On Income Inequality - What Is a "Fair" Maximum Tax?

Income...And Wealth...Inequality
President Obama's latest State of the Union speech is upcoming (a bit of a tired constitutional requirement in the modern era, but still an important speech) and it is widely believed that one of the central themes of his speech will be about rising income inequality in the United States.  Liberal commentators have been all over this theme of late, especially with the outright gluttony on display at the Davos conference last week (essentially that conference has devolved into rich people talking about being rich.)

One of the big pieces of data that has been repeated over and over again is that the 85 richest individuals in the world have as much wealth as the bottom half of the world population.  While this story is slightly misplaced in the context of an income inequality discussion - income and wealth are two related but distinct concepts - it is certainly a jarring reminder of how the other half lives.

In the United States, income inequality looks like this (all figures are adjusted for inflation):
The 20th percentile in the US have household incomes averaging $20.3K per year, essentially flat to 20 years ago (up 0%)
The 50th percentile have household incomes averaging $50K, also essentially flat to 20 years ago (up 3%)
The 80th percentile have household incomes averaging $101.6K, up 11% from 20 years ago
The 95th percentile have household incomes average $186K, up 20% from 20 years ago

So, essentially 80 percent of the population has about the same income level that it did 20 years ago, whereas the further up the chain you go, the more you have benefitted from the past 20 years.

A couple of very big caveats to these numbers.  Measures of income exclude social benefits received from the government such as food stamps.  They also exclude the impact of changes in tax policy.

However, in many ways social benefits have become less generous in the past 20 years (welfare reform in the 1990s, for instance) and tax policy has become a little more friendly to the top of the house (Clinton-era reductions in capital gains taxes and the components of the Bush tax cuts that were extended by Obama), so if anything, these numbers probably understate how much the problem has grown.

So should we care?  One could make an argument that in a free-market system, by definition you have winners and losers.

Major league income inequality, however, is socially destabilizing.  In addition to the potential moral aspects of having a rich country with a lot of poor people, it is a political mess when the majority doesn't control much of the wealth - it leads to all kinds of punitive actions by governments and it leads to a lot of social unrest from people who feel excluded from the system.  A large, vibrant middle class is therefore the key to maintaining a stable economy and stable democracy.

So, what are the good and the bad solutions to this problem, if, in fact, you agree with me that it is a problem.

Good Solution - Reward Work
Solutions which encourage participation in the economy are always my first choice for solving the issue.  Those include hiking the minimum wage (which now seems to be gaining momentum, but regular readers know I have been talking about for years) and supporting and expanded the Earned Income Tax Credit, which is essentially a federal subsidy for those working at low incomes.

Bad Solution - Redistribute Wealth
Redistribution can be politically appealing.  And I'm certainly not saying that the rich shouldn't pay more taxes than the poor - they can afford to after all.  But simply transferring money creates class warfare and creates poor economic incentives - the poor aren't encouraged to work and the rich aren't encouraged to innovate.  While I've supported some tax hikes on the rich in the past, the top marginal rates on earned income are getting scary.  In California, the top tax rate is 12.3%.  Combined with a top federal rate of 39.6%, the Medicare Tax of 2.4% and the Obamacare tax of 0.9%, top earners in California pay a top rate of 55.2%.  Taking more than half of the money someone earns is getting to a dangerous level.

Good Solution - Increase Workforce Skills
One of the major drivers of income inequality has been the globalization of the workforce and the automation of manufacturing processes.  In the 50s and 60s, one could earn a nice middle-class lifestyle with a High School diploma and a job in auto manufacturing.  These days, there are a lot less of those jobs, partly because of the globalization of labor markets but more importantly because of automation.  You need about 10% of the people that you needed 50 years ago to make an equivalent number of cars.  It is therefore imperative that more people have skills beyond a High School Diploma, since I'm not sure that this can ever be a path to a middle-class lifestyle again.  Supporting post-secondary education, be it technical trade skills or degrees in science, math and engineering is a essential part of building a 21st century workforce that can be middle class.  Support should be targeted - majoring in Art History isn't going to give you the skills to compete.  Post-Secondary education should be viewed as job prep not some humanist period of discovery.  If you want discovery, that's fine, but we'll only PAY to support things which will build your job skills.

Bad Solution - Cut Taxes on Investment
A popular conservative solution to income inequality is that if you cut taxes on investment income, it would encourage more investment which would in turn create more middle class jobs.  This is belied by two inarguable facts - the first is that corporations have TONS of cash already on their balance sheets that they could deploy if they saw attractive uses for it.  The second is that the ways to generate the highest returns on capital are often not the same things that create middle-class jobs.  The key is making investments in US jobs pay off better, not simply taxed less.

Good Solution - Build Better Infrastructure
Our transit infrastructure needs a lot of work - bridges, roads, tunnels, mass transit are all dated and many in poor condition.  Our electric grid and power generation is also out of date - our grid is inefficient and vulnerable and we need to build capacity to make less power with coal.  All of these investments are a two-fer - they provide middle class, blue collar jobs now to construct the infrastructure of tomorrow and they have a huge multiplier effect that will make private investment more attractive in the future.

Let's hope President Obama proposes some common-sense solutions in his SOTU speech and not simply a bunch of initiatives aimed to divide the classes.  And let's hope the GOP is willing to work with him on this issue - shunning every one of Obama's initiative is a bit tired since the GOP will never have a chance to defeat him at the polls again.  We'd just as soon see everybody work on solving problems.

If you like this site, tell your friends.