Income tax inequality: Who pays their fair share?

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Wall Street Cheat Sheet
By: Dan Ritter
April 22, 2014

In 2011, the Internal Revenue Services collected $1.1 trillion in income taxes from Americans -- all told, about 48 percent of the total taxes collected that year (payroll taxes accounted for another 32 percent, but never mind that). Of that $1.1 trillion, about $208 billion, or 19 percent, was paid by the top 0.3 percent of cash income earners (for tax purposes, different than adjusted gross income).

According to 2011 data compiled by the Tax Policy Center -- the brainchild of the Urban Institute and the Brookings Institute -- this top 0.3 percent represents 433,000 taxpayers with an average pre-income of around $2.9 million, about 11.8 percent of total pre-tax income. With an average federal tax rate of 29.1 percent, this tranche averaged a tax burden of $845,000, giving this 0.3 percent of the population 10.2 percent of post-tax income.

Taking a step back, data compiled by Kiplinger show that the top 1 percent of cash income earners -- those making more than $388,905 in 2011 -- took home 18.7 percent of all income and paid 35.1 percent of all taxes, leaving them with approximately 16 percent of post-tax income. On the other side of the spectrum, the lowest 50 percent of income earners -- those making less than $34,823 per year -- took home 11.5 percent of all income, and paid about 2.3 percent of total taxes, leaving them with a smaller share of total post-tax income.

This kind of gross financial inequality is nothing new to Americans. Measured using the Gini index, maintained by the Central Intelligence Agency's World Factbook, the U.S. falls between Uruguay and the Philippines on the list of countries with the most unequal distribution of family income. Moreover, the distribution of family income in the U.S. is less equal than the world average. The CIA calculated a Gini index score of 45 for the U.S. in 2007, the most recent year for which there is data, which compares against the world average of about 39.7 (in the Gini index, zero is a perfectly equal distribution of income, while 100 is a perfectly unequal distribution).

The big question behind most discussions about financial inequality is: Is it fair? Or, on the other side of the coin: Is it even meant to be? The issue of inequality is really an issue of distribution -- an idea illustrated by the Gini index, which plots total family income against the total number of families. The distribution of income in a capitalist economy is necessarily unequal, but not necessarily unfair.

The answer to that big question is anything but clear, but there are some pieces of data that can provide insight into a possible answer. For example, the U.S. Gini index score increased from 40.8 to 45 in the decade ended 2007, and research from the University of California, Berkeley suggests that inequality has only gotten worse in the post-crisis period. As much as 95 percent of the new wealth created between 2009 and 2012 has gone to the wealthiest 1 percent. Meanwhile, incomes at the bottom 99 percent grew just 0.4 percent between 2009 and 2012. Between 2007 and 2011, the share of working families considered low income -- meaning their earnings are within 200 percent of the official poverty threshold -- increased from 28 percent to 32 percent nationally.

Regardless of whether the current distribution of income is fair and regardless of whether it is even meant to be, the observed increase in inequality in recent years suggests that there is something wrong with the system. Income inequality cannot continue to increase indefinitely without creating severe problems for the entire economy. There is a reason why countries with high Gini index scores -- like South Africa at 63.1 and Colombia at 55.9 -- are home to economies that are less than desirable.

In the U.S., the public and policymakers have both picked up on the idea that inequality is increasing and that increasing inequality is, ostensibly, a bad thing. The issue made its way back into the spotlight in the wake of the financial crisis, and it has been kept there in part by President Barack Obama, who has championed economic reform, with varying success, throughout his tenure.

In his 2013 State of the Union address, he described the economy as he saw it: "Today, after four years of economic growth, corporate profits and stock prices have rarely been higher, and those at the top have never done better. But average wages have barely budged. Inequality has deepened. Upward mobility has stalled. The cold, hard fact is that even in the midst of recovery, too many Americans are working more than ever just to get by - let alone get ahead. And too many still aren't working at all."

Efforts to address the issue have been anything but straightforward, but one facet of the president's strategy is rooted in the tax code -- and, specifically, the income tax. In 2013, a new top tax bracket of 39.6 percent (previously 35 percent) was introduced. At the same time, the president has advocated for a simpler tax code that would reduce the burden on the all-important middle class. Obama has championed edits to the Child Tax Credit, the Earned Income Tax Credit, and the American Opportunity Tax Credit, which are all aimed at this goal.

However, income tax data show that the Americans who are hardest off -- take those earning below $20,000 as an example -- have almost meaningless tax burdens to begin with. The 14.9 percent of tax payers with cash income less than $10,000 in 2011 had an average tax burden of just $89 and accounted for just 0.1 percent of total taxes paid. This same group accounted for 1.4 percent of pretax income and 1.6 percent of post-tax income. Those earning between $10,000 and $20,000 had an average tax burden of $144 and accounted for 0.2 percent taxes paid. This group accounted for 4 percent of pretax income and 4.8 percent of post-tax income.

Beginning to move outside of the poverty wage zone, the 12.7 percent of taxpayers with incomes between $20,000 and $30,000 had an average tax burden of $1,408 and accounted for 1.5 percent of total taxes paid. This group accounted for 4.8 percent of pretax income and 5.6 percent of post-tax income. The 10.5 percent with incomes between $30,000 and $40,000 had an average tax burden of $3,432 and accounted for 3.1 percent of total taxes paid. This group accounted for 5.6 percent of pretax income and 6.1 percent of post-tax income.

Only at a cash income level of more than $100,000 in 2011 (11.2 percent of taxpayers) did the group's post-tax share of income actually fall relative to its share of pretax income -- from 24 percent to 23.6 percent, in this case. At incomes higher than this, taxes are sufficient to reduce the group's share of total income. The new top tax bracket of 39.6 percent, which phases in at incomes over $400,000 for a single filer (effectively those in the top 1 percent of earners), will likely do more to reduce the total share of post-tax income claimed by those at the top of the ladder.

Back to the question of whether this is fair: the answer is still unclear. What we know, though, is that income taxes can serve as one mechanism to reduce effective income inequality. What we don't know is whether that mechanism is being used correctly -- or, at least, proficiently.

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