income cohorts have experienced the lowest percentage point increases in effective rates.

In analyzing overall tax burdens, payroll taxes properly are taken into account for two reasons. First, the relationship between payroll taxes paid and Social Security and Medicare benefits received is very tenuous.172 Second, as already noted, since 1983 payroll taxes have been set at a level that is significantly more than adequate to fund the Social Security system and Medicare on a pay-as-you-go basis, and the excess revenue from payroll taxes funds general expenditures. In this regard, it is important to note that, these “excess” payroll tax receipts made the most significant contribution to the transitory surplus of the late 1990s that was “returned to the taxpayers” by the Bush tax cuts of 2001 and 2003. The “refund,” however, did not go to the taxpayers who paid the payroll taxes; most of the “refund” went to the top 1% of the income pyramid.

[*PG1035]b.  Corporate Taxes

Corporate taxes are important to progressivity because corporate taxes are borne disproportionately by high-income taxpayers. As noted previously, the CBO studies treat corporate taxes as borne by owners of capital and allocate corporate taxes to households in proportion to their income from interest, dividends, rents, and capital gains.173 Under this assumption, high-income households bear a disproportionately large share of the burden of corporate taxes, and the tax is highly progressive.174 A decline in the effective corporate tax rate benefits high-income households more than other households.175

The percentage of total federal taxes represented by corporate income tax collections has fallen dramatically in the last forty years. Prior to 1968, corporate tax receipts consistently represented more than 20% of total federal taxes. Corporate income taxes fell below 10% of total federal tax receipts for the first time after the 1981 Act, which significantly reduced the statutory rates and provided much more generous cost recovery allowances (depreciation) than had previously been allowed. Through much of the 1990s, corporate tax receipts hovered around 11.5% of total federal taxes, before dropping back to about 10% in the last years of the twentieth century. In the first years of the twenty-first century, corporate income taxes plunged to 8% or less of total federal taxes.176

[*PG1036] In part, the decline in the relative importance of the corporate income tax to total tax receipts has been attributable to the increasing relative importance of payroll taxes. But the corporate tax itself has become less burdensome through both rate reductions and erosion of the base, the latter primarily through increasingly generous depreciation deductions.177 Some analysts also have attributed its decline to the rise of corporate tax shelters in the 1990s,178 but this proposition remains controversial.179 Nevertheless, it is undeniable that effective corporate tax rates (measured at the corporate level) have fallen significantly in recent years, even apart from any significant statutory changes.180 Consequently, effective corporate tax rates measured at the individual level also have fallen.

From 1979 to 2000, the overall effective corporate income tax rate for individuals fell from 3.4% to 2.5%, although the overall rate [*PG1037]fell to as low as 1.4% in 1982 and rebounded to as high as 2.9% in 1997. Comparison of 1979 and 1982 data for the “all quintiles” category helps to identify the 1981 Act as the key point in the decline of effective corporate tax rates.

As should be expected, most of the benefit of the decline of the corporate income tax inured to the highest-income cohorts—not the top quintile, not even the top 10%, but to the top 5%, and within that small group, mostly to the top 1%, whose effective corporate tax rate was halved. The magnitude of the decline depends on the share of the cohort’s income derived from capital,182 and the top 5%, and particularly the top 1%, realize a significantly greater proportion of their income as income from capital than do classes lower in the income distribution.183 The greater reduction in the impact of corporate taxes for the highest-income classes has reduced progressivity.

c.  Excise Taxes

Finally, the federal government imposes a variety of excise taxes, for example, gasoline, cigarette, and liquor taxes. Excise taxes claimed a fairly constant share of overall income—at or just under 1%—between 1979 and 2000 despite increases in statutory rates. But that consistent overall rate obscures significantly different effects within different income categories. Members of the lowest quintile first saw excise taxes increase from 1.6% of their income in 1979 to 2.6% in 1994, before dropping back to 2.2% in 2000. In 2000, the second quintile’s effective excise tax rate was 1.4%, while the third [*PG1038]quintile’s was 1.2%, both only 0.1 percentage points higher than in 1979. In contrast, the top quintile saw its excise tax rate drop from 0.7% in 1979 to 0.6% in 2000, while the top 1% excise tax rate dropped from 0.05% to only 0.3% over the same period. In short, the continuing overall effect was to make a regressive tax even more regressive.184 Excise taxes claimed more than five times the share of income from the lowest-income households than they claimed from the highest-income households.185

3.  Total Effective Tax Rate

In the end, what is important from the broadest tax policy perspective is not the progressivity of any one tax, but the progressivity of the tax system. One tax might be changed so as to enhance progressivity, whereas another tax is changed to lessen its progressivity. Neither of the changes standing alone provides an adequate viewpoint for public policy analysis.186

In its 1997 study, the CBO concluded that total federal taxes had become more progressive from 1979 to 1997. By this the CBO meant that the federal tax system had served to narrow the gap between taxpayers at the top and taxpayers at the bottom, and that the extent to which it did so had increased over this time period.187 The CBO analysis was based solely on changes in effective tax rates, because, as the CBO study acknowledges, the before-tax incomes of those at the top of the income pyramid increased so dramatically relative to the incomes [*PG1039]of those further down the pyramid,188 that the gap in after-tax income between those at the top and those at the bottom actually increased.189

The total effective tax rate for selected years between 1979 and 2000, as computed by the CBO, is shown in the following table.

These data indicate that any increased progressivity was only with respect only to the bottom 60% of the income pyramid vis-�-vis the 61st through the 99th percentile. There was no increase in progressivity vis-�-vis the top 1%. That small cohort saw a greater reduction in effective tax rates than any cohort other than the bottom quintile. Even the conclusion that there was increased progressivity with respect to the bottom 60% vis-�-vis the 61st through the 99th percentile is questionable, however, given that the effective tax rates of the higher-income cohorts increased not through statutory changes, but because their before-tax incomes, which increased by higher percentages than did the lower-income cohorts, pushed portions of their income increments into higher marginal tax brackets.192

[*PG1040] The study by Petska, Strudler, and Petska concludes that the individual income tax significantly contributed to the declining total effective tax rates at the top of the income distribution.193 In contrast to the CBO, however, they conclude that average income tax rates for the top 1% of the income distribution decreased substantially from 1979 to 2000, with the top 0.10% of taxpayers seeing the largest decrease.194 They find changes in the trends for average tax rates can be divided into four distinct periods.195 First, prior to the 1981 Act, average tax rates were climbing, primarily due to bracket creep. Second, from 1982 through 1992, average tax rates generally declined for most income classes, with the most marked decline for the top 0.10%. Third, average tax rates for the top quintile—mostly the top 10%— increased as the 31%, 36%, and 39.6% brackets took effect in the early 1990s. Finally, average tax rates fell for the top two quintiles— most markedly again for the top 1% and top 0.10%—after the reduction of capital gains rates in 1997.

Trying to discern the effect on progressivity of these changes in effective rates is difficult. Some comparisons indicate that progressivity has increased since 1979. Using the CBO data, in 1979, the effective tax rate for the top 1% was 4.625 times the effective rate for the lowest quintile, and by 2000, it had climbed to almost 5.2 times the effective rate for the lowest quintile. On the other hand, in 1979, the effective tax rate for the top 1% was just under twice the effective rate for the middle quintile, and by 2000, it had remained at just under twice the effective rate for the middle quintile. In 1979, the effective tax rate for the middle quintile was 2.325 times the effective rate for the lowest quintile, and by 2000, it had increased to approximately 2.61 times the effective rate for the lowest quintile. These comparisons suggest that progressivity increased at the lower end of the income scale, but not at the upper end. Comparison of percentage decreases in rates confirms that the reduction of effective tax rates for the lowest quintile, all of which occurred in the late 1990s—virtually all of which resulted from expansion of the earned income credit and the enactment of the refundable child credit—increased progressivity at the lower end of the income distribution. Furthermore, progressivity measured by comparing the second and third quintiles as a group with the fourth and fifth quintiles, as a group, increased. But focusing [*PG1041]on progressivity at the very top of the income pyramid, by comparing the top 1% with the second, third, fourth, and fifth quintiles (exclusive of the top 1%) as a group, reveals that progressivity markedly decreased between 1979 and 2000.196 Moreover, most of that decline occurred in the early 1980s, following the dramatically disproportionate tax cuts accorded to the very highest-income taxpayers and the corporate tax cuts in the 1981 Act.

Another method for examining overall changes in progressivity is based on analysis of changes in the Gini index. The Gini coefficient is a measure of the degree of income inequality; a higher Gini value represents greater income inequality.197 Changes in progressivity between two points in time can be measured by comparing changes in the before-tax Gini index and changes in the after-tax Gini index. If the percentage difference between the before-tax Gini index and the after-tax Gini index increases, progressivity has increased. Conversely, if the percentage difference between the before-tax Gini index and the after-tax Gini index decreases, progressivity has decreased.

Petska, Strudler, and Petska’s study provides a very revealing analysis of changes in the Gini index.198 Their analysis shows the be[*PG1042]fore-tax Gini index climbing from 0.469 in 1979 to 0.588 in 2000, with the biggest jumps coming in the periods 1981 to 1988 and 1994 to 2000.199 The after-tax Gini index, although always lower than the before-tax Gini index, thus demonstrating that the federal tax system is indeed progressive, likewise increased between 1979 and 2000. The largest differences were prior to the 1981 Act, with the percentage difference falling to its lowest point in 1991. There was a significant increase in the difference from 1992 to 1993. The post-1981 peak in the difference, which was well below the pre-1982 peak in the differences between the pre-tax and post-tax Gini indices was reached in 1996, before the difference began to fall again in 1997. The difference remained relatively flat through 2000.200 This pattern confirms what one might expect—that the tax system has been relatively more progressive in years of higher marginal rates and relatively less progressive in years in which the highest marginal rates on highest-income earners were lower. The post-1996 dip also indicates that reductions in capital gains rates reduce progressivity.

4.  Isolating the Effect of Statutory Rules

For reasons explained earlier in this Part, analysis of effective tax rates does not necessarily accurately illustrate the effect on tax burdens of statutory changes. As the distribution of incomes shifts upward and as the composition of income within income classes changes, effective tax rates change without any change in statutory rates. Thus, effective rate analysis does not completely capture the impact of policy decisions reflected in tax legislation. Isolating the impact of changes in the statutory structure, including rate schedules, requires computer simulations of tax liabilities for different years under the law as in effect for that year but using the income from only one of the years. One such study by Andrew Mitrusi and James Poterba paints a very different picture of the changing progressivity of the federal tax system than the one [*PG1043]painted by the CBO.201 On an overall basis, the changes in the structure of the federal tax system in the last decades of the twentieth century not only did nothing to mitigate the growing disparity in incomes, but in fact contributed to it.

According to Mitrusi and Poterba, 62.6% of families that paid both income taxes and payroll taxes had lower personal income tax liabilities in 1999 than they would have had if the 1979 law had still been in effect, but only 36.4% saw a decline in combined income and payroll tax liabilities.202 Strikingly, most families at low-income levels experienced a combined payroll and income tax increase between 1979 and 2000. Only at income levels above $50,000 did a majority of families see a reduction in combined income and payroll taxes.203 Less than 20% of families with incomes below $10,000—roughly 25.5% of all filers204—had either an income tax reduction or a reduction in combined income and payroll taxes. Only 45% of families with incomes between $10,000 and $20,000—another 18.9% of all returns— had an income tax reduction, and only 30.1% of that group saw a reduction in combined income and payroll taxes. Seventy-eight percent of returns in the $20,000 to $30,000 category—another 14.5% of all filers—had an income tax reduction, but only 34.5% of families in that group had a reduction in combined income and payroll taxes. On the other hand, nearly 90% of filers with an income between $500,000 and $1 million, and over 90% of filers with an income exceeding $1 million saw a reduction in both income taxes and combined income and payroll taxes.

The picture is clear. The marketplace for before-tax income is increasingly becoming a winner-take-all market, and Congress loves a winner. Those who win in the marketplace likewise win in the legislative halls. As the rich have gotten richer, Congress has continually cut their [*PG1044]taxes, and their tax cut has been relatively larger than those accorded to most income classes lower on the income pyramid. From the mid-1990s until the turn of the millennium, only the rich have seen a decrease in their effective tax rates. The Matthew Effect is pervasive.

IV.  Tax Policy in the New Millennium

A.  The Legacy of the Roaring Nineties

At the dawn of the new millennium in the United States, the regular individual income tax had five marginal tax brackets as follows: 15%, 28%, 31%, 36%, and 39.6%. The upper and lower parameters of each bracket were statutorily specified in terms of 1992 dollars, and the brackets were, and continue to be, adjusted for inflation.205

The regular income tax was, and continues to be, backstopped by the alternative minimum tax (the “AMT”). The AMT was first enacted in 1969 to limit the ability of high-income taxpayers to eliminate virtually all tax liability through the benefit of various tax preferences, generally speaking, provisions enacted to promote economic and social goals (primarily those provisions classified as “tax expenditures”), rather than to measure net income. Generally speaking, the AMT has a broader base than the regular tax and rates lower than the highest regular tax rates but higher than the lower regular tax rates. Five deductions, most of which are “personal” in nature and not the result of tax planning involving tax preferences aimed at business and investment—the original target of the AMT, which are allowed under the regular tax, are not allowed under the AMT. These deductions—personal exemptions, standard deductions, state and local tax deductions, medical expense deductions, and miscellaneous itemized deductions—collectively comprise about three-quarters of individual AMT preferences and adjustments.206 All of these adjustments were added into the AMT base in the 1986 Act. Since 1992, the AMT rate has been 26% on the first $175,000 over the exemption amount and 28% on the excess over that amount. The exemption amount was $45,000 for married taxpayers filing a joint return and $33,750 for single taxpayers. Unlike the regular tax, in which exemptions, the [*PG1045]standard deduction, and rate brackets are indexed for inflation, the AMT rate brackets and exemption are not indexed for inflation.207

Studies indicate that, by 2007, almost 95% of the revenue from AMT preferences and adjustments will be derived from the personal exemption, the standard deduction, state and local taxes, and miscellaneous itemized deductions.208 As a result, the AMT increasingly affects middle-income wage earners—taxpayers not engaged in tax-shelter or deferral strategies. In 2000, the percentage of taxpayers, grouped by AGI, who were liable for the AMT peaked in the range from $100,000 to $200,000. At the higher-income levels, however, the percentage of taxpayers liable for the AMT steadily dropped. By 2010, the percentage of taxpayers liable for the AMT is projected to become significant in the $50,000 to $75,000 range, to peak in the $200,000 to $500,000 range, and thereafter to decline steeply.209 A recent study by the Treasury Department suggests that, by 2010, 17 million individual taxpayers, nearly 16% of all taxpayers, will be subject to the AMT.210 In 2001, the Staff of the Joint Committee on Taxation estimated that, by 2010, 16.4 million taxpayers, many of whom Congress never intended to be subject to the AMT, nevertheless will be liable for the AMT.211 Subsequent legislation might have changed the precise magnitude of the projections, but the trend has not been substantially affected. More recently, in 2003, the National Taxpayer Advocate reported that the Staff of the Joint Committee on Taxation has estimated that the AMT will affect 12.7 million taxpayers in 2005 and about 32 million in 2010.212 Because the individual AMT so widely misses its original mark, while adding inordinate complexity to the tax system for mid[*PG1046]dle-income wage earners due to its interaction with limitations on the various personal credits, there is growing sentiment for its repeal, even among those policy analysts who originally supported the enactment of the individual AMT.213 In the political arena, however, there is no major initiative for AMT relief.214

B.  The Republican Tax Relief Agenda

1.  The Economic Growth and Tax Relief Reconciliation Act of 2001

In 2001 there was a Republican president and Republican control of both houses of Congress for the first time since the early 1950s. In a highly partisan vote, Congress quickly enacted the Economic Growth and Tax Relief Reconciliation Act of 2001 (the “2001 Act”), which in large part fulfilled the campaign promises of President George W. Bush. The changes in this Act were intended to reduce tax revenues by $1.35 trillion during the period from 2001 through 2010.215 The most significant provisions of the 2001 Act were a substantial reduction in income tax rates and the complete repeal of the federal estate tax. To reduce the immediate budgetary impact of the drastic rate reductions, most of the income tax rate reductions were scheduled to be phased in over five years, to take full effect in 2006. All of the rate brackets above 15% were to be reduced according to the following schedule.

[*PG1047]In addition, a new initial 10% marginal rate bracket was carved out of the previously lowest 15% rate bracket, which was not reduced.216 The 10% rate bracket applied to the first $12,000 of taxable income for married taxpayers filing a joint return ($14,000 after 2007), and $6000 for single taxpayers ($7000 after 2007). Even this rate reduction, however, was not targeted to the bottom of the income pyramid. Millionaires received as much or more benefit than most taxpayers in the first two quintiles. Most taxpayers in the first quintile already had little or no income tax liability as a result of personal exemptions, the standard deduction, and the earned income credit.217 The same was true for many taxpayers in the second quintile, in which the earned income credit, as well as the child credit, also provided substantial relief.

The 2001 Act also provided relief from the so-called “marriage penalty.” To this end the Act increased the basic standard deduction for a married couple filing a joint return to twice the basic standard deduction for an unmarried individual filing a single return. The increased standard deduction was to be phased in over five years beginning in 2005 and would be fully effective for 2009 and thereafter. The 2001 Act also increased the upper limit of the 15% income tax rate bracket for a married couple filing a joint return to twice the amount applicable to an unmarried individual filing a single return. This change was to be phased in over four years, beginning in 2005, to be fully effective in 2008.

Although the expansion of the upper limit of the 15% bracket might at first blush appear to provide tax relief for the middle class, it is not in fact so. Expansion of the 15% bracket provides no benefit for taxpayers who were not subject to tax at any rate above 15%, but mainly benefits high-income taxpayers.218 For 2000, about 70% of taxpayers with some tax liability were in the 15% bracket.219 Thus, only 30% of taxpayers—the top 30%—benefited at all from this change. When the smoke cleared, it looked like 72% of all taxpayers who filed returns and 64% of all taxpayers who had positive tax liability did not [*PG1048]see any decrease in marginal rates, although they did see some decrease in average rates.220

Even the rate reductions aimed solely at the top 30% or so were structured to benefit the higher-income classes. The 39.6% bracket was reduced by 11.62%, the 36% bracket by 8.33%, the 31% bracket by 9.68%, and the 28% bracket by 10.71%. The pattern is somewhat random, but it is clear that the highest marginal tax bracket received the greatest percentage decrease. Even a flat across-the-board percentage rate reduction would have been anti-progressive.221 Across-the-board percentage cuts increase inequality in after-tax income because they reduce taxes of higher-income taxpayers proportionately more than taxes of lower-income taxpayers.222 For a tax cut to be distributionally neutral it must increase everyone’s after-tax income by the same percentage.223 The 2001 Act did not do that.224 Furthermore, the regular tax cuts for much of the top 30%—particularly those with incomes between $75,000 and $1 million—were substantially offset by increased AMT liability.225

Not all of the targeted tax relief in the 2001 Act went to the highest-income classes. There was some mitigation of anti-progressive rate changes through “targeted” tax cuts.226 The 2001 Act also increased the amount of the child credit under I.R.C. � 24 from $500 to $1000, with the increase to be phased in over ten years—$600 in 2001 through 2004, $700 in 2005 through 2008, $800 in 2009, and $1000 in 2010. The I.R.C. � 24 child credit is allowed with respect to each of a taxpayer’s dependent children under age 17. As originally enacted, the child credit generally was not refundable to the extent that it exceeded the taxpayer’s income tax liability.227 Because the child credit was intended by Congress to benefit the “middle class,” it is phased out by $50 for each $1000 (or fraction thereof) by which the taxpayer’s “modified AGI” exceeds $110,000 in the case of joint returns [*PG1049]($55,000 in the case of married taxpayers filing separately) and $75,000 for unmarried taxpayers (who in all likelihood will file under head of household status).228

The 2001 Act allowed partial refundability of the child credit. For 2001 through 2004, the credit is refundable to the extent of 10% of the taxpayer’s earned income in excess of $10,000 (indexed for inflation beginning in 2002). After 2005, the percentage increases to 15%.229 If a taxpayer has three or more children, the credit is refundable to the extent that the taxpayer’s Social Security taxes exceed the sum of any other nonrefundable credits plus the taxpayer’s earned income credit, if that amount exceeds the amount otherwise refundable. Generally speaking, this last rule means that otherwise unusable child credits are available to obtain a refund of Social Security taxes. In addition, the 2001 Act allowed the child credit to be claimed against the AMT. At the lowest end of the income scale, the 2001 Act expanded the earned income tax credit230 by raising the threshold and ceiling on the earned income tax credit phase-out by $1000 for 2002 through 2004, $2000 for 2005 through 2007, and $3000 after 2007 (adjusted annually for inflation after 2008).

A glaring omission in the 2001 legislation was any substantial reform of the individual AMT. The regular tax deductions added back to alternative minimum taxable income, including the standard deduction and the personal and dependency exemptions, remained the same. The AMT exemption remained substantially unchanged and remained unindexed for inflation; it was temporarily increased for 2001 through 2004 from $45,000 to $49,000 for married taxpayers filing a joint return and from $33,750 to $35,750 for single taxpayers.231 The rates remained the same and the rate brackets continued to be unindexed for inflation. As a result, apart from the temporary partial relief in 2001 through 2004 resulting from a slightly increased exemption amount, many of the middle-class taxpayers who appeared to receive a tax cut under the I.R.C. � 1 rate reductions in fact saw little or no reduction in their income taxes because the reduction in their regular income tax liability gave rise to significant AMT liability for which they [*PG1050]had not theretofore been liable.232 Pulitzer Prize winning New York Times investigative tax reporter David Cay Johnston has described the combination of the widely touted regular income tax cuts with the continuation of a substantially unchanged AMT as follows:

The design of the Bush tax cuts made sure that the very rich, those making $1 million or more per year, got nearly the full measure of the cuts that candidate Bush promised. Not so those making less. To hold the cost of the tax cuts to 1.3 trillion over the first ten years, someone had to lose out. The administration could have decided to cut the top rate of 39.6 percent to 36 percent instead of 35 percent, for example. It could have revised the alternative minimum tax to make it fall more heavily on the very rich so that those making less than $1 million or $500,000 could be exempted. Instead, the administration relied on the stealth approach of letting the alternative tax silently take back from those making less than $500,000 a year some or all of what they were told to expect. This design meant that the upper middle class, families making $75,000 to $500,000, would subsidize the tax cuts for those in the million-dollar-and-up income class.233

The most dramatic provision in the 2001 Act, however, did not involve income taxes at all, and was a bonanza for the super-rich. The federal government has imposed estate taxes—a tax on the wealth passing from a decedent to the decedent’s heirs and legatees—since 1916. The purpose of the estate tax is not primarily to raise revenue.234 It is “antidynastic.”235 The purpose of the estate tax is to reduce [*PG1051]wealth inequality.236 But the national philosophy apparently changed, and in the 2001 Act Congress repealed the estate tax as of 2010.

Immediately prior to the 2001 Act, the transfer taxes—estate, gift, and generation-skipping taxes—were levied on cumulative lifetime transfers (excluding transfers to spouses and charities) at rates of up to 55%.237 Generally speaking, the first $675,000 was tax-free, and that exemption was scheduled to increase in steps to $1 million by 2006.238 Through relatively simple tax planning, a married couple could effectively pass double the exemption amount on to the objects of their bounty tax-free.239

Although proponents of its repeal described the federal estate tax as a “death tax” and gave the impression that it affected almost everyone,240 in fact only about 2% of all decedents’ estates have any estate tax liability.241 Within that small group, slightly less than 10% of the estates—less than 0.2% of all estates, reported over 30% of gross assets and paid over 60% of the total estate tax liability.242 The estate tax truly is primarily a tax on the super-rich. Furthermore, in large part the estate tax has been a tax on previously untaxed wealth. Despite the popular misperception that the estate tax is an additional levy on after-tax savings, much of the value subjected to the estate tax is unrealized appreciation. Thirty-seven percent of all value in estates above $500,000 is unrealized capital gains, and, more importantly, among estates valued at more than $10 million, 56% of value was unrealized capital gains.243

Under the 2001 Act, estate tax rates are scheduled to be reduced moderately, and the exemption will be increased significantly, between 2001 and 2009, with the estate tax (and the generation-skipping [*PG1052]tax, but not the gift tax) to be completely repealed in 2010.244 The inevitable result of repeal of the estate tax will be increased inequality of wealth.245 The rich will be able to pass on unrealized capital gains for generation after generation without the imposition of any tax whatsoever.

For reasons having to do primarily with congressional procedural rules, every provision enacted in the 2001 Act is scheduled to sunset on December 31, 2010. Thus, absent further congressional action, on January 1, 2011, all of the changes implemented by the 2001 Act are automatically repealed, and the Code reverts to its pre-2001 Act provisions. The supporters of these changes never really intended for them to sunset, particularly the repeal of the estate tax, and President Bush’s 2005 Fiscal Year Budget proposal calls for making permanent almost all of the temporary provisions in the 2001 Act, including the rate reductions and the repeal of the estate tax.246

2.  Job Creation and Worker Assistance Act of 2002

Later in 2001, following the terrorist attacks of September 11, 2001, Congress enacted the Terrorist Victims Relief Act of 2001, which provided targeted tax relief for victims of the terrorist attacks, and members of their families, and tax incentives for investments in the affected area of lower Manhattan or investments by businesses in that area. Most of the provisions were temporary; only a few permanent provisions affecting victims of future terrorist or military actions were enacted.

The somewhat misleadingly named Job Creation and Worker Assistance Act of 2002 (the “2002 Act”)—it was not completely misnamed because it extended unemployment benefits—provided tax cuts for businesses through a series of new and extended accelerated depreciation deductions and credits for business expenses, as well as tax benefits for businesses in New York City affected by the September 11, 2001 terrorist attacks. One of the principal, broadly applicable provisions of the 2002 Act was the addition of I.R.C. � 168(k), which, [*PG1053]as an additional stimulus to capital investment, allowed an immediate deduction of 30% of the adjusted basis of qualified property—primarily equipment used in a trade or business247—placed in service after September 10, 2001, and before September 11, 2004.248

The 2002 Act, although generally not directly addressing individual tax burdens apart from targeted relief for victims of terrorism, nevertheless had an important impact. The partial expensing for equipment purchases under � 168(k) can be expected to reduce corporate tax revenues significantly while it is in effect.249 As discussed earlier, corporate taxes generally are considered to be borne by capital, which is owned very disproportionately by the highest-income cohorts.

3.  The Jobs and Growth Tax Relief Reconciliation Act of 2003

The Jobs and Growth Tax Relief Reconciliation Act of 2003 (the “2003 Act”) accelerated the effective date of the rate reductions enacted in the 2001 Act by putting the 25%, 28%, 33%, and 35% brackets previously scheduled to take effect in 2006 into effect for all years after 2002 and before 2011. The 2003 Act also temporarily increased (for taxable years beginning in 2003 and 2004) the standard deduction and the upper limit of the 15% regular income tax rate bracket for married taxpayers filing joint returns to twice the upper limit of the 15% regular income tax rate bracket for single taxpayers.250 The 2003 Act also provided that an increase in the upper limit of the 10% rate bracket from $6000 to $7000 for single taxpayers and from $12,000 to $14,000 for married taxpayers filing joint returns (indexed for inflation in 2004), previously scheduled to take effect in 2008, would be temporarily effective in 2003 and 2004.251 As a result, starting in 2003 there are six rate [*PG1054]brackets—10%, 15%, 25%, 28%, 33%, and 35%. As adjusted for inflation, the thresholds for taxable income in each rate bracket for taxable years beginning in the year 2003 are as follows.252

Acceleration of the rate cuts for the four highest brackets benefited only about 22% of taxpayers; 78% of taxpayers faced a 15% or lower tax rate.253 The 2003 Act also temporarily increased the amount of the child credit to $1000 for 2003 and 2004. Thereafter, the amount of the credit reverts to the amounts provided in the 2001 Act—to $700 in 2005 through 2008, $800 in 2009, and $1000 in 2010.254

The lion’s share of the targeted tax reductions in the 2003 Act, however, went to income from capital. First, the 2003 Act amended I.R.C. � 168(k) to increase the additional first-year deduction to 50% of the adjusted basis of qualified property placed in service after May 5, 2003, and extended the deduction until December 31, 2004.255 The 2003 Act significantly reduced the maximum rate of tax on long-term capital gains. Generally speaking, most long-term capital gains realized by noncorporate taxpayers are now taxed at 15% if the taxpayer is otherwise in the 25% or higher marginal tax bracket, and at a 5% rate if the taxpayer is otherwise in a lower tax bracket.256

[*PG1055] The most dramatic targeted tax relief in the 2003 Act was the drastic reduction of tax rates on dividends received by individuals with respect to corporate stock. Under the 2003 Act, dividends received from domestic and qualified foreign corporations after 2002 are taxed at the same preferential rates applicable to long-term capital gains—15% for individual taxpayers otherwise taxable at a rate greater than 15%, and 5% for individual taxpayers otherwise taxable at 10% or 15%.257 Despite arguments by the proponents of these changes that they benefited everyone, based on claims that over half of Americans owned stock, these changes were essentially tax relief for the super-rich.

The 2003 Act did a bit more than the 2001 Act to ameliorate the impact of the AMT on the ever increasing number of middle and upper-middle class taxpayers—primarily those with incomes between $50,000 and $500,000—by increasing the exemption amounts for 2003 and 2004, but not thereafter, to $58,000 for married taxpayers filing joint returns and to $40,250 for singles. This temporary balm for the ever increasing anti-progressive impact of the AMT on middle-income taxpayers stands in stark contrast to the longer-term temporary reductions in � 1 rates and tax cuts on capital gains and dividends.258 Although President Bush’s 2005 Fiscal Year Budget proposes [*PG1056]to make permanent the � 1 rate cuts and the reduced rates for capital gains and dividends, it proposes to extend the increased AMT exemption only through 2005.259

Recent analysis shows that the AMT will become the primary tax for most taxpayers who are not income millionaires.260 In 2003, less than 1% of taxpayers with incomes between $50,000 and $75,000 faced AMT liability; slightly more than 1% of those with incomes between $75,000 and $100,000 also did so. For taxpayers with incomes between $100,000 and $200,000, 9.3% had AMT liability. AMT “participation” jumped to over 55% of those with incomes between $200,000 and $500,000, before dropping to 28.9% of taxpayers with incomes between $500,000 and $1 million, and only 19.3% of those with incomes of $1 million or more. The picture will change dramatically by 2010, when more than 36% of taxpayers with incomes between $50,000 and $75,000 will face AMT liability; nearly 73% of those with incomes between $75,000 and $100,000 will pay AMT. For taxpayers with incomes between $100,000 and $200,000, 92% will have had AMT liability. AMT “participation” will jump to over 92% of those with incomes between $200,000 and $500,000, before dropping to 49.3% of taxpayers with incomes between $500,000 and $1 million, and only 24.1% of those with incomes of $1 million or more.

The impact of the AMT on the tax cuts enacted in 2001 and 2003 (excluding the reduced rates for capital gains and dividends), projected for 2010, is shown in the following table.

[*PG1057]Thus, for many taxpayers the “permanent” tax cuts in the 2003 Act were as illusory as the tax cuts in the 2001 Act. Ironically, given that the original theory of the AMT was to impose a lower marginal rate on a broader base, many of these taxpayers facing AMT liability will be subjected to a higher marginal tax rate imposed on a lower base than under the regular tax.262 As in 2001, however, those with annual incomes exceeding $1 million remained largely unscathed by increased AMT liability, free to enjoy fully the benefits of the regular tax rate reductions,263 including the new 15% preferential rate for long-term capital gains and dividends received on corporate stock, which apply for AMT purposes as well as for regular tax purposes.264

All of the key provisions in the 2003 Act were originally enacted as temporary changes (like the 2001 Act), and were scheduled to sunset on December 31, 2008. As was the case with the 2001 Act, supporters of the 2003 Act did not really intend for them to sunset, and President Bush’s 2005 Fiscal Year Budget proposal calls for making permanent almost all of the key provisions in the 2003 Act (except additional first year depreciation under I.R.C. � 168(k)).265

C.  Quantifying Tax Relief for the Rich

As explained above, the impact on progressivity of the 2001 and 2003 Acts cannot be measured simply by looking at the changes in the regular income marginal rates, and preferential rates for capital gains, in I.R.C. � 1. The various changes are too complex and interact too extensively with other provisions, primarily the AMT.

It is difficult, if not impossible, to assemble from the various official reports—primarily explanations of pending legislation prepared by the Staff of the Joint Committee on Taxation—accurate estimates of the distribution among income classes of the tax relief provided by the spate of tax legislation in the first three years of the twenty-first century.266 The official distributional estimates that were [*PG1058]once in vogue have been abandoned, killed by criticisms of their inaccuracies.267

Some of these criticisms are valid. Distributional tables hide significant differences between individuals in the same income class— primarily because tax liabilities are highly sensitive, even more so after the 2001 and 2003 Acts—to the form of the receipt. For example, at the higher end of the income pyramid, under current law, an investor realizing most of a $20 million annual income in the form of capital gains and dividends faces an average tax rate of less than 15%, and if the portfolio mix includes tax-free state and municipal bonds, a rate that might be much lower. Conversely, a best-selling book author earning that same amount from royalties would face an average tax rate of nearly 35%. Moving down the income pyramid, one finds that income tax liabilities for the middle class are highly sensitive to the number of children in the household, due to the dependency exemption, child credit, and earned income credit. Nevertheless, the significance of the public policy choices inherent in any tax legislation cannot be appreciated fully without considering the distributional impact of the changes, and distributional tables based on income classes are all we have to use in our analysis.

The most reliable estimates of the distribution of tax relief provided by recent legislation have been prepared by the Tax Policy Center, jointly sponsored by the Brookings Institution and the Urban Institute.268 Presenting the conclusions, let alone the data, derived from the Urban-Brookings Tax Policy Microsimulation Model is a daunting task because of the year-by-year pattern of ever shifting rules resulting from the myriad phase-ins, delayed effective dates, phase-outs, and sunsets in [*PG1059]all of the recent tax legislation. One might try to describe who wins big, who wins moderately, who wins nothing, and who loses on a year-by-year basis, but the cumulative big picture effect is really all that is worth considering. Otherwise, the forest will be lost for the trees.

Initially, if either the percentage of the reduction in aggregate income taxes or the percentage change in after-tax income is the yardstick, the benefits of the 2001 Act, measured by the impact in 2002, seemingly are distributed primarily to the middle classes.

Measured by reduction in aggregate income taxes, the fourth quintile came out on top, followed by the middle quintile, but then various cohorts within the top quintile, excepting the 91st through 95th percentiles, fared better than the second quintile. (The first quintile paid so little in income taxes before the changes that it could not receive anywhere near a matching cut in income taxes.) Measured by increases in after-tax income, the second quintile came out ahead of all others, followed closely by the third and fourth quintiles. It looks like tax relief for the middle classes, but it is not, for several reasons.

First, it is important to note that the top 1%, which received 11% of the tax cut, measured in dollars, received an extraordinarily disproportionate tax cut. That group received a larger tax cut than the 4% immediately below it, the 5% immediately below the top 5%, and two-thirds of the amount received by the bottom of the top quintile, [*PG1060]the 81st through 90th percentiles. From a slightly different perspective, those households with an AGI of more than $1 million dollars— the less than two-tenths of 1% of households at the very top of the income pyramid—received 5.9% of the tax relief.

More importantly, these data present a deceptive picture for two reasons. First, they do not fully take into account the varying effective dates, and second, they do not take into account the impact of the estate tax repeal. Projections of the distribution of income tax changes for 2010 reveal a much different pattern.

By 2010 the clear winner has emerged, and it is the top 1% by such a wide margin that it is hardly worth discussing the differences between the other income cohorts,271 or how far below the top 1% they are as a relative matter in the congressional largesse sweepstakes. The top 1%, a group that collectively realizes just under 20% of the total income, walked away with 34% of the income tax relief in the 2001 Act, at least [*PG1061]as measured by the year 2010, which is far more representative than the year 2002.272

The 2001 Act provided such a number of interrelated changes that, short of a computer simulation, it is difficult to describe how specific provisions deliver or fail to deliver benefits to the various income classes. The new 10% bracket helped all taxpayers who previously had a positive tax liability after credits, but did nothing for the tens of millions of filers with no liability; the increased child credit helped middle-income taxpayers with children—the more children, the more help (unless the AMT clawed back the benefits of the regular tax rate reductions). The increase in the ceiling on the 15% bracket helped primarily upper-middle class taxpayers, but the other rate cuts disproportionately helped taxpayers toward the top of the income pyramid—the closer to the top, the more the help. But the income tax changes are far from the entire story of the 2001 Act.

When the effect of the repeal of the estate tax, which all of the proponents of its demise expect to be permanent, not temporary, is factored in, the congressional solicitude for the super-rich is even more striking.

Taking into account the estate tax repeal, the top 1%—roughly 1.1 million households in the United States—walked away from the 2001 Act with 42% of the goodies.274 And this is without the benefit of the further tax cuts inuring disproportionately to the super-rich in the 2003 Act.

The major changes in the 2003 Act that further skew the benefit of the recent tax cuts in favor of the super-rich are the reduction of the tax rates on capital gains and dividends. Capital gains and dividends are a much larger share of the income of people who have high incomes than of people whose incomes are lower.275 The Tax Policy [*PG1063]Center’s distribution tables for the 2003 Act, comparable to those it prepared for the 2001 Act, demonstrate that the top 1% continues to claim the lion’s share of the tax cuts. For 2005, 64% of the benefits of the 2003 Act will go to the top 1% of taxpayers. That group will see a 3.0% increase in its after-tax income solely as a result of tax cuts. The bottom 90% of taxpayers will receive only 16.9% of the tax cut and the bottom 80% only 7.6% of the tax cut.

More importantly, the effect on after-tax income, which is the best measure of distributional neutrality of a tax cut,276 was skewed to favor the very top of the income pyramid. The top 1% will see a 3% increase in after-tax income as a result of the tax cut, whereas no other income cohort will see more than a 0.6% increase in after-tax income, and no income cohort outside the top 10% will see more than a 0.3% increase in after-tax income.

The Tax Policy Center analysis further shows that an astounding 17.3% of the tax relief in the 2003 Act went to approximately 184,000 taxpayers with AGI of more than $1 million—less than 0.1% of all taxpayers. Another 6.3% went to 359,000 taxpayers with AGI of between $500,000 and $1 million. These data clearly demonstrate that the 2003 Act was highly skewed in favor of the super-rich. Given that the legislation was passed against the backdrop of massive federal [*PG1064]deficits and was projected significantly to increase those deficits,278 this is truly welfare for the wealthy.

Rudolph Penner has summarized the combined effects of the 2001 through 2003 tax cuts as follows:

For the bottom 40 percent of the distribution, the individual income tax has become negative on average; that is, refundable tax credits exceed the liability stemming from positive tax rates. The effects of 2001–03 legislation were minor for this group as a whole. For the next 59 percent of the distribution, it is difficult to discern a pattern. Increases in after-tax income resulting from the cuts are similar in various percentiles, ranging from 2.3 to 3.6 percent for the classifications shown in the table. The proportionate cut in tax rates is, however, considerably larger at the bottom than at the top of this 59 percent.

The top 1 percent appears to reap a bonanza. Their after-tax income rises 6.0 percent and the fall in the income tax rate is larger than for any other group in the top quintile. The large tax cut at the top is a result of two factors. The first is ironic. The alternative minimum tax (AMT), originally designed to limit how much the rich could lower their tax bill with various deductions and exclusions, has become largely irrelevant for the ultra-rich because the top income tax rate exceeds the AMT rate. Consequently, those at the very top of the income distribution enjoy the full benefit of the 2001–03 tax cut, whereas most of those [*PG1065]somewhat farther down the distribution have a portion of their benefits taken away by the AMT.279

This lopsided distribution of tax cut benefits is easily understood if one examines the distribution of ownership of capital assets and corporate stock, both of which are highly concentrated. Although it might be true that ownership of capital and capital income is not as highly concentrated as it was in the later part of the nineteenth century and the first few decades of the twentieth century,280 capital wealth in general remains highly concentrated.

In 1998 the richest 1% of households held half of all outstanding stock, financial securities, and trust equity, two-thirds of business equity, and 36% of investment real estate. The top 10% of families as a group accounted for about 90% of stock shares, bonds, trusts, and business equity, and about three-quarters of non-home real estate. Moreover, despite the fact that 48% of households owned stock shares either directly or indirectly through mutual funds, trusts, or various pension accounts, the richest 10% of households accounted for 79% of the total value of these stocks, only slightly less than its 85% share of directly owned stocks and mutual funds.281

Personal ownership of corporate stock—the source of dividends—is highly concentrated. The top 1% holds as much as 53% of household stock holdings.282 The top 2% receive approximately 40% of all taxable dividends.283 Furthermore, over one-half of all realized capital gains are realized with respect to stock.284 With this kind of concentration of wealth, particularly corporate stock, is it any wonder that a tax cut targeted at dividends and capital gains is extraordinarily lopsided in favor of the wealthy? It could not be otherwise.

[*PG1066] Most capital gains are reported by wealthy investors who hold many assets and sell assets frequently.285 The data indicate that a high percentage of taxpayers who realize capital gains do so regularly.286 In 2000, capital gains were 71% of the income of the 400 highest-income taxpayers. For 2000, capital gains were 27% of income for those with AGI above $200,000 (the highest cohort broken out by the IRS), but in 2001, due to a depressed stock market, capital gains fell to 21% of the group’s income.287 The most recent study of long-term averages (covering the period from 1979 through 1988) shows that the top 1% realized 57% of capital gains and the top 3% realized 73% of capital gains; from that data it can be estimated that the top 2% realized about two-thirds of all capital gains.288 In 1999, however, the top 2% realized 73% of all capital gains and the top 7.5% realized 85% of all capital gains.289 For that year, taxpayers with AGIs of $1 million or more realized 47% of all long-term capital gains, and taxpayers with AGIs of $500,000 or more realized 56% of all capital gains.290

[*PG1067] The case of the Fortunate 400 is striking. In 2000, the Fortunate 400 had 8.13% of total net capital gains. Even before the Bush tax cuts, when dividends were taxed at ordinary income tax rates and capital gains were taxed at 20%, the average income tax rate of the Fortunate 400—a group that in 2000 could be joined only by those that had greater than $87 million of AGI—was 22.3%.291 That was lower than the rate on those with only $1 million of income, whose peak average income tax rate was 29.4%.292 Because membership in the Fortunate 400 depends largely on capital gains realizations, the regressive rate structure is a product of the lower rate on capital gains.

To be sure, there is some argument that the extraordinarily high incomes of the Fortunate 400 reflect the lumpiness of capital gains realizations, but that does not substantially affect the regressive rate issue. If long-term capital gains were taxed at the same rate as ordinary income, but were allowed forty-year income averaging, over $50 million of the capital gains of the lowest-income member of the Fortunate 400 would nevertheless have been taxed at the highest marginal rate (assuming current rate schedules were applied to all years). This is a good illustration of the effect of the rate preference because the realization requirement largely cancels out the failure to index basis for inflation over such a period.293

Even a 22.3% tax rate on the Fortunate 400 might overstate the actual tax rate. Assume that the Fortunate 400 and the Forbes 400 (the wealthiest individuals) were congruent—a counter-factual assumption. Taking into account the change in wealth of the Forbes 400, their effective tax rate on economic income, which includes unrealized appreciation, was only 9%.294 As a result of the 2003 Act, the Fortunate 400 will do even better, because the capital gains tax rate has been reduced by 25%, from 20% to 15%. If an effective income tax rate of 9% is reduced by 25%, the resulting 6.5% income tax rate, plus the effective corporate tax burden allocable to the group probably is roughly comparable to the overall effective tax rate on the second income quintile.

[*PG1068] When all is said and done, the combined effects of the tax cuts enacted in the 2001 through 2003 period are startling, even without considering the effects of the estate tax reduction and repeal. In 2003, before the full effects of the tax cuts targeted to the super-rich were fully effective, the after-tax income of households with incomes that exceed $1 million was increased by nearly $112,925 per household—a 5.4% average increase in after-tax income. For the top 1% of households, the average after-tax income increase was $26,335 per household, or 4.6%. After-tax income of households in the middle quintile increased by $676, or 2.6%. Thus, in percentage terms, the income tax cuts alone increased the after-tax incomes of income millionaires by twice as much as they increased the after-tax incomes of those in the middle of the income scale, and by twenty–seven times the increase for those at the bottom fifth of the income pyramid. The dollar values of the skewed benefits are far greater.295

The President’s 2005 Fiscal Year Budget proposes that the various sunsets on the tax cuts enacted in 2001 through 2003 be removed and that the tax cuts be made permanent.296 This proposal, if adopted will further increase the regressivity of the twenty-first century tax cuts. The Tax Policy Center has preliminarily described the effect of making the tax cuts permanent as follows:

The expiring tax cuts are regressive—they provide a larger percentage cut in after-tax income for high-income households than for low-income households. If the tax cuts were made permanent, filers with income above $1 million would see a 5.7 percent increase in their after-tax income, whereas filers with income below $50,000 would see just a 2.2 percent average increase in their after-tax income. (These figures do not include the estate tax repeal, which is also quite regressive.)

The percentage changes in after-tax income are the most theoretically preferred method of examining the progressivity of tax changes, but attention also naturally focuses on other measures. For example, the top 1 percent would receive 27 percent of the tax cuts provided by making the expiring provisions permanent, even though that group pays only 21 percent of federal taxes. As a second example, taxpayers with income above $1 million would receive average [*PG1069]annual tax cuts of $107,000 (again, this does not include the estate tax). This is higher than the income of about 86 percent of tax filing units.297

A study published by the Center on Budget and Policy Priorities estimated that if making estate tax repeal permanent is factored in, when the tax cuts are fully phased in, the top 1% would see a 7.3% change in their after-tax income, while the middle income quintile would see only a 2.5% increase in after-tax income.298 Another study, by the Tax Policy Center estimated that if the tax cuts are made permanent, the top 1% would receive a 9.2% increase in after-tax income, the middle 60% of the income distribution would receive between a 2.0% and 2.7% increase in after-tax income, and the bottom quintile would receive an increase of only 0.1% of income.299 In calling for the tax cuts to be made permanent, however, President Bush did not mention how the benefits would be distributed. Instead, he referred to those small benefits that inured to lower income taxpayers.300

The President Bush’s 2005 Fiscal Year Budget provides further tax relief for the wealthy.301 Under the proposal, the three types of individual retirement accounts (“IRA”) under current law would be consolidated into a single “retirement savings account” (“RSA”). Individuals could contribute up to $5000 (or earnings, if less) to an RSA annually. As in the case of current Roth IRAs, and unlike regular IRAs, contributions would be nondeductible but earnings and retirement withdrawals would be tax-exempt. All income limits on eligibility would be removed. Thus, many individuals who cannot make contributions to Roth IRAs under current law, because they are covered by a qualified employer plan, could make contributions to an RSA. In addition, individuals could contribute up to $5000 annually, whether or not they had earn[*PG1070]ings, to a “lifetime savings account” (the “LSA”), regardless of wage income. LSAs are an entirely new tax-favored savings vehicle. As with RSAs, contributions would be nondeductible and earnings would accumulate tax-free, but in the case of LSAs, all distributions would be excluded from gross income, regardless of the individual’s age or use of the distribution. Again, there would be no income limits on eligibility to make LSA contributions.

Despite rhetoric to the contrary, these proposals are targeted at the rich. A family of four—spouses and two children—could put $20,000 per year in LSAs,302 and an additional $10,000 in RSAs (assuming only the spouses have wages), wholly apart from their participation in employer-provided retirement plans. The Treasury Department has estimated that this proposal would raise revenues by $21 billion for the five-year period 2005 to 2009, but only by approximately $5.6 billion for 2005 to 2014.303 These projections presumably are based on individuals shifting from making contributions to deductible tax-preferred savings plans—IRAs—under current law, which would no longer be available, to nondeductible LSAs and RSAs, and taxes imposed as individuals elected to roll over balances in old deductible-at-deposit/taxable-at-withdrawal accounts to the new accounts, which would trigger a current tax. Some analysts question whether the short-term revenue increases are realistic.304

More importantly, these proposals would effect a major change in the fundamental nature of our tax system. Over time, as the balances in these accounts increase, investment income from capital— interest, dividends, and capital gains—would be eliminated from the tax base for all but the very rich. According to a study by the Tax Policy Center, if everyone who is eligible takes advantage of LSAs, the revenue losses could be $100 to $200 billion over the first ten years and could continue to grow over time. Most of the benefits of the tax cuts represented by this revenue loss would go to high-income households.305 Participation in retirement accounts and the amount held in [*PG1071]retirement accounts increases significantly as income increases.306 Furthermore, these households can be expected to respond mostly by shifting existing assets into LSAs rather than by undertaking new saving.307 This has most likely been the experience with IRAs.308 Thus, the proposal is unlikely to have much of an effect on private savings.309 Even the CBO agrees with this assessment.310 Because, as will be discussed in Part VI, the savings rate does not respond positively to lower taxes on the yield to capital, it is merely a tax cut for those who are already savers. Indeed, the CBO estimates that the complete package of the President Bush’s 2005 Fiscal Year Budget proposals will reduce the effective tax rate on capital income to 13.3%, which would be an 8.7% reduction in the effective rate that otherwise would be in effect after 2010.311

D.  The End Game

The inevitable effect of the cumulative tax cuts in the 2001, 2002, and 2003 Acts, and those proposed for 2005, if enacted, will be to increase further the concentration of after-tax income and wealth at the top of the pyramid. The highest-income cohorts have benefited from [*PG1072]tax cuts that are greater than the average tax cut by any measure.312 Most importantly, the percentage by which after-tax income has increased as a result of the tax cuts is higher for the top 1% than for any other income cohort, and higher for income millionaires than for the remainder of the top 1%. Even if the tax cuts had increased the after-tax incomes of all income cohorts by an identical across-the-board percentage, income inequality would have increased.

Income inequality is further increased by the reduction in corporate income taxes. The burden of corporate income taxes is borne disproportionately by high-income individuals. There is a strong correlation between income and wealth, a strong correlation between wealth and income from capital, and the corporate tax is borne by all income from capital. The ownership of income producing capital is highly concentrated in the top 1% and in smaller even more elite cohorts within that small group. When corporate taxes are reduced, whether through direct congressional action, or through corporate self help—tax shelters, expatriation through corporate inversions, or even excessive tax-free perquisites for corporate executives (which nevertheless remain deductible to the corporation)313—the effective tax rate on the super-rich, as the owners of an extraordinarily disproportionate share of corporate stock, is reduced disproportionately to other taxpayers.

Income inequality will be further increased by the impact of increasing payroll taxes, the ceiling on the Social Security portion of which increases annually. The average payroll tax rate rises more rapidly for those taxpayers whose income is just above the ceiling for the previous year than it does for taxpayers whose income is relatively further above the previous ceiling because a greater portion of the previously untaxed wage income is now subject to tax. Furthermore, as total incomes move up the income pyramid, wages generally represent a smaller percentage of total income. Thus, identical increases in the absolute amount of payroll taxes represent a greater increase in [*PG1073]average tax rates for those with relatively less income. This change in average tax rates increases after-tax income inequality.

Decreased progressivity in the income tax will increase not only income inequality, but wealth inequality as well.314 “[P]rogressive taxation has cumulative dynamic effects because it reduces the net return on wealth, which generates tomorrow’s wealth.”315 It is obvious that the repeal of the estate tax will further increase wealth disparities. The core purpose of the estate tax is to break up great fortunes and to be antidynastic.316 But the repeal of the estate tax will even further increase income inequality. Without an estate tax, the heirs to great fortunes will have an even greater amount of capital on which they will earn before-tax income than they would have had if there had been an estate tax. This increased before-tax income will per force increase after-tax income, which in turn will further increase wealth inequality, and the cycle will continue like the magic of compound interest.

It is unlikely that the end result is something that most Americans would support on either moral or economic grounds. The United States already has very high income inequality compared with other industrialized nations. By the mid-1980s the inequality was higher than in any major Western European industrialized democracy,317 and it continues to be so.318 According to the United Nations Human Development Report for 2003, greater economic inequality generally is found only in South America, a number of African countries, and a few Southeast Asian countries.319 The United States is moving backwards. “The decline in income tax progressivity since the 1970s and the . . . repeal of the estate tax might again produce in a few decades levels of wealth concentration similar to those at the beginning of the [twentieth] century.”320 The rich will get richer, and they will get richer relative to everyone else. And nothing assures that everyone else will be better off. Indeed, there is good reason to believe that everyone else might be worse off as a result.

[*PG1074]V.  The Economic Arguments

Traditional tax policy analysis focuses on (1) whether the tax system raises adequate revenue, (2) in an equitable manner, (3) without undue complexity, and (4) without undue interference with the economic system.321 Many economists focus on avoiding interference with the efficiency of the market economy.322 An efficient market economy, however, is not an end unto itself, but rather it is “merely a means to the encouragement of production and the generation of wealth.”323 “[T]he rationale behind a market-based system is that we achieve . . . profits and wages by making others better off. The exchanges are meant to make society richer as a whole.”324 In other words, distribution counts.325 To the extent that those lower on the income pyramid are not benefited as a result of increased economic efficiency resulting from disproportionate tax cuts for those at the top of the income pyramid, avoidance of interference with the market diminishes greatly in importance, and the other criteria become relatively more important. This is particularly true if the tax cuts result in diminished government spending on programs that benefit the population broadly. In that case, the tax cuts and spending cuts together represent a public policy decision to reduce the after-tax income of those lower on the income pyramid who received disproportionately small tax cuts and increase the after-tax income of those at the top of the income pyramid who received disproportionately large tax cuts.326

[*PG1075]A.  The Supply Side Justification

All of the tax cuts enacted in the first three years of the twenty-first century were justified by their proponents as promoting economic growth. There is no doubt that economic theory supports the idea that tax cuts that create or increase a government budget deficit, as these tax cuts (coupled with significant spending increases) did on a massive scale,327 can be expected to act as a short-term economic stimulus.328 That is classical Keynesian economics.329 But these tax cuts were skewed to the rich, not to the bottom and middle of the income pyramid. Nothing in Keynesian economics or classical macroeconomic theory requires that tax-cuts be provided to the rich to stimulate the economy. Indeed, if the problem is inadequate demand, tax cuts disproportionately benefiting low- and middle-income individuals, who are more likely to spend the increased after-tax income than to save it, are far more likely to provide the desired economic stimulus.330

The 2001 through 2003 tax cuts are unlikely to stimulate long-term growth for a number of reasons.331 To start with, the proposition that high levels of taxation generally impede economic growth is a theory that is not supported by empirical data. During the two decades between 1970 and 1990, some low tax countries, such as Japan, enjoyed substantial rates of economic growth, while others—the United States in particular—performed below average. Likewise, some high tax countries saw poor economic growth, while quite a few others performed above average.332 Even before the Bush tax cuts of 2001 through 2003, the United States had one of the lowest overall tax rates among all industrialized democracies—among Organisation for Economic Co-operation and Development (the “OECD”) countries in 2001, only Mexico, Japan, and Korea collected lower percentages of [*PG1076]GDP in taxes.333 By 2003, as a result of the 2001 through 2003 tax cuts, the tax rate on income and profits (as a percentage of GDP) for the United States fell from 15.1% to 10.9%,334 and the overall tax rate (tax-to-GDP ratio) of the United States fell from 29.9% to 25.4%.335 Among all OECD countries, only Mexico had a lower overall tax rate than the United States in 2003,336 although several countries that rely heavily on value-added taxes and/or wage taxes had slightly lower tax rates on income and profits, even though they generally had significantly higher overall tax rates.337

The particular nature of the 2001 and 2003 tax cuts makes them look like the “trickle-down,” “supply-side” tax cuts enacted in 1981,338 based in part on the infamous, and now discredited, “Laffer Curve.”339 Trickle-down, supply-side tax cuts are tax cuts skewed to high-income and wealthy taxpayers intended to increase incentives to invest and work, thereby creating jobs for the poor and middle class who did not directly benefit from the largess the government bestowed on the [*PG1077]rich. There are still economists who support the trickle-down theory,340 and some observe that the distribution tables for the 2001 through 2003 tax cuts do not take into account the trickle-down effects.341 Nevertheless, the trickle-down theory does not command mainstream support among economists.342 In order to have any possibility of encouraging long-term economic growth, supply-side tax cuts must be matched by spending cuts,343 or provide significant incentives to increase savings and labor.344

B.  The Fallacy of the Justification

1.  The Equity/Efficiency Trade-Off Is a False Choice

Historically, economists generally have concluded that graduated progressive taxation impedes economic efficiency, even if graduated progressive tax rates might be more desirable on equity grounds.345 More broadly, the trade-off is described as one between “productive efficiency (and/or growth) and social justice.”346 With equity and efficiency viewed as mutually exclusive objectives between which policy makers must choose, the issue is thus framed as involving a trade-off of efficiency for equity.347 Debates over progressive taxation have [*PG1078]divided scholars into those who champion efficiency over equity and those who favor equity over efficiency.348

More recently, however, many economists are concluding that the trade-off is not as significant as it was once thought to be. Based on the experiences with numerous changes in the progressivity of rates in the 1980s and 1990s, Joel Slemrod concludes as follows:

[T]here is a clear hierarchy of categories of behavioral responses. At the top, the most responsive, is the timing of taxable activity. In the second tier, often quite responsive but not as much so as timing, are responses sometimes called avoidance—including income shifting, financial restructuring, change in the form of legal entity, “renaming” what you’re already doing to obtain a more favorable tax treatment—as well as flat out evasion. At the bottom of the hierarchy, the least responsive in general, is the responsiveness of critical real economic variables such as labor supply, saving, and investment. There is no convincing evidence that either aggregate labor supply or saving responds in a significant way to taxes, and the evidence regarding business investment is mixed.349

Other recent studies concur that changes in reported income in response to changing tax rates appear more to be the result of temporary timing changes rather than permanent behavioral responses.350

[*PG1079] Timing and evasion problems cannot be dismissed as unimportant behavioral responses,351 but there are other ways to deal with evasion—tightening up the substantive rules governing the base and better enforcement352—and timing is more of a problem because of constantly shifting rules and rates than it would be if the rate structure were more stable.353 For example, the data do not support the argument that capital gains realizations are responsive to tax rates in the long run; there are, however, short-run spikes from lowering rates due to opportunistic behavior.354 Because a mere shift in the timing of an economic activity may have no long-run effect on the economy,355 these other inefficiencies can be dealt with in other ways, and the problem of “real” inefficiencies is not really serious; equity can be achieved without the big trade-off.

Optimal tax theory can reinforce the conclusion that there might not be too great a trade-off between equity and efficiency.356 Under [*PG1080]optimal tax theory, the best (“optimal”) tax is one imposed on activities with relatively low elasticities. Thus, imposition of the tax will not decrease productivity; indeed, it might have the opposite effect. If individual work effort and savings are not responsive to the rate of tax, optimal tax theory suggests that imposing higher rates of taxation on the rich can improve equity while not decreasing productivity.357 Thus, if labor and savings are relatively inelastic in response to changes in the tax rates, the classically described equity/efficiency trade-off is not a problem in practice apart from evasion and timing issues, both of which can be addressed through solutions that do not involve the rate structure.

2.  Labor and Savings Are Not Highly Responsive to Tax Rates

The theory that apparently underlies the distribution of the Bush tax cuts is that lower taxes on the rich will lead them to save more and to work harder. Some economists support this idea.358 Most who have studied the question find nothing to support the notion.359 The crucial question is whether the income effect or the substitution effect predominates.360 Substitution and income effects offset to some degree.361 Economists do not all agree on whether the substitution or the income effect predominates.362 If the income effect predominates, reducing taxes actually could cause the labor supply and savings rate to decrease rather than to increase. Furthermore, if high incomes are the result of superior endowment and luck rather than greater work [*PG1081]effort and skill, “optimal marginal tax rates in all likelihood should be high because high realized income” is random and the disincentive effects should be minimal.363

a.  Labor Supply

Economists who conclude that the level of tax rates affects the labor supply reach this conclusion from models based on the idea that the substitution effect—substituting leisure for labor when the yield to labor decreases in an effort to maintain income levels when wages fall—predominates over the income effect.364 Nevertheless, economic theory alone cannot predict which effect will predominate.365 The models that predict that work effort will increase if tax rates are decreased are based on assumptions regarding responsiveness of the labor supply to wages. In contrast, empirical studies indicate that the labor supplied by primary wage earners does not respond significantly to after-tax pay changes.366 Secondary wage earners, however, do appear to be responsive to changes in after-tax pay.367 Recent work suggests that male labor supply is not very responsive to wage rates except at the lower wage levels, and may be negative; female responsiveness might not be as great as previously estimated, and for females consistently in the work force, it may resemble [*PG1082]that of males.368 The only group for which wage income has increased significantly as tax rates have been cut in the past twenty years is the top 1%.369 But that is not likely attributable to tax cuts, because wage income did not respond to the dramatic Kennedy tax cuts in the 1960s.370 The surge in wage income of the top 1% in recent years is merely the reflection of a long trend of rapidly increasing incomes for this group starting in the mid-1970s, coupled with a shift of income from the corporate to the individual sector—effected through the increasing use of partnerships rather than corporations to conduct business—since the mid-1980s.371 Although the top 0.10% has seen the most dramatic increase in incomes and “non-trivial” rate reductions, there is no clear evidence of a causal relationship.372

Historically, over the long-term in the United States, increasing real wages have led to shorter work weeks, longer vacations, and earlier retirement.373 This is evidence that the income effect predominates over the substitution effect.374 Furthermore, there is nothing to [*PG1083]indicate that high-income earners behave any differently than anyone else, unless perhaps their labor supply is more inelastic than that of low-income workers because of the nature of their jobs and the reasons that they work.375 Although some studies conclude that the taxable income of very top wage earners—the top 1%—shows some responsiveness to tax rates, their economic income is not nearly as responsive.376 There is evidence that elasticity of labor supply systematically decreases as income increases.377 In short, the empirical evidence indicates that those who predict that lower tax rates will increase work effort have made erroneous assumptions about human behavior.378 In many cases, at-the-margin work effort of the highest-income earners probably is motivated more by nonmonetary factors such as interest and prestige.379 It is doubtful that increased taxes would cause corporate executives, financiers, and Wall Street lawyers to reduce their work efforts to the extent that the economy noticeably will be harmed.380 On balance, the most reasonable conclusion is that although there are theories that predict that the labor supply in general varies inversely to tax rates, these theories are unproven and, in all likelihood, erroneous.

[*PG1084]b.  Savings

Economists traditionally have thought that it is inefficient to tax capital income, because doing so retards growth by decreasing savings, the source of investment.381 Applied to income from capital, the substitution effect predicts that, if the yield to capital increases, saving becomes more attractive relative to present consumption. Under the income effect, however, if the yield to savings increases, a target saver can reduce savings and still have the same accumulated fund in a future year. Which of these two effects predominates depends on the motivation for saving.382 Different economists, employing different models, reach different results. Some economists conclude that personal savings responds significantly to the interest rate.383 Many other economists conclude that there is little if any response; it is “small and hard to find.”384 Many econometric models predict that reducing taxes on income from capital at best would lead to only modest increases in the savings rate.385 The reality is that the motivations for saving and the decision of whether to save or consume are so complex that economic theory cannot deal with them very well.386

[*PG1085] Furthermore, there are developing theories supporting the notion that taxing capital income more lightly than labor income—as is currently the case in the United States—is less than optimal and can retard economic growth. Recent work by Emmanuel Saez concludes that steeply progressive capital income taxation does not introduce inefficiencies and produces desirable results.387 Other recent theoretical work indicates that taxing capital income fosters growth:

A government . . . is faced with tradeoffs: lower capital income taxation means either lower government expenditures or higher debt financing or higher labor income taxes. Keep the level of government expenditure and debt financing fixed for the sake of the argument. If we think of labor income being paid mostly to the young and capital income accruing mostly to the old, a lower capital income tax and thus a higher labor income tax means that the younger people in an economy are left with less income out of which to save and to buy the capital stock. If savings decisions are not too elastic with respect to long term interest rates, this will lead to lower savings and thereby to slower growth rather than faster growth.388

Yet other recent work in economics indicates that high personal tax rates do not discourage entrepreneurial activity:389

[L]ow tax rates alone are not plausibly the main factor affecting the amount of entrepreneurial activity . . . . The fact that countries and time periods with high growth rates often had quite high tax rates also suggests the importance of other factors. . . .
. . .
In the United States, for example, the 1950s and 1960s were a period of particularly high growth rates, yet top per[*PG1086]sonal tax rates during this period were as high as 87 percent.390

Thus, the old-time conventional economic theory, that taxes stifle productivity, no longer can be viewed as clear and certain.391 It is beginning to look more and more like that theory has it backwards.

Empirical evidence indicates that an increased yield to capital might actually decrease household savings.392 Over the long term, the United States personal savings rate has varied inversely with the yield to capital.393 Our most recent experience with attempts to increase the savings rate by reducing tax rates indicates that the effort is counterproductive. During the 1980s, when real interest rates increased and marginal tax rates, particularly the rates on the income from capital, decreased, producing a significant increase in after-tax yield, the savings rate fell.394 The private savings rate has been plunging since the mid-1980s.395 There is no good reason to expect the Bush tax cuts to increase national savings. Although the complete analysis is quite technical, recent analysis of the 2001 cuts by Alan Auerbach indicates that they actually would decrease national savings.396 Even the [*PG1087]CBO has concluded that the tax cuts “will probably have a net negative effect on saving, investment, and capital accumulation over the next 10 years,”397 and the Staff of the Joint Committee on Taxation concurs with this conclusion.398 Thus, the tax cuts could actually have the opposite of the effect that their supporters predict.399 According to two Federal Reserve Board economists, “a sustained cut in personal income taxes raises GDP by less than the amount of the tax cut itself, and it likely reduces GDP if phased in gradually over time.”400

Furthermore, even if taxation does influence savings behavior, increased savings might not increase the GDP and benefit Americans generally. The United States GDP would increase only if the savings were invested domestically, and there is no certainty that this would occur. Financial markets are international.401 Much of the investment in the United States comes from foreign capital,402 and domestic savings may lead to foreign investment.403 If increased domestic savings lead to foreign rather than domestic investment, the wealth of the savers would increase, but domestic labor productivity would not necessarily increase.404 Thus, the benefits of increased wealth would not be spread among the entire populace, but would inure only to savers, the owners of capital. In this case, all of the economic benefits realized as a result of the tax cut would inure only to those who received the tax cut, while no one else shared in the economic dividend. The [*PG1088]Matthew Effect operates, the rich get richer, and inequality increases, unless trickle-down works, which it does not.

c.  Targeted Capital Income Tax Cuts

Even if savings were responsive to capital income tax rates, targeted tax cuts focusing on capital gains and corporate dividends are not likely to be the type of tax cuts that would produce the most response. Even those who conclude that lower taxes on capital stimulate economic growth on efficiency grounds,405 acknowledge that the potential for growth from lower taxes on capital gains is smaller than a general cut in taxes on capital.406 Over one-half of capital gains are realized with respect to stock,407 and as far as corporate stock is concerned, lock-in is not a major economic problem because of the large percentage of stock owned by tax exempts.408 Likewise, tax relief does not have as much of an impact as it might in theory because most corporate dividends are not, in fact, taxed twice. Only 40% of dividends paid by corporations are reported on personal income tax returns, primarily due to ownership of dividend-paying stock by pension funds and tax exempts.409

d.  Summary

In the end, the arguments that the tax cuts were necessary to assure economic growth fail for lack of proof. The theoretical basis for the position is weak because it accounts for only some of the complex effects of taxation. A number of more complete recent studies have concluded that making the 2001 and 2003 tax cuts permanent would actually impede long-term economic growth rather than encourage it.410 Furthermore, the empirical evidence is clearly to the contrary. A more accurate picture of the true relationship of taxes to economic [*PG1089]growth has been painted by Henry J. Aaron, William G. Gale, and Peter R. Orszag:

Historical evidence shows no clear correlation between tax rates and economic growth. The United States has enjoyed rapid growth both when taxes were low and when taxes were high. The strongest recent extended period of growth in U.S. history spanned the two decades from the late 1940s to the late 1960s, when the top marginal personal income tax rates were 70% or higher. Economic growth accelerated after the top marginal tax rate was increased from 31% to 39.6% in 1993. Comparisons across countries confirm that rapid growth has been a feature of both high- and low-tax nations. These considerations suggest that well-designed revenue increases need not inflict significant damage and may even strengthen economic performance.411

Thus, in setting levels of taxation—at least within levels that have been known historically—fairness should be of far more concern than economic stimulus. Before getting to the question of what level of taxation is “fair,” however, we should inquire whether inequality affects economic growth.

3.  Inequality Impedes Economic Growth

Historically, economists took the view that wealth inequality enhanced growth.412 The traditional view that inequality led to increased growth was based on the following three arguments: (1) the rich have a higher marginal propensity to save than the poor, (2) wealth must be concentrated in order to cover the large sunk costs of starting new enterprises, and (3) the poor would be motivated to work harder to become wealthy.413 This relationship between inequality and growth was synthesized into the Kuznets hypothesis by economist Simon Kuznets.414 According to the Kuznets hypothesis, income inequality starts low in a rudimentary economy, increases with development, and then diminishes in a fully industrialized economy. This pattern fairly could be said to be consistent with the United States experience, as [*PG1090]well as the experience in most OECD countries, from the late eighteenth century until about 1970.415 Since 1970, however, inequality has been increasing in the United States, as well as in many other OECD countries.416 This empirical contradiction of the Kuznets hypothesis has led to a reexamination by economists of the relationship between inequality and economic growth.

Recently, an imposing body of literature from economists around the world “unambiguous[ly]” supports the proposition that high concentrations of wealth and income reduce the rate of economic growth.417 Over long periods of time, a relatively more equal distribution of pre-tax income increases economic growth; inequality has a negative impact on economic growth.418 These studies cover a large number of countries and focus on time periods of between ten and twenty-five years. The results are consistent.

Some early studies on the negative impact of inequality followed the theory that there is a trade-off between equity and efficiency. The studies found the negative correlation only in democracies, not in dictatorships, and concluded that growth during any particular period was inhibited because inequality led to a political decision to redistribute income, and that the result of the redistribution to achieve greater equality was to inhibit growth.419

Other studies that more fully integrate taxes into their model, however, contradict those conclusions and find that redistributive taxes that are intended to ameliorate inequality do not inhibit economic growth.420 Equality affects growth by promoting investment, [*PG1091]whereas inequality discourages investment.421 This is particularly true when capital markets are imperfect.422 No one who has followed the Wall Street Journal, the financial pages of any major newspaper, or even watched nightly television news accounts can doubt that capital markets are far, far from perfect.423 Redistribution from the rich to the poor thus encourages economic growth. Yet other studies conclude that even if redistribution, effected by increasing the tax burden on capitalists and investors, does reduce the propensity to invest, the reduction in social tensions and consequential increased political stability in a more egalitarian society improve the socio-political climate for investment and productivity and foster growth.424

Inequality also reduces educational opportunities for those at the bottom of the income pyramid.425 Returns to education for those lower on the income pyramid should be expected to compare to those higher up. Thus, general welfare could be increased by devoting more public resources to education. Public investment in education has been demonstrated to be an important source of improving productivity.426 Public education could be funded by placing higher taxes on those at the top of the income pyramid and by rejecting proposals that would exacerbate income disparities, such as lower taxes on capital gains and dividends. If higher revenues derived from redistributional taxes were devoted to improving public education, productivity and growth would increase.427

4.  The Rising Tide Fallacy

The argument for supply-side tax cuts rests on two propositions. The first proposition is that the tax cuts will promote economic growth. This economic growth is measured by two related indices: [*PG1092](1) gross domestic product, and (2) per capita income. The second proposition is that the bountiful growth the advocates of supply-side tax policy envision will be shared by all. Their belief is that “a rising tide lifts all boats,” which is a phrase borrowed from a speech by President John F. Kennedy over forty years ago.428 As we have seen, the first proposition is highly doubtful and, in any event, is a false shibboleth, while the second proposition is clearly wrong.

The theory that the tax system should promote growth, that is, improve Kaldor-Hicks efficiency,429 as measured by the GDP,430 rests on the judgment that aggregate wealth maximization is a desirable public policy.431 Economic growth as a goal for its own sake is based on modern welfare economics, which focuses largely on aggregate wealth maximization, which treats all dollars as having equal utility,432 regardless of who receives those dollars.433 The problem with this judgment is that an efficient market, evidenced by a large GDP, can result in extreme poverty for many and extraordinary wealth for a few.434 Furthermore, a move, such as a change in the tax laws, is Kaldor-Hicks efficient anytime the winners gain more than the losers lose.435 Thus, from this [*PG1093]perspective, increased efficiency, meaning economic growth, is viewed as a positive even if it results in redistribution from the poor to the rich, as long as the rich also get something more to boot.

The effect on per capita income is likewise a poor measure by which to compare alternatives. Focusing on per capita income is closely related to focusing on growth of Kaldor-Hicks efficiency, and both are errors. Per capita income is simply the average income of everyone. If the income of the richest person in the country increases and everyone else’s income falls, as long as the income of the rich person increased by more than everyone else’s income fell, per capita income would increase. It is difficult to envisage an open democratic government making a transparent policy decision that would have such an effect. Thus, it is clear that the maximization of either GDP or per capita income alone is not an adequate basis for determining the structure of the tax system, even if our only concern is the economic welfare of the citizenry. Again, distribution counts.436

That brings us to the rising tide. Does economic growth automatically result in increased income for all? Barely! Most estimates of the distribution of growth of per capita income in the last part of the twentieth century conclude that the poor saw some small increase in their incomes alongside the soaring incomes of the rich. The extraordinary surge in salaries of the top 1% “since the early 1970s has been accompanied with a dismal growth for the bottom 99% [of] salary earners, and thus does not seem to have had a positive impact on the vast majority of working families.”437 According to another study,

[t]he top 20% of families amassed 62% of total income growth between 1973 and 2000—with more than half going to the top 5 percent—while the bottom 20% accrued only 2% of total income growth; the second lowest quintile accrued only 5%. The pie grew larger, but hardly any of the increase went to those at the bottom.438

Within more discreet, but yet lengthy periods, we find examples of significant increases in GDP and per capita income that are accompanied by decreasing real incomes for large segments of the [*PG1094]population. For example, according to analysis of CBO data by Paul Krugman, from 1977 through 1989, the bottom 40% of the income distribution experienced decreasing real incomes, while everyone else below the top 1% saw modest increases in real incomes and the top 1% more than doubled its real income.439 Professor Krugman estimates that 70% of the aggregate increase in average family income in this period accrued to the top 1% of families.440

Other recent work finds even more dramatic evidence that the economy is tilting in the reverse Robin Hood direction even as GDP and per capita income rise. Thomas Petska and Michael Strudler have found that constant dollar incomes for the bottom 60% of the income distribution fell rather steadily from 1979 through 1995, a long period of growth dotted with a few recessions, before beginning to rebound in the late 1990s, but by 2000 constant dollars income had not yet reached 1979 levels.441 Yet another analysis, by Alan B. Krueger, paints an even worse picture, interpreting data for the period from 1973 to 1998 to indicate that although the overall average income grew, the average fell for everyone below the top 1%.442 That estimate might be overly pessimistic, but the data from the CBO and Census Bureau both indicate that those in the lower half of the income spectrum experienced extraordinarily small increases in real income in a number of different time periods in which average household income grew substantially.443 For example, the CBO data show that from 1982 to 1986, a period during which average household pre-tax income (in constant dollars) increased by $4100 (a 16.07% increase), the average [*PG1095]household income of the bottom quintile increased by a mere $100 (a 0.8% increase), while the average household income of the second quintile increased by $700 (a 5.05% increase). Likewise, from 1991 to 2000, a period during which average household pre-tax income (in constant dollars) increased by $16,800 (a 29.32% increase), the average household income of the bottom quintile increased by only $1100 (a 8.15% increase), while the average household income of the second quintile increased by $3900 (a 13.27% increase).444 Furthermore, from 1999 to 2000, when average household income increased by $1100, average household income for the bottom three quintiles actually decreased. Consistently, the historical data from the 1980s and early 1990s reveal that poverty rates were unresponsive to economic expansion.445 More recently, as the economy, measured by GDP, expanded in 2002, the poverty rate rose.446

The Census Bureau data for recent years are even more striking.447 They show that mean household income (in constant dollars) for the first four quintiles declined fairly steadily from 1999 to 2001, while household income for the top quintile increased. Within that quintile, gains were concentrated at the top. While the mean income of the top quintile increased by 1.49%, the mean income of the top 5% (the smallest cohort measured by the Census Bureau) increased by 4.17%. Furthermore, the Census Bureau data understate the differences, because they do not include capital gains, which are highly concentrated in the top 5%, in its measure of income.

Although the details of the interpretation of the data may differ slightly, the big picture is unambiguous. The tide rises quite differently for the rich and the poor. Trickle-down might work to some extent, and the tide might rise a bit for everyone. But for those at the bottom, the flow of the tide is barely perceptible, and the tide is often ebbing for them while it flows for the rich. Those at the bottom are being trickled on,448 and the trickle is not really lifting their boats.

[*PG1096]C.  The Budget Deficit Problem

Notwithstanding that the 2001 through 2003 tax cuts have contributed significantly to massive federal deficits,449 their proponents claim that the tax cuts, and the resulting deficits will so stimulate the economy that the nation will “grow out of the deficit.”450 That is highly unlikely.451 Tax cuts increase output only if they increase personal saving by more than the revenue lost and the accumulating interest on national debt created by the tax cuts.452 The CBO has acknowledged the problem with respect to the Bush tax cuts:

The revenue measures enacted since 2001 will boost labor supply by between 0.4 percent and 0.6 percent from 2004 to 2008 and up to 0.2 percent in 2009 to 2013 . . . .

[*PG1097] But the tax legislation will probably have a negative effect on saving, investment, and capital accumulation over the next 10 years. . . .

The tax laws’ net effect on potential output . . . will probably be negative in the second five years.453

Joel Slemrod has noted the following:

To the extent that the tax-cut-as-Trojan-Horse-for-spending cuts tactic is not successful, tax cuts result in bigger deficits. . . . . [I]f there is little change in the path of planned spending, a tax cut now must then imply tax increases later. This inescapable “pay-me-now-or-pay-me-later” logic undercuts one common argument for a tax cut: that it will increase incentives to work, save, invest, and innovate. This is just loose language unless other aspects of the fiscal policy are specified. If lower taxes now imply there will be higher taxes later, then any increase in incentives now will be offset, and probably outweighed, by an increase in disincentives later— when the tax increases materialize.454

More recent projections by the CBO indicate that the situation will be worsened if the tax cuts are made permanent as requested by President Bush:

[I]f all of the tax provisions that are set to expire over the next 10 years (except some related to the alternative minimum tax) were extended, the budget outlook for 2014 would change from a surplus of $13 billion to a deficit of $443 billion. Debt held by the public at the end of that year would climb to 48 percent of GDP, and the 10-year deficit would total $4.1 trillion.455

Even before the tax increases envisaged by Professor Slemrod come to pass, however, these budget deficits will present major problems to the economy. Over the long run they will result in diminished economic growth and a lower standard of living. One recent study by former Treasury Secretary Robert E. Rubin, Peter R. Orszag, and Allen Sinai concluded the following:

[*PG1098]In the absence of significant policy changes, federal government deficits are expected to total around $5 trillion over the next decade. Such deficits will cause U.S. government debt, relative to GDP, to rise significantly. Thereafter, as the baby boomers increasingly reach retirement age and claim Social Security and Medicare benefits, government deficits and debt are likely to grow even more sharply. The scale of the nation’s projected budgetary imbalances is now so large that the risk of severe adverse consequences must be taken very seriously, although it is impossible to predict when such consequences may occur.

. . . [S]ustained budget deficits demonstrate the negative effects of deficits on long-term economic growth. Under the conventional view, ongoing budget deficits decrease national saving, which reduces domestic investment and increases borrowing from abroad. . . . The reduction in domestic investment (which lowers productivity growth) and the increase in the current account deficit (which requires that more of the returns from the domestic capital stock accrue to foreigners) both reduce future national income, with the loss in income steadily growing over time.456

A recent Brookings Institution study concludes the following:

[A] conservative estimate is that a $5.3 trillion accumulation of additional debt over the next ten years [2004 through 2014] would reduce national income by $212 billion annually at the end of the period. This translates into about $1,800 less annual income for the average household than they otherwise would have earned.457

All of this may come to pass before the tax increases that Professor Slemrod foresees are enacted. Although sound economics might dictate that today’s tax cut is the precursor to tomorrow’s tax increase, in the world of politics, there is an asymmetry. Tax cuts are far easier to enact than tax increases.458 Thus, the untoward effects of the federal budget deficit likely will come home to roost long before any unto[*PG1099]ward effects of the future tax increases. As economist Martin Sullivan has observed:

[E]ven the most wonderful economic scenario is not rosy enough to eliminate deficits under current Republican policies. And don’t let Republicans tell you that tax cuts will trigger growth that will reduce the deficit. That might be true if Republicans paid for tax cuts the old fashioned way—by cutting spending. Like a good martini, deficit-financed tax cuts can be temporarily invigorating, but you are fooling yourself if that is your program for long term health.459

Of course, it is difficult, if not impossible, to predict precisely who among the American population will be the winners and who will be the losers when national income growth diminishes as a result of these deficits. But if past is prologue, the Matthew Effect will hold sway and the lower and middle classes will fare more than proportionally worse than those at the top of the income pyramid. Even as the personal income tax system became more progressive during the 1990s, there was little increase in the overall progressivity of the federal tax system, and after-tax income inequality increased at a rate only slightly below the rate at which before-tax income inequality increased. And if the deficit problem is addressed through spending cuts, the effects are bound to be anti-progressive. Spending tends to be more proportional than taxation, and thus tends to be more progressive.460 Tax cuts for the wealthy offset by spending cuts on programs that benefit the population as a whole reflect a clearly conscious Matthew Effect public policy decision.

VI.  The Philosophical Arguments

“Every tax system is an expression of a country’s basic values— and its politics.”461 The socially desirable distribution of after-tax incomes is not an economic issue, it is a philosophical issue to be resolved in the political arena.462 There are no principles of economic theory dictating the manner in which aggregate social product will or [*PG1100]should be distributed. How the social product, or any increase in the social product will be distributed among taxpayers before-tax is an empirical issue, not a theoretical question. If we are at all consequentialist, because either a Kaldor-Hicks efficient or Pareto optimal state can exist even though many people are in extreme poverty and a very few are extraordinarily wealthy,463 welfare economics really has very little to offer to use in the formulation of tax policy except to provide some baseline expectation regarding the pre-tax distribution of income as the background against which to construct a tax system that will produce the socially desired after-tax distribution of income.

Traditionally, progressive taxation has been justified either on the grounds of “ability to pay” or on the principle of the diminishing marginal utility of money. Those arguments have been thoroughly discussed elsewhere, so they will not be rehashed here.464 The evidence of the diminishing marginal utility of money is more than adequate to support a graduated progressive rate structure, and one that is quite steeply progressive at the very top end.465 The super-rich simply have so much money that their lifestyle is not currently,466 and has not in the past few decades been, affected by taxation in any manner with which we as a society ought to be concerned, and it would not be significantly affected even if their marginal tax rates were significantly increased.

[*PG1101] Here I will add the further argument that progressive taxation easily can be justified purely on redistributive grounds to mitigate economic inequality and to further social justice. These are the very grounds that led Walter J. Blum & Harry Kalven Jr. in The Uneasy Case for Progressive Taxation467 to be “uneasy” about progressive taxation.468 Unlike Professors Blum and Calvin, I believe that society as a whole rightly has the paramount say in the distribution of incomes and wealth.

A.  The Myth of Ownership

“Taxes are what we pay for a civilized society”469—government, courts, police, national defense, schools, roads, and the like. Much of the philosophical opposition to taxes, particularly graduated progressive taxes on the rich, is based on the neoconservative philosophy, epitomized by Robert Nozick,470 that individuals are morally entitled to keep the fruits of their labor and have a claim superior to the societal claim.471 This argument flows from the Lockean position that the rights of the individual precede those of the state.472 Similar arguments have been advanced by Milton Friedman473 and Richard Epstein,474 among others, to support flat-rate taxation rather than graduated progressive taxation.475 These arguments have been thoroughly discussed elsewhere, and I will not review the details. They all are essentially grounded on a libertarian philosophy.476 That libertarian claim is simply not supportable.

In a modern industrialized society everyone benefits from governmental infrastructure. Incomes are not earned solely by one’s own efforts.477 In addition to the head start most of the wealthy receive by [*PG1102]being born into affluence,478 which alone destroys the baseline for Professor Nozick’s proceduralist argument that everyone starts out equally,479 everyone’s pre-tax income is earned in an infrastructure created by government.480 Often the benefits conferred on the wealthy by government go beyond mere infrastructure and are subsidies that are in essence the seed money or even the life-blood of their enterprises. Patents, which are very important in building great wealth, often represent the privatization of public resources—ideas that were based largely on publicly funded research.481 Another public resource, the telecommunications broadcast spectrum, has been made available free of charge to entrepreneurs, as well as to large corporations, and has been a source of great wealth. The bottom line is that “the baseline for determining the benefits of government is the welfare a person would enjoy if government were entirely absent; the benefit of government services must be understood as the difference between someone’s level of welfare in a no-government world and their welfare with government in place.”482

Some of the rich clearly acknowledge this state of affairs. Warren Buffett, who perennially appears as one of the five richest Americans in the Forbes 400 list, has said the following:

I personally think that society is responsible for a very significant percentage of what I’ve earned. If you stick me down in the middle of Bangladesh or Peru or someplace, [*PG1103]you’ll find out how much this talent is going to produce in the wrong kind of soil.483

William H. Gates, Sr.—the father of one of the world’s richest men and an outspoken opponent of estate tax repeal—has articulated the point as well:

Like the “great man” theory of history, our dominant “great man” theory of wealth creation borders on mythology. Such folklore fills the pages of business magazines. In a recent interview, one chief of a global corporation was asked to justify his enormous compensation package. He responded, “I created over $300 billion in shareholder value last year, so I deserve to be greatly rewarded.” The operative word here is “I.” There was no mention of the share of wealth created by the company’s other 180,000 employees. From this sort of thinking, it is a short distance to, “It’s all mine” and, “Government has no business taking any part of it.”

There is no question that some people accumulate great wealth through hard work, intelligence, creativity, and sacrifice. Individuals do make a difference, and it is important to recognize individual achievement. Yet it is equally important to acknowledge the influence of other factors, such as luck, privilege, other people’s efforts, and society’s investment in the creation of individual wealth.

Consider the many components of the social framework that enable great wealth to be built in the United States. Among them are a patent system, enforceable contracts, open courts, property ownership records, protection against crime and external threats, and public education. Even the stock market is a form of socially created wealth that provides liquidity to enterprises. David Blitzer, the chief investment strategist at Standard and Poors, recently wrote, “Financial markets are as much a social contract as is democratic government.” When faith in this social system is [*PG1104]shaken, as it has been by recent breaches of trust, we see how quickly individual wealth evaporates.484

As this passage so clearly explains, the entire infrastructure of society, which is funded by taxes, is an absolute prerequisite to the ability to earn the munificent incomes realized by America’s richest citizens. Liam Murphy and Thomas Nagel have elegantly expressed and expanded on these principles in The Myth of Ownership:

There is no market without government and no government without taxes; and what type of market there is depends on laws and policy decisions that the government must make. In the absence of a legal system supported by taxes, there couldn’t be money, banks, corporations, stock exchanges, patents, or a modern market economy—none of the institutions that make possible the existence of almost all contemporary forms of income and wealth.485

This is a proposition with which no one reasonably can argue. Because this proposition is immutable, the starting point for Professor Nozick’s philosophy—Hobbes’ man in a state of nature—that leads him and others to find strict moral limits on society’s right to levy taxes is so counterfactual that their entire argument vaporizes with no further criticism needed.

Alice Abreu and I have previously focused on this immutable truth to analogize taxes to “rent” in effect charged by society for the privilege of participating in the market. That rent is in turn plowed back into maintaining that market in the form of public goods.486 We argue the following:

[N]o individual has a right to any particular [rental] “price,” that is, tax rate, for the use of public goods, just like no individual has a right to buy an automobile at the lowest price at which the dealer has sold it to another individual. Everybody must pay the price that the market will bear. Thus there is no [*PG1105]need to justify progressive taxation as redistributive. It is no more redistributive than the difference in price between a Cadillac and a Ford Escort. The purchaser of a luxury car, who exercises a claim on a greater share of resources than does the purchaser of a modest car, must pay more—however much more the seller wants to charge. If the buyer doesn’t like the price of the Cadillac, she can purchase the Escort. A high income earner, like a low income earner, must pay more for the use of those public goods—however much more the seller, the citizenry acting through its government, wants to charge. If she doesn’t like the price, she can choose a lower income level.487

Professors Murphy and Nagel make a similar point when they treat taxes as “essentially modifications of property rights.”488 Because property rights are derived from society, acting through government, taxes cannot be evaluated as a modification of a “just” pre-tax income.489

In debunking theories of “benefits” taxation, Professors Murphy and Nagel go on to make an even more important point. They point out that without government,

there is little doubt that everyone’s level of welfare would be low—and importantly—roughly equal. We cannot pretend that the differences in ability, personality, and inherited wealth that lead to great inequalities of welfare in an orderly market economy would have the same effect if there were no government to create and protect legal property rights and their value and to facilitate mutually beneficial exchanges.490

That stark, realistic and hardly debatable proposition leads to the conclusion that the “fairness” of taxes is not a function of their effect on pre-tax income:

[*PG1106]It is therefore logically impossible that people should have any kind of entitlement to their pre-tax income. All they can be entitled to is what they would be left with after taxes under a legitimate system, supported by legitimate taxation—and this shows that we cannot evaluate the legitimacy of taxes by reference to pretax income. Instead we have to evaluate the legitimacy of after-tax income by reference to the legitimacy of the political and economic system that generates it, including the taxes that are a legitimate part of that system. The logical order of priority between taxes and property rights is the reverse of that assumed by libertarianism.¹

This analysis reflects a consequentialist viewpoint of distributive justice, a view with which I agree.

For a variety of reasons, wholly apart from the preceding argument, it should be obvious that pre-tax income is in no way “deserved.” To start with, many large incomes are derived from inherited wealth.491 These rich, high-income earners did nothing to earn their wealth or their income.492 Both are an accident of birth. Even at incomes below these rarified levels, there is a significant correlation between parents’ and children’s lifetime incomes.493 Thus, the “lucky gene pool” club is a significant determinant of incomes even apart from large inheritances.

Even among those who have risen to wealth or high incomes from more modest means, there is no valid basis for concluding that they “deserve” that income more than many other individuals who have not achieved anywhere near such a high income level. First, as so clearly demonstrated by Robert H. Frank and Phillip J. Cook in The Winner-Take-All Society,494 labor markets increasingly operate in ways [*PG1107]that provide rewards vastly disproportionate to differences in effort and ability. In these “winner-take-all-markets,” a large number of individuals compete for a relatively small number of positions that offer the possibility for financial rewards that far exceed those that await less successful competitors. Although this type of labor market might have originated in entertainment and athletics, in recent years this model describes the market for doctors, lawyers, corporate management, and investment bankers, among others at the top of the income pyramid.495 Even though in most, if not in all, cases it took hard work to get to the top, there was a lot of luck involved—being born intelligent, having become the prot�g� of a well-connected mentor, or simply being in the right place at the right time—and others who worked just as hard simply did not have such good luck.

Furthermore, the very high incomes of some top-income earners might be attributable to luck that was “made” in a manner that reflects anything but deservedness. For example, during the 1990s most of the astronomical pay of the CEOs of publicly traded corporations was attributable to stock option transactions. Much of the increase in the value of their stock options was attributable to a general rise in the stock market, not to anything that they did to increase the value of their corporation’s stock. Moreover, in many instances when the value of the corporation’s stock fell to below the strike price of the option, the options were rewritten to better assure the executives a chance to make a profit on the options. On top of that, the nature of the transactions generally was hidden from shareholders. That these individuals could extract wealth from the shareholders of the corporations on such a scale was the result of a market failure, not the result of well-functioning markets.496 Again we see, through an example, that before-tax income is not necessarily “deserved” in any moral sense.

Finally, we must take into account the scale on which the federal government acts to preserve the wealth of the rich when their own economic actions threaten the preservation of that wealth. Persistent government bailouts have effectively eliminated “moral hazard” from investment decisions. These bailouts, which preserve the wealth of shareholders of corporations and other financial speculators range from saving a single corporation, such as automobile manufacturer [*PG1108]Chrysler, from bankruptcy—although Chrysler was hardly the only such individual manufacturing corporation assisted by the government—to industry wide bailouts, such as the bailout of the savings and loan industry in the late 1980s and early 1990s. The list is a long one.497

All of this leads to the inevitable conclusion that it is the after-tax distribution of income that counts the most. Because there is nothing “fair” or even efficient about the before-tax distribution of income, it is pointless to discuss the fairness of tax rates or the relationship of before-tax income to after-tax income in the abstract. Before-tax income is relevant only insofar as it is the benchmark for society to use in determining the tax structure necessary to reach the desired distribution of after-tax income. A vastly disproportionate distribution of before-tax incomes in and of itself can justify highly progressive income taxation for no other reason than doing so will achieve the societally desired distribution of after-tax incomes, as much as for the reason that progressive taxation is fair because it is the only system that takes into account the diminishing marginal utility of money. It is as valid to levy taxes that equalize income as it is to levy proportional taxes. I will not go so far as to say that it is equally valid to level a head tax, as some have suggested is the only valid tax.498 Reliance solely on capitation taxes can have such a deleterious effect on the welfare of the worst off in society that it must be rejected,499 as even the proponents of “flat taxes” acknowledge when they consistently propose generous exclusions.500 Subject to this limitation—that we must avoid doing great harm to those who have the least—there is no reason for society not to adopt a tax structure that results in the greatest good for the greatest number of citizens. This does not require absolute equality, despite the implications of such an end if the concept of the diminishing marginal utility is followed to its logical conclusion. The level of taxes and transfer payments necessary to achieve that end—taxes and government expenditures at levels heretofore inconceivable—would be bound to have disincentive effects that historical lev[*PG1109]els of taxation never have produced. But there is good reason to tax the very rich heavily—much more heavily than we do now—to provide for the very poor and to provide greater government infrastructure, particularly universal healthcare and high quality education, for everyone,501 even if it diminishes the welfare of the rich by more than it improves the welfare of everyone else.502

B.  The Danger of Concentration of Political Power in the Wealthy

Concentration of wealth and income in a very small segment of society will lead to an undesirable concentration of political power.503 This notion is as old as our nation.504 Although many of the Founders believed in a “natural aristocracy,” membership in which depended partly on wealth, and which would have a major role in government, they also were concerned with excessive wealth inequality.505 Thus, any debate over the most desirable rate structure must take into account the effect of the distribution of income and wealth on political outcomes generally.506

Concentrations of wealth provide a greater voice to the wealthy in the political process.507 In the 2000 federal elections, nearly one-[*PG1110]third of combined contributions to the political parties could be traced to “large individual donors.”508 One-sixth of contributions consisted of “soft money” and nearly 10% was PAC money, much of which might be traceable to the rich. Over one-half of contributions came from contributions of $10,000 or more, and 15% came from contributions of $100,000 or more.509 Nearly 50% of donors to congressional campaigns had a family income of $250,000 or more, and 20% had a family income of $500,000 or more.510

Large contributions influence elected officials in a number of subtle and not so subtle ways beyond “vote buying.” Contributions “help shape the context of legislation, the candidates who run for office, and the agendas on which parties campaign,” and help provide access.511 Because one of the principal determinants of winning an election is financial resources,512 the candidate who garners the most contributions most often garners the most votes.513 Thus, the wealthy, who generally make the most political contributions, enjoy a disproportionate say in who gets elected. This disproportionate say is not limited to the general election, but applies to primaries as well. Thus, in the general election, candidates of both parties are beholden to donors from the upper class. Although there are legal limitations on amounts that can be donated, they have not been particularly effective.514

[*PG1111] The influence of money does not necessarily end with the election. There is evidence that contributions influence the actions of legislators and other elected officials, although there is not strong evidence that floor votes are directly influenced.515 But only proposals approved in committee get to a floor vote, and there is stronger evidence that contributions affect actions of legislators in committees.516 Likewise, presidential proposals might be influenced. Some would suggest that we need look no further than President Bush’s environmental and energy policies to support this thesis.517

Wholly apart from the obvious anti-democratic philosophical problems of wealth purchasing influence in the public policy arena, the disproportionate voice of the wealthy in politics also may be economically inefficient. For example, “[w]hen inequality is high, the wealthy are more likely to block efficiency enhancing programs that would improve educational opportunities for the less well off.”518 Education increases human capital and fosters equal opportunity to prosper. To the extent concentration of wealth works to reduce the amount of aggregate societal resources that will be devoted to education, it inhibits economic growth as well.

Thus, to the extent highly progressive income taxes (and estate taxes) on those at the very top of the income pyramid help to mitigate concentrations of wealth and consequent political power, those taxes help to preserve liberty, freedom, and opportunity for the greatest number of citizens.519 Of course, there are limits to the ability to limit the economic power of the rich over politics through a progressive income tax,520 but that does not mean we should not try. Furthermore, the income tax need not be the only tool applied to solve this problem. A preserved and strengthened estate tax should aid in attempting to achieve this goal. Another more radical proposal would be to impose an excise tax on political contributions, or simply make [*PG1112]them subject to the gift tax with only a very small annual exclusion—a few hundred dollars at most—and no lifetime exemption.

VII.  The Paradox of Voter Acquiescence

This brings us to the question of why the typical voter tolerates growing economic inequality and a parade of tax legislation that not only is doing nothing to mitigate that growing inequality, but instead is systematically working to increase that inequality. Some economists express concern that large disparities of wealth cause socio-political instability; their concern is that such instability impedes economic growth.521 In the United Kingdom, when the Margaret Thatcher government attempted to replace a property tax with a capitation tax in 1990, the result was riots in the streets of London. The change would have been very regressive. The public outcry is credited with leading to the replacement of Margaret Thatcher by John Major as prime minister.522

One of the studies of the relationship of economic inequality, socio-political instability, and economic growth concluded that the United States has one of the marginally higher indices of social-political instability among major industrialized democracies.523 If that is true, it does not appear that the instability is manifesting itself in demands for more redistributive taxation. The question is, why not?

One possible explanation is that Americans do not care about inequality, that their focus is on the “American dream.” That explanation has been offered by journalist Robert J. Samuelson, who believes Americans focus on their own ability to get ahead rather than on existing inequality.524 Nathan Glazer similarly has argued that “most Americans remain apathetic about inequality: What we have today is outrage against those who do not play fair—not outrage over inequality as such.”525 Professor Glazer goes on to observe the following:

[T]his is surprising. After all, the United States is the most unequal of the economically developed countries—and that inequality has been increasing. If Americans don’t care about inequality, it obviously isn’t because inequality doesn’t exist here.

[*PG1113] One could argue that they don’t care about inequality because the poor do pretty well in America . . . .526

Professor Glazer appears to conclude that Americans conclude that inequality does not matter because the poor are well off.

That the poor in America are better off than the poor elsewhere in the industrialized world is a misconception. It is true that until recently the United States was so much richer than other countries that even the poor lived better here than anywhere else, but that is no longer true. America’s poor are still better off than many, in some cases most, of the population of Third World countries, but a better point of comparison is the industrialized democracies of Western Europe. Based on real purchasing power, the poor (measured at the tenth percentile) are better off than the poor in the United Kingdom and Australia, but are marginally worse off than the poor in Sweden, Canada, and Finland, and substantially worse off than the poor in the Netherlands, Germany, Belgium, France, Switzerland, Denmark, and Norway.527 Reflecting our inequality, at the ninetieth percentile Americans had the highest standard of living. But perception rather than reality is more important in shaping voter attitudes. Do Americans recognize the growing economic inequality?

Americans generally do seem to understand that inequality is increasing, and they generally are not pleased by it. Although Americans are tolerant of some amount of inequality as long as it results from equal opportunity and merit, they generally believe that there should be less inequality than currently exists, recognizing that needs as well as merit should be taken into account in the distribution of wealth.528 In a 2002 National Election Study Survey,529 nearly 75% of respondents said that the difference in incomes between rich people and poor people was larger than twenty years ago; more than 40% recognized that it was much larger; and only about 8% thought ine[*PG1114]quality had decreased.530 “[A] majority of those who recognized that income inequality has increased said they thought that it was a ‘bad thing’; most of the rest said they ‘haven’t thought about’ whether it is good or bad, while only about 5% said it was a good thing.”531 Furthermore, most Americans do not view income inequality as a merely natural phenomenon. Slightly more than half believe that unequal access to quality education is an important factor, while slightly less than half believe “unequal effort” is “very important” and many believe discrimination and government policies are important.532

Perhaps American distrust of government is the reason that voters do not demand more progressive taxation. Christopher Jencks has observed the following:

Almost everyone who studies the causes of economic inequality agrees that by far the most important reason for the differences between rich democracies is that their governments adopt different economic policies. The fact that the American government makes so little effort to reduce economic inequality may seem surprising in a country where social equality is so important. . . . But while the tenor of American culture may be democratic, Americans are also far more hostile to government than the citizens of other rich democracies. Since egalitarian economic policies require governmental action, they win far less support in the United States than in most other rich democracies.533

This might explain skepticism in regard to overtly redistributive policies, but it does not fully explain the apparent apathy toward disproportionate tax cuts for the rich. Do most people really think the rich pay too much in taxes and that they deserve disproportionately large tax cuts? It is doubtful.534 In the 2002 National Election Study [*PG1115]Survey, more than half the respondents said that the rich pay less taxes than they should, whereas less than 15% believed that the rich pay too much.535 Larry M. Bartels has summarized the views on levels of taxation of the rich and poor from the 2002 National Election Study Survey as follows:

Here, as so often, it is easy to disagree about whether the glass is half full or half empty. Half of the American public thinks that rich people are asked to pay less than they should in federal income taxes—but almost half do not think so. More than 60% agree that government policies have exacerbated economic inequality by helping high-income workers more—but more than a third deny that assertion, and more than 85% say that “some people just don’t work as hard.” More than 40% say the difference in incomes between rich and poor has increased over the past 20 years, and that that is a bad thing—but an even larger proportion either don’t recognize the fact or haven’t thought about whether it is a good thing or a bad thing.

On the other hand, what is pretty clearly absent in these data is any positive popular enthusiasm for economic inequality. Americans may cling to their unrealistic beliefs that they, too, can become wealthy; but in the meantime they do not seem to cherish those who already are. Fewer than 7% say that a larger income gap between the rich and the poor is a good thing (or that a smaller gap is a bad thing). Fewer than 15% say the rich are asked to pay too much in taxes, while three times that many say the poor are asked to pay too much in taxes.536

If this is true, then why do so many Americans support the Bush tax cuts? A Harris Poll in June 2003 found that 50% thought the 2003 tax cut was “a good thing,” while 42% said it would help “the rich” a lot and only 11% said it would help “the middle class” a lot. An even more recent survey that asked whether respondents approved or disapproved [*PG1116]when they were reminded that “President Bush and Congress have made two major cuts in federal income tax rates” found that 54% approved of the tax cuts, while only 37% disapproved.537 Why do a majority of people approve of tax cuts that increase economic inequality when a majority thinks there is already too much inequality and that the rich do not pay as much in taxes as they ought to?

The obvious possibility is that most voters “just don’t get it.” It might be that most Americans do not understand that the Bush tax cuts, like most other tax legislation in the past twenty-five years, with the notable exceptions of the Omnibus Budget Reconciliation Acts of 1991 and 1993, have been regressive. This misperception, of course, could simply be one facet of misunderstanding of the tax system as a whole. A study by Joel Slemrod has found that voters support various tax proposals because of widespread misperceptions.538 For example, there is widespread support for a flat rate tax or a national sales tax, both of which would be highly regressive moves, because most voters doubt that the current system actually is progressive. Thus, they believe the rich would pay more, not less, under a flat-rate tax or a national sales tax. Similarly, overwhelming popular support for repeal of the estate tax appears to be linked to the misperception held by nearly 50% of the respondents in the study that most families have to pay the tax.539

Professor Slemrod also found that lack of sophistication, represented by lower educational achievement, increased the chances of misperceiving a move to a retail sales tax as increasing progressivity. This is consistent with recent findings—contravening the conventional wisdom that less sophisticated individuals vote their own pocketbook—that less sophisticated voters cannot make the necessary associative linkages between government policies and their own pocketbooks that more sophisticated individuals can make.540 Thus, particularly in presidential elections, less sophisticated voters focus on the economy as a whole in assessing candidates, whereas more sophisticated voters are able to make the necessary associative linkages between government policies and their own pocketbooks. Extrapolating, this might mean [*PG1117]that relatively less sophisticated voters, who generally will be found below the top of the income pyramid, simply do not understand who benefits from the tax cuts. For them, tax cuts are tax cuts and they think everyone benefits.

Evidence from the 2002 National Election Study Survey supports the idea that much of the populace is simply clueless about the tax cuts. Depending on how the question was asked, that is, support for the tax cuts Congress passed or support for the tax cuts President Bush signed, either 35% or 45% of respondents answered that they “haven’t thought about it.”541 Public opinion about the tax cuts does not appear to be particularly well informed.

This lack of understanding—or disinterest—in the effects of the Bush tax cuts is just one aspect of broad based ignorance about the tax system. A 2003 survey of views on taxes sponsored by National Public Radio, the Kaiser Foundation, and the John F. Kennedy School of Government revealed the following: (1) 34% of respondents answered that they did not know whether they paid more in income tax or Social Security and Medicare tax, and the answers of most of the rest were wrong; (2) 28% did not know whether they were eligible for the eanred income tax credit; (3) 42% answered that they did not know whether taxes are higher in the United States than in Western Europe; (4) 61% had not heard of President Bush’s then recently announced proposal to exempt dividends from taxation; (5) 48% had no opinion on whether the 2001 tax cuts should be accelerated; (6) 60% had no opinion on whether the tax cuts should be allowed to expire in 2011 or be made permanent; and (7) 41% did not know whether accelerating the cuts and making them permanent would primarily help high-income, middle-income, or lower-income people.542 All of this indicates that although people are generally supportive of tax cuts in the abstract, they really do not know exactly what—or whose interests—they are supporting. The public in general is uninformed about the tax system, and much of what it thinks it knows is just plain wrong.

If people know so little about the tax system, how do they decide whether or not they favor or oppose tax cuts? Professor Bartels has advanced the proposition that their opinions are based on “simple-minded and sometimes misguided considerations of self-interest.”543 [*PG1118]His analysis of the data from the 2002 National Election Study Survey shows, for example, that an individual’s view that one’s own federal income taxes were “too high” was a much better predictor of support for repeal of the estate tax than was a person’s view with respect to whether or not the rich pay too much or too little in taxes.544 Furthermore, the view that one’s own federal income taxes were too high was a stronger predictor of support for repeal of the estate tax among lower- and middle-income classes—the groups least likely ever to be subject to the estate tax, even though most of them mistakenly believed that they would be subject to it—than among those in the top third of the income distribution. The same correlation applies with respect to support for the 2001 income tax cuts. An individual’s view that one’s own taxes were too high was a far more significant predictor of support for the tax cuts than was a person’s view with respect to whether or not the rich or the poor pay too much or too little in taxes.545 In this case, however, there was at least some logical reason for those who thought their own taxes were too high to support the tax cuts. Perhaps the most striking finding was that including spending preferences, ideology, and party identification in the analyses along with attitude regarding one’s own tax burdens completely eliminated the impact on support for the tax cut of attitudes about the tax burden of the rich. From this, Professor Bartels concludes that “public support for the Bush tax cuts derives in considerable part from unenlightened considerations of self-interest on the part of people who do not recognize the implications of Bush’s policies for their own economic well-being or their broader political values.”546 In other words, they just do not get it!

One last factor in why the middle class just does not get it, may be the rhetoric in the political arena. To put it bluntly, the average voter has been deceived by the politicians seeking tax cuts for the wealthy. [*PG1119]The political rhetoric of tax cuts always focuses on tax cuts for the struggling middle class family. The tax cuts that are delivered are anything but that. This aspect of the class warfare of the past twenty years has been seriously explored by a handful of political analysts and investigative journalists over the past two decades.

Prominent political analyst Kevin Phillips observed over a decade ago that, the 1980s were “an era of tax deception . . . where the average American family was concerned.”547 As has been demonstrated, Phillips was right. Despite all of the rhetoric of tax reduction, families in the middle quintiles saw their share of the tax burden rise even as their share of income was declining. Apart from the impact at the very bottom, resulting from expansion of the earned income tax credit,548 only families in the top 5% saw their share of income rise more steeply than their share of taxes, and only families in the top 1% saw it happen dramatically.

Investigative journalists Donald Barlett and James Steele reached a similar conclusion.549 They describe the process as the “Capital Hill Magic Show.”550 Politicians provide very modest tax relief for the poor and middle class, on which they focus their public pronouncements, while quietly delivering significant tax relief to the wealthy. They make the further point that proponents of tax relief for the wealthy—or opponents of increasing taxes on the wealthy—also respond with the cry that those on the other side of the issue are engaged in “class warfare.” Barlett and Steele point out the following:

They were right about one thing. There has been class warfare. But it didn’t start with the introduction of the Omnibus Budget Reconciliation Act of 1993. Nor was it directed against the rich. In truth it began quietly in the 1960s, and continued through the 1970s and 1980s. And the target was the middle class.551

In their analysis, Barlett and Steele compare the public statements of politicians of both political parties with the actuality of numerous tax acts, demonstrating the differences.

[*PG1120] William Greider has similarly analyzed the politics of the tax legislative process in the 1980s and early 1990s, describing it as “bait and switch,” while emphasizing that Democrats have participated equally with the Republicans in this gambit.552 Greider concludes that politicians of both parties have responded to the desire of the “economic elites” for reduction of their taxes, while engaging in political rhetoric portraying their actions as in the broad public interest and beneficial to all. He notes that “[t]he Reagan tax cutting had begun with the Great Communicator’s paeans to the energies of the everyday working people.”553 The great bait and switch was the 1983 legislation increasing payroll taxes dramatically. Any benefit from income tax cuts for the middle class was offset by the increased payroll taxes. Greider attributes the Democrats’ penchant for joining Republicans in this process as emanating from the fact that campaign funds came from the economic elite and lower-income voters increasingly failed to participate in the political process.

More recently, David Cay Johnston exposed how “this policy of taxing the poor and the middle class to finance tax cuts for the superrich” did not end with the changes in the 1980s, but continued through the 1990s and into the early years of the twenty-first century.554 Johnston’s analysis focused primarily on tax administration, rather than on the political rhetoric of campaigns for tax legislation, but he did not ignore the politics of the tax legislative process. He examines in detail the importance of changing the nomenclature to “death tax” for the political campaign behind the drive to repeal the estate tax. This new terminology helped convince the populace that the estate tax applied to everyone and that their taxes were being reduced rather than only those of the super-rich.555 Although the drive to repeal the estate tax was primarily a Republican goal, in which some Democrats joined, more broadly, Johnston also finds little real difference between the two political parties in regard to the general propensity to deliver large tax cuts to the rich cloaked in the rhetoric of tax cuts for the masses. Johnston, too, chronicles the great deception of the vast expansion of the payroll tax beginning in 1983 that has in fact been used to fund general expenditures and which contributed significantly to the transitory “surplus” of the later 1990s that [*PG1121]was “returned” to the taxpayers—mostly to the super-rich taxpayers— through the Bush tax cuts.556 Johnston describes the combination of payroll tax increases on low- and middle-income earners and income tax cuts skewed to high-income earners as follows:

[A] massive redistribution program right out of George Orwell’s Animal Farm, where the ruling pigs declared that some animals were more equal than others. That teachers and cops and truck drivers and clerks pay extra Social Security taxes so the rich can pay less income tax is an economy Orwell would have understood.557

This viewpoint of the politics of taxation also is shared by some noted economists, including Nobel Prize-winning economist Joseph E. Stiglitz. He described the political process surrounding the 1997 reduction in long-term capital gains rates from 28% to 20% as follows:

Greed on the part of Wall Street and the real estate industry, wrong-headed accounting, a conservative political establishment perfectly willing to use this accounting for their long-run goal of downsizing the government, combined with more liberal politicians who wanted to put themselves in good graces with sources of campaign finance, all worked to pass the capital gains tax cut of 1997, one of the most regressive tax cuts in American history (with strong competition to come four years later from Bush II). But there was one more ingredient: Not only did many of those forces succeed in convincing America that deregulation, however executed, would be of benefit to all Americans: they also convinced middle-class voters, and even poorer Americans that they too would benefit from the capital gains tax cut. The capital gains tax cut was politically popular. Everybody has their shares (though most of their shares were held in accounts in which the accumulations were, in any case, tax free). They would do everything they could to protect these little pieces of capitalism against the rapacious government. . . . No matter that the tax cut saved the upper-income taxpayer $100 for every $5 that the middle-income taxpayer was spared. They were all in the [*PG1122]same boat, all working to save themselves from those who would take—and supposedly waste—their money.558

Professor Stiglitz expressed great concern about the values that both the result and the process represented—reducing capital gains rates and increasing taxes on wages (through the payroll tax) taught “[t]hat it is far better to make your living by speculation than by any other means.”559 And the process was equally bad; by talking about incentives that would result from the capital gains tax cut “when most of the tax giveaways had no incentive effect at all, we were also teaching our young people another lesson in political hypocrisy.”560

Focusing mainly on the Bush tax cuts, Paul Krugman has described the political process as “The Tax-Cut Con.”561 In a New York Times Magazine article bearing that title Professor Krugman observed that the current Bush administration has been remarkably successful in putting a “populist gloss on tax cuts so skewed to the rich.” Part of that “con” was “an insistent marketing campaign [that] has convinced many Americans that they are overtaxed.” But the public pronouncement of the reasons for the tax cuts constantly shifted and Professor Krugman describes the 2003 tax cuts, particularly those focused on dividends and capital gains, as achieved “through a combination of hardball politics, deceptive budget arithmetic and systematic misrepresentation of who benefits.” Clearly, the “tax deception” that Kevin Phillips so accurately described as characterizing the 1980s has continued unabated through the 1990s and into the twenty-first century.

VIII.  Quelling the Matthew Effect

The facts are incontrovertible. Very few Americans have a great deal of the economic wealth of the country and very many have very little of the economic wealth of the country. And the Matthew Effect continues to control the distribution of increasing aggregate national income. The rich are getting much richer and the poor and the middle class are relatively stagnant. The United States suffers greater economic inequality than any other major industrialized democracy, and that inequality is increasing. And we cannot validly defend this situation factually by claiming that even our poor are better off than the poor in other industrialized democracies. They are not.

[*PG1123] Our tax system, although somewhat redistributive, is unfair. It taxes the rich, particularly the super-rich, too lightly relative to everyone else. The income tax is progressive only up to the point of slightly more than $300,000 of annual income.562 The income tax is not sufficiently progressive, however, to offset the impact of regressive flat-rate payroll taxes, which are the most significant tax for most Americans, but which largely do not apply to most of the income of the rich. At the top of the income pyramid, the progressivity is largely nonexistent. We make no attempt to distinguish between the near rich, the rich, and the super-rich. For all three groups, there is only one normal marginal rate— 35%—and much of the income of the super-rich—that which is realized in the form of dividends and capital gains—is taxed at only 15%. For the super-rich, the income tax is essentially either a flat rate tax or a regressive tax. As a result, the tax system fails adequately to take into account the diminishing marginal utility of money, fails to allocate tax burdens according to ability to pay, and fails to effect significant redistribution in the face of the greatest economic inequality among the major industrialized democracies of the world.

Furthermore, the situation is getting worse. The incomes and wealth of the super-rich are growing far more rapidly than the incomes and wealth of everyone else, including the merely rich. For that matter, in real terms, the before-tax real incomes of many in the base of the income pyramid have stagnated or even fallen. A fair-minded person would think that the reaction would be to increase the progressivity of the tax system by increasing taxes on the rich. Instead, with the exception of two tax acts in the 1990s, over the past twenty-five years the United States has been systematically reducing taxes on the rich by magnitudes that dwarf any tax relief for the middle class. The Matthew Effect has prevailed in the political arena. In tax act after tax act, the burden of aggregate taxation has been shifted down (or to future generations through tax-cut-induced deficits). It is only the extraordinary rate of growth of the before-tax share of income realized by the rich that causes their share of total taxes paid to increase, allowing the effects of tax legislation on tax burdens to be hidden from voters.

Tax cut mania is fueled by erroneous perceptions that the United States is a high tax nation, when the facts are exactly the opposite. The United States has one the very lowest tax burdens of all of the OECD countries, and by a wide margin when compared to Western [*PG1124]European countries.563 The spurious argument that our taxes are so high that they create disincentives to save and to work and that tax cuts for the rich will lead to bounteous economic growth in which all will share, have been trotted out again and again by tax cut proponents without any real challenge in the public policy debates, even though the empirical data prove the claim to be false. The significant empirical evidence that economic inequality impairs economic growth has been ignored entirely.

The result of this frenzy of tax cuts for the rich has been to fuel a massive federal deficit that has been exacerbated by, even though not wholly attributable to, tax cuts for the rich at the same time that the United States invests too little in the infrastructure of human capital. We fail to provide higher quality education and healthcare for tens of millions of poor and middle-class Americans who would be far more productive with greater public investment in education and healthcare. But we claim that we cannot afford to make these investments because of the budget deficit. To be sure, the budget deficit is a problem, a serious problem. Eventually the budget deficit will interfere with economic growth and, as it leads to the United States becoming even more of a debtor nation, it will reduce the living standards of Americans generally.

The American people want government services in the form of education and healthcare, as well as highways, police protection, national security, and all of the other public infrastructure necessary to create a prosperous industrialized state. Yet the American people have supported tax cuts that in fact go disproportionally to the wealthy, while spending on infrastructure other than national security languishes.

Millions of citizens say that the federal government should spend more on a wide variety of programs, that the rich are asked to pay too little in taxes, and that growing economic inequality is a bad thing—but simultaneously support policies whose main effects will be to reduce the tax burden of the rich, constrain funding for government programs, and exacerbate growing economic inequality.564

How does this come to pass? Collectively, we appear to suffer from cognitive dissonance. It is the responsibility of our government to get it right—to do the right thing, not the popular thing. What [*PG1125]should be done is obvious. At the very least we need to re-impose higher tax rates on the super-rich. Steep progressivity through most of the income pyramid is not nearly as important as it is at the top. It is in the top 1% where the greatest disparities are found.

The top 1% is strikingly different from the 95th percentile, even though the bottom of the top 1% actually more nearly resembles the 96th through 99th percentiles than it does the top of the top 1%. The differences in the top 1% as a whole are enormously striking. The same is true for each income group in increasingly smaller cohorts within the top 1%. Each cohort is closer to those below it than to those ahead of it. And the peak of the pyramid is enormously different. The 6836 income tax returns that reported AGI of $10 million or more for 2001—a mere 0.001% of all filers, reported 2.84% of all income, over twice as much as reported by the 12,266 filers in the $5 million to $10 million cohort, and more than the 52,157 filers in the $2.5 million to $5 million cohort.565 The increasing differences, not only in dollars but in multiples of income, are sufficient to warrant significantly increasing steepness in the graduation of rates.

The highest marginal income tax rate faced by the top of the income pyramid—the top 1%—is 35%. That 35% rate applies to a marginal dollar of income whether it is the $500,000th or the $5,000,001st. Furthermore, due to the preferential rates for capital gains and dividends and the concentration of those types of income at the top of the income pyramid, those at the very top often face marginal, and sometimes average, rates lower than that and lower than most taxpayers in lower cohorts, who generally have little or no capital gains or dividend income. Until the mid-1960s, the income tax system was largely flat rate or mildly progressive for the masses, with steeply progressive surtaxes on a relatively small percentage of the population. Today, the federal tax system is progressive for the masses, but progressivity tapers off at the top of the income pyramid.

Forty years ago, the top of the income pyramid faced dramatically higher tax rates. In 1962, the top 0.5% of filers, by AGI class, was subject to marginal tax rates of 50% or more. Slightly less than 4% of filers were in marginal tax brackets higher than 50%.566 Even after the 1964 rate reduction, high-income taxpayers continued to face marginal rates of up to 70%. In 2001 dollars, applying the 1965 rate schedule, the [*PG1126]threshold for the 50% bracket for a joint return would be slightly less than $250,000, an income now in the 31% bracket.567 The threshold for the 60% bracket would be approximately $493,000, and the threshold for the 70% bracket would be approximately $1,121,000.568 The mid-1960s rate schedules thus took into account the differentials just below the top of the income pyramid better than any rate structure we have had since.569 Today, however, the income differentials for those whose income exceeds $500,000 are extraordinary compared with the halcyon days of the 1960s. Although we must be concerned with declining taxes on the near rich and wannabes just below the near rich, it is the true top with which we must be most concerned.

For 2001, the income cohorts above $500,000 represent slightly more than 0.4% of all returns, and they reported over 13% of AGI. The IRS has recently revised its Statistics of Income reporting, which previously had top-coded data at AGI of $1 million to break out cohorts between $1 million and $1.5 million, $1.5 million and $2 million, $2 million and $5 million, $5 million and $10 million, and over $10 million.570 These income cohorts represent the top 0.15% of returns, and they reported over 9% of total AGI. These are the income cohorts with which we should be concerned. These are the income cohorts that have seen their income taxes slashed while payroll taxes have steadily increased. These are the income cohorts whose taxes should be increased dramatically.

Even though the budget might not be balanced by increasing taxes on the super-rich,571 both the tax system and the after-tax distribution [*PG1127]of incomes will be fairer if marginal rates on incomes above $500,000 are increased. As incomes increase above $1 million, marginal tax rates should continue to increase. At the very least, each of the income cohorts identified in the Statistics of Income data ought to be subjected to increasingly higher graduated rates. Higher marginal rates should apply to incomes that exceed $1.5 million, compared to those that exceed $1 million but do not exceed $1.5 million. The exact width of the rate brackets can be determined another day. But a reasonable starting point would be to increase rates every $500,000. And as incomes move above $10 million, there is no reason to stop at a 50% marginal rate. There was nothing wrong with the top end of the 1950s rate schedules if the bracket thresholds are adjusted to modern income levels.

One aspect of 1950s taxation that still lives in the tax system must be eliminated to establish just tax rates. The preferential rate for capital gains, and its offspring, the preferential rate for dividends, must be eliminated.572 When thoughtfully analyzed, the capital gains preference never has been justifiable as part of an income tax.573 The newly enacted preferential rate for dividends is a poorly designed partial substitute for corporate tax integration. If corporate integration is desirable—which might not be true with respect to publicly held corporations574—a credit imputation system is a far superior alternative. A credit imputation system results in corporate income that is distributed being taxed at the shareholder’s marginal rate, whatever it might be.575 Capital gains and dividend income are too highly concentrated [*PG1128]at the top of the income pyramid and constitute too high a percentage of the income of the super-rich to achieve just tax rates and a just distribution of after-tax income if these income items continue to be taxed at preferential rates.576 The ordinary income rate schedule of I.R.C. � 1 cannot carry the entire burden.

Conclusion

It is time to restore steep graduated progressivity at the very top of the income pyramid. It is time to eliminate the capital gains preference. It is time to lift the ceiling on payroll taxes577 and return payroll taxes to a pay-as-you-go basis, while reducing the rates—or, even better, it is time to repeal the payroll taxes and raise the revenue for Social Security and Medicare through the progressive income tax.578 It is time to cease the foolish drive to repeal the estate tax and preserve its important antidynastic function.579 It is time to reverse the Matthew Effect. The critical question is, will we do it in time to avoid the corrosive effects on American society and democracy of the ever-increasing concentration of economic well being? As President Franklin D. Roosevelt stated in his second inaugural address, “The test of our progress is not whether we add more to the abundance of those who have much; it is whether we provide enough for those who have too little.”580