7 Changes in Taxes and Transfer Payment Programs

Victoria Heist, Charlie Tarazona, and Junwei Lu

Introduction

When trying to understand income inequality in the United States, it is important to look at changes throughout American history. The focus of this chapter will be on the early 20th century through today. We will be analyzing the effect of changing tax structures on income inequality in the United States by looking at important wars and presidencies. This paper will be split up into three sections in order to extensively analyze the effect of tax structures on income inequalities in different time periods. Section I will focus on World War I and World War II, Section II will focus on the 1980s and Reagan’s presidency, and Section III will focus on the changing tax structure in the 21st century under former presidents George W. Bush and Barack Obama, and current president, Donald Trump. We find that there is a relationship between changes in tax structure and income inequality in the United States.

Early 20th Century –  World War I and World War II

World War I and World War II have both had great power in altering the American economy. Changing tax structure in America during the early 20th century has contributed to the rise in income inequality in the United States.

World War I shifted the American economy from a dominating global power to the strongest economic power in the world. One of the defining moments in taxes during World War I was with the passage of the sixteenth amendment in 1913. Prior to 1913, there were some calls for a federal income tax, but they proved unsuccessful (Jensen 1107). It was in the 20th century when Roosevelt and Taft both called for the implementation of the income tax amendment. Jensen argues that the sixteenth amendment was intended to shift “the tax base from consumption to income, and thereby tying tax burdens to ability to pay” (1109). The income tax was supposed to reach the wealthy, but it was different from a wealth tax (1128). World War I dramatically changed the federal taxation system by implementing a progressive tax system and an income tax for federal revenue, and the 1920s followed this pattern with high and progressive tax rates. Anne L. Alstott argues that World War I helped shape the taxation in the 1920s because there was federal debt generated from the war and “debate over the nation’s financial obligations to World War I veterans” (Alstott 374). Higher taxes were implemented at an attempt to combat the debt acquired from the war (375). Before World War I, “the share of total income received by the top 1% was about 18%” (Piketty and Saez 9). Further, the top 1% share declined with World War I, went up in the early 1920s, and declined again with the Great Depression and World War II (9). Wars affect the top incomes because there are increases in taxes during times of war in order to pay for them (9-10). Shocks play a major role in income inequality because they affect capital income (9). In the early 20th century, “the top 0.01% earned incomes were 400 times larger than the average income” which was much more than in 1970 (10). Overall, income inequality in World War I was focused on income concentration at the top. Income inequality was experienced among richer people rather than everyone in the United States (Lindert and Williamson 173).

World War II brought new economic changes in the United States with changes to the tax structure and war finance. One major change in the tax structure with World War II was the call for corporate tax reform. Corporate income was taxed twice in the United States unlike other countries. This double taxation was introduced under FDR during the New Deal. During World War II, businesses were responsible for the burden of the tax through increased corporate income taxes to financed the war. The corporate income tax and the excess profits tax made up about 56% of “net income reported to the government by 1944” (Bank 208). It was the United States Revenue Act of 1942 that increased income tax rates and corporate tax rates (Bank 209). It was believed by Roy Blough, the Director of Tax Research in the Treasury, that the combination of these taxes would hurt the economic recovery of the United States after the war ended. With the ending of World War II in the late 1940s, this double taxation was viewed as unnecessary because the United States was no longer funding a war. This created a call for corporate tax reform, with 46 proposals sent out by early 1946 (Bank 208).  It is argued by Herman that economic prosperity after World War II was due to tax cuts (Herman 23). He argues that the passage of the Revenue Act of 1945 was responsible for boosting government revenues and the American “post-war boom” (Herman 23). The Revenue Act of 1945 was just the opposite of the Revenue Act of 1942. It lowered tax liabilities, removed the corporate excess-profits tax, and lower the marginal tax rate (Herman 23). Herman’s conservative views on this are not shared by less conservative economists. In addition, the government imposed new taxes during World War II, increased existing taxes, and made more people liable for tax payments. Excise taxes and employment taxes increased and there were higher income taxes for both individuals and corporations (Higgs 444). But what did these swift economic changes do for income inequality in the United States?

After World War II, the income of the top 10% was stable (Frank 65). Piketty and Saez argue that income inequality is in a U-shaped pattern from 1913-1998. Income inequality declined during the Great Depression and World War II (Frank 56). The Great Leveling was the period from approximately 1910 to 1970, that exhibited “more economic equality and strong economic growth” (Thornton 159). Authors Lindert and Williamson argue that one of the causes of “for the decline in the share of income captured by top earners in industrialized nations” was the Great Leveling (Thornton 158).  The Great Leveling attributed to this decline in income inequality and as a result, regional incomes began to converge (Lindert and Williamson 205). The Great Leveling was caused by the shocks to the economy that resulted from the American entrance in World War II (206). Further, the “shrinkage of trade probably contributed to the equalization of American incomes up through World War II” (217). However, it is also important to note that high-income families with a male head-of-household and a wife in the labor force obtained their income status because of the number of family members in the household. This was prevalent in World War II, with women increasingly joining the labor force at the onset of the war (Metcalf 27). Simon Kuznets,  founded an inverted u-shaped pattern (later called the Kuznets curve) of changes in income inequality over time in developing countries. He theorized that “when economies reached a certain stage of development, income inequality” begins to recede (Levinson 135). He argued that this happened after World War I for the United States, but it really took off after World War II and well into the 1960s and 1970s (136). Overall, World War II experienced a decrease in income inequality even with changes that were made to the tax structure at that time. Although there was a decrease in income inequality at this time, there has still been a steady increase in income inequality in the United States. From 1870 to around 1940, there were increases in income inequality, in 1950 it decreased, and since there have been increases in income inequality (Osberg 47).

By analyzing the changing tax structures during World War I and World War II, we are able to recognize that WWI had increasing income inequality and WWII had decreasing income inequality. However, the second half of the twentieth century, with new tax policies and presidents, tells quite a different story.

Section II: Late 20th Century

In continuing our look at income inequality throughout United States history, we next look at the tax policy from the 1980s through the early 2000s. Specifically, we look at the Tax Reform Act of 1981, along with looking at the implications of other economic policies and their effect on economic inequality.

In the years following the end of World War II, the United States saw unprecedented economic growth along with financial stability. During this time period, however, we begin to observe trends that could come to explain why economic inequality in the United States has progressively increased over the period from 1980-2005. In this period productivity levels of labor had risen 67.4%, but there was not a substantial increase in incomes (Levy and Temin 2). As a result of productivity growth being correlated to income, the income gained from this productivity growth was not normally distributed throughout the United States population. It was found that during this time period, the group of earners that had their incomes increase the most from the labor productivity growth was the top 1% of earners. It was also reported “that in 1980, average income per tax unit rose from $40,774 to $46.806. A gain of $6,032 per tax filing unit. Thus, a sample of 100 tax filing units would have an aggregate income gain of $603,200. Over the same years, the average income in the top 1 percent of tax filing units rose from $317,607 to $812,497, a gain of $494,890.”(Pikkety and Saez 39). This clearly exemplifies the disproportionate gains the 1% had made during the time period. During this time,  the Tax Reform Act of 1986 was introduced. This act is credited with widening the tax base exchange for lower tax rates. This change to the tax system could perhaps be a reason why incomes only increase for the top 1%, but the evidence for this is unconvincing.

The effects 1986 policy had on family income as a result of these changes are telling when evaluated. The top 1-5% saw actual and projected gains that nearly tripled their family incomes during the time period from 1977-1988. Lower deciles saw gains that paled in comparison, with the lowest gains to family income being 68% from 1977-88 and other top deciles seeing gains of around 90%. The top 1% of families however saw their incomes increase 190.07% over the period, concluding in an average gain of about 111% more than the highest and lowest deciles combined. An even better comparison of the difference in gains between the 1% and everyone else can be seen when looking at the lower 9 deciles of families combine. This group saw an average increase of 127% and the lower 8 deciles combine saw an average increase of 119%. These numbers are still pale in comparison to the 190% gain had by the top 1% of families. It is also notable to mention that during this period the pre-tax and post-tax gini coefficients also increased 15% from 1977-1988 further showing a growth in inequality over the time period, when placed in comparison with income data the results are expected. The increase in incomes to the 1% and lack thereof to the lower deciles saw an increase in the income equality over the time period as a result thought to be largely due to the tax policy.

Even though during this time “tax rates clearly influence the year-to-year timing of increases but the underlying trends are the mirror image of an 53 average worker who is losing ground both to capital and to the best paid members of the economy” (Levy and Temin 52). Although this does not say much about the divergence of income between everyone and the 1%, it does allow us to rule out the TRA 1986 as a possible explanation for the 1% seeing a majority of the benefits of the labor productivity increase. This still leaves the possibility open that the TRA of 1986 had alternative negative effects on family and corporate incomes.

The TRA lowered the corporate tax rate from 50% to 35% which set the stage for the next period of American tax policy that largely focused on supply side and trickle down economics that increased corporate wealth. These changes arguably had a significant effects on income and inequality during this time. The tax policy of the 1980s would be seen to have long-lasting impacts on the income inequality that is growing rapidly today.

When looking at 1986 Tax Act, specifically in its relation to the budget deficit during this time period, the increase of standard deductions could be seen as having an adverse effect on some Americans. However, the major concern was held with the fact that it excluded many Americans. This exclusion, of some of the lowest income Americans, led to a loss in the budget of around $36.5 billion, just as a result of the increase to standard deductions and change to the tax brackets (Auerbach and Slemrod 596). The Tax Reform Act also resulted in losses of $39.5 billion due to changes in personal rates that allowed individuals to deduct more (Auerbach and Slemrod 596). Overall, the broad individual changes lead to a loss of about $48.9 billion in personal income to the Federal Reserve.When it came to the effect of the Tax Reform Act on corporate taxes, we see a similar story. A decrease in corporate taxes losses were expected to be had on the budget side with the hope that the money would get reinvested and boost the economy. The changes to corporate taxes the Federal Reserve lost a total of $30 billion in individual rate reductions alone (Auerbach and Slemrod 596). These changes to the budget were essential in Reagan’s goal of boosting the economy using supply side economic policy. However, this shows the blatant contradiction in Reagan’s tax policy, that saw him attempt to employ monetary policy to expand the economy while also implementing a contractionary fiscal policy.

The Reagan tax plan of 1981, titled, “Economic Recovery Tax Act of 1981,” was formulated with assistance from David A Stockman, Jude Wanniski, and Jack Kemp. The individuals were all firm believers in supply side economics and saw to large changes in the tax system and welfare spending in the United States. The plan had three major parts, all having varying effects on the economy as a whole. The first part of the plan was to “decrease federal spending from 23% of GNP to 19% by 1986” (Peterson 96). The second major part of the plan included a “10% reduction per year in personal income tax rates for 3 years along with substantial tax relief for business by accelerating business depreciation” (Peterson 96). The third part of this plan involved cooperation with the Federal Reserve in which the president requested a “reduction in the rate of growth for money and credit from 1980s levels, which saw M2 grow 8.9%, to half those levels in 1986 (Peterson 97).

During 1981 tax rate reductions were made in the capitals gains tax, reducing it to 20% with the Tax Reform Act of 1986 that repealed the exclusion of long term gains (Gerald 58). This allowed for individuals to be taxed in the current year on long term gains instead of pushing them to later time periods. However, the provisions that were added to the tax had minimal impact on the income inequality gap that was growing in the country during this time.

Some of the aspects of Tax policy at the time have had adverse effects on relatively poor individuals. However, Tax cuts were not the only reason we saw poor individuals adversely affected during this period. Cuts to spending on social programs, along with corporate tax cuts made it difficult for low income Americans to get by. There were also increased barriers to entry for social programs, which made it even harder to get aid from the state if people were struggling financially. For example, the Omnibus Budget Reconciliation Act, which essentially attempted to decrease welfare spending, had placed new restrictions on Aid to Families with Dependent Children, also referred to as AFDC (Omnibus Budget Reconciliation Act of 1981). These restrictions had made most families ineligible in some way, furthering their fall into poverty. The immediate impact of these restrictions included a decrease of about 408,000 families to the AFDC program and 299,000 individuals seeing a decrease in their benefits (Soaz 620). Income was also impacted with implementation of these new restrictions and policy as seen with individuals in Dallas seeing as decrease in average monthly income of about $229. A similar situation occurred in Boston where there was a decrease in average income of about $115 (Moffitt and Wold 61). The U.S. census data on poverty shows that there is a slight increase in poverty during this period, suggesting that these policy actions and tax cuts could be contributing factors. The actual impact of Omnibus Budget Reconciliation Act of 1981 however had  not been realized until looked at in the long term. It was found that “OBRA had resulted in a statistically significant decline in total AFDC caseloads, it did not lead to a significant decline in total expenditures”(Englander & Kane 16). Failing to achieve the goals of the time period to reduce welfare spending. Combined with tax cuts to the wealthy, one can see why the 1980’s saw an overall increase in economic inequality. Wealthy individuals benefited most from the TRA of 1986, while poor individuals saw a decrease in their welfare and incomes during the time leading to further economic inequality. The changes to the budget left little for individuals looking for government assistance during the time along with increasing taxes on individuals. Once again, we see that wealthy individuals are the ones who manages to go unscathed and also likely benefited the most from the provisions. Overall, these economic policies and the tax acts of this time contributed to widening the income inequality gap in the United States.

Section III: 21st Century

After the World War II, Reaganomics, and the economic policies of former U.S. president Ronald Reagan are associated with the reduction of taxes and the promotion of unrestricted free-market activity, gained popularity and brought profound influences in tax policies in the next few decades (Bloomberg 1). Also, Reaganomics policies brought economic opportunities to everyone that was displayed through intergenerational mobility (Business Insider 1). Based on the previous section, the government increased the taxes on individuals. Thus, the intergenerational mobility actually decline during this time period. However, the problems of the poverty gap and income inequality still existed. In the 21st century, income inequality had become a very serious problem in America. Tax policy is an important factor that affects income inequality. According to Ziliak’s research, if the poor and the rich pay the same portion of the tax, the poverty gap increases. The reason is that the income of the poor is much lower than that of the rich. In this case, the poor have less money left than the rich after paying taxes. So, the poverty gap would increase. To solve this problem, the appropriate tax credits would be one of the most effective methods to fill the gap (Ziliak 83).  However, how much people in different income levels should pay in taxes has always been a controversial and debatable topic. The tax policy has transformed in the past few decades; former presidents, George W. Bush and Barack Obama, and current president, Donald Trump, have issued different tax policies affect income inequality. Under Bush and Obama administration, one consensus that may be found from these different policies is that reducing the tax rate of low-income and mid-income classes and increasing the tax rate of high-income classes. This may potentially reduce the poverty gap. In theory, this could be an effective way to address the problem of income inequality. However, the fact is that the ultra-rich still becomes richer under the current tax policies since the basis of the income differences between the poor and the rich is so significant. Rich people earn hundreds of thousands or even millions of dollars a year. Rich people need to pay high taxes, but that part of the money is actually very rare for them. On the contrary, the poor pay very little tax, but they make little money. This way, the rich could still be benefiting from the current tax policies, which indirectly causes the increase of the poverty gap to increase substantially.

In 2001, President George W. Bush authorized a tax cut called the Economic Growth and Tax Relief Reconciliation Act for the next ten years in America. This policy was solely aimed to reduce taxes for families with one or more children. According to the income tax rate decreased from 2001 to 2010. We found that this policy lowered federal income tax rates and reduced the top tax rate from 39.6 percent to 35 percent between 2001 and 2010. In addition, this policy lowered rates for several other tax brackets (Kiefer, 90).

In 2003, President Bush approved the Jobs and Growth Tax Relief Reconciliation Act which reduced the tax rate on long-term capital gains and increased tax breaks for small businesses. This tax policy contained further tax cuts and accelerated tax changes. In January 2005, he led a nine-member advisory group that gave advice on reforming federal tax laws. He wanted to broaden the tax base and reduce the rates as the Tax Reform Act of 1986 did. He also wanted to guarantee the equality of taxation to mitigate the problem of income inequality.  For low-income class, the panel used a family credit to replace the standard deduction, the personal exemption, the credit for child and dependent care, head of household filing status, and the 10% tax bracket (Witner 42). By using family credit, many people with low incomes could avoid paying income taxes. In addition, the U.S government encouraged people to go to work. They used work credit instead of earned income tax credit (EITC) for the low-income class. The maximum work credit for a working family was $3,570 for one child and $5,800 for two or more children (Witner 42). If new workers were satisfied with the condition, they would have work credit to avoid raising other taxes.

In 2002, the top transfer tax rates would decrease from 55 percent to 50 percent. According to the estate and gift tax rates from 2002 to 2010, we found that the estate and gift tax rates decreased from 50 percent to 35 percent between 2002 and 2010 (Kiefer, 93). This means that rich people can let their children inherit more money and properties. Thus, the intergenerational mobility would be higher for high-income families.

Under the Bush administration, we could see that the low-income class received a lot of benefits. Also, the intergenerational mobility was lowered at this stage since family credit policies not only increased the opportunities for lower-income families to send their kids for higher education, but also enhanced the childhood environment of the lower-income class (Chetty and Hendren 1).  The high-income households needed to pay more in income tax, but these people still became richer from 2001 to 2009 and their average annual after-tax income increased from $236,500 to $264,700, which means they could save more money for future use (Washington Times 1). We could see that the intergenerational mobility was a little bit higher for high-income families, because they could earn more money under these tax policies. In this case, high-income class families’ children could have better education than low-income class families’ children. The intergenerational mobility of education would have an important effect on children’s income in the future. Overall, from 2001 to 2009, due to tax reduction, the low-income class was able to earn more, but income inequality is still a significant problem.

In 2009, in order to end the recession, President Obama authorized the American Recovery and Reinvestment Act. Under this policy, families got benefits from the tax cuts and tax credits. Also, the government aided to low income workers. In 2010, the Economic Growth and Tax Relief Reconciliation Act was close to its deadline. At that time, the United States just experienced a financial crisis and economy was struggling to recover from the recession. So, President Obama decided to extend two years expiration for the Economic Growth and Tax Relief Reconciliation Act. During 2010 to 2012, families with children and high-income workers still received a lot of benefits.

Based on the distribution of federal income taxes in 2009, we found that the top one percent of income earner pay 36.7% of the total income tax (Hagopian 15). In addition, Warren Buffett announced that he paid a lower rate of taxes on his income than his secretary did (Hagopian 17). Based on the above information, we find that the top one percent of earners pay taxes disproportionate to their share of income.

In 2013, President Obama signed The American Taxpayer Relief Act of 2012. Under this policy,  the high-income class pay more taxes, especially the taxpayers with incomes of more than $1 million. More specifically, the highest individual income tax rate is increased from 35 percent to 39.6 percent and the qualified dividends and long-term capital gains tax rate from 15 percent to 20 percent (Yang, 21). At the same time, he lowered the tax rate for the workers with mid-income and low-income classes.

Under Obama administration, the mid-income and low-income classes can get more after-tax income, which increased the intergenerational mobility. So, the mid-income and low-income families’ children could have better education and earn higher income in the future. In contrast, the intergenerational mobility was lowered at this stage since tax rate was increased for high-income families.

During Obama administration, he has fought for income inequality. The tax system helped mid-income and low-income households paid less taxes. At the same time, the high-income households paid more taxes. Thus, the income inequality began to narrow.  However, we could see that the problem of income inequality still has not been resolved.

In recent years, one of President Trump’s critical action items is a “massive” tax reduction, especially for upper-income taxpayers. In addition, the median household income declined in 2016. This phenomenon has not appeared since the 1970s (Morris 6). In 2017, President Trump approved the Tax Cuts and Jobs Act. Under the Tax Cuts and Jobs Act, families earning $50,000 to $70,000 would see only a 0.6 percent increase in after-tax income and families earning $20,000 to $40,000 get no benefit. Therefore, the intergenerational mobility basically unchanged for low-income and some middle-income families. In this case, it was still hard to solve the income inequality in the future.  Some upper to middle-class families are losing popular tax breaks like the state and local income tax. It caused some of those in the middle-income class need to pay more taxes (Washington Post 1). So, the intergenerational mobility was lowered for upper middle-income families, which may result in lower education and lower income for their children. Compared to taxes under President Bush and President Obama, the tax plan under Trump cut the more corporate tax rate, which gives more benefits to rich groups, but harms the middle-class. Thus, the top one percent of income earners are getting much richer. The intergenerational mobility was increased at this time period for high-income families. They could send their kids for higher education in the future. From 2016 to 2018, under the Tax Cuts and Jobs Act, Trump also uses American Opportunity Tax Credit, which is a partially refundable tax credit of up to $2,500 for each eligible student (Kess 64). We can see that the tax break on paying higher education could help low-income and mid-income families’ children go to better universities. Overall, the promulgation of these tax policies has helped many low-income people get a lot of benefits, but the poverty gap is still widening.

According to the General Social Surveys, 62.57% of people who paid federal taxes think that the taxes were too high, 36.4% said the taxes were just about right and only 1% said the taxes were too low (Shigehiro 157). It is not hard to predict that most Americans will have a negative attitude toward taxes and related policies. In other words, under the current tax system, although the low-income and mid-income classes are seemingly paying a smaller portion of the tax, the tax rate is still high for them to support their daily basis. Moreover, the current tax policy may not minimize the poverty gap, but widen it substantially. Therefore, to better address the issue of income inequality, the U.S. government still needs to formulate or revise tax policies. The income tax on low-income and mid-income classes should be lower. At the same time, the income tax and related policies of high-income people should be adjusted based on raw income instead of ranges of income. By doing this, the gap between the rich and the poor would shrink significantly.

Conclusion

Overall, it is evident that the changes in tax structure from World War I to today have had a impact on income inequality in the United States. In the aftermath of WWI and beginning of WWII we saw another change to the tax system this time involving some of the most significant changes in corporate taxes until later in the 1980s. In terms of economic inequality over this period, not much can be said. “Shocks” such as the World Wars and Great Depression kept income and economic inequality relatively low. Overall, WWI and WWII did not exhibit extreme increases in income inequality. The later 1980s played a stronger role in the rise of income inequality in the United States, but the changes in the tax structure during these major wars contributed to income inequality by first increasing it in WWI and then decreasing in WWII. However, in the period following, changes to the tax structure would undoubtedly have an stronger impact on income inequality.

In the years following World War II, many generations of  president would make impactful changes to our tax structure . This chapter specifically looked at the impacts of the Tax Reform Act of 1981, the Tax Reform Act of 1986, and the Omnibus Budget Reconciliation Act of 1981. The effects of these taxes and transfers of wealth are broad and general. The Acts as a whole generally increased income for the wealthy, whether it be on retained income or future earnings. With the changes made to corporate and income taxes along with increased deductions, increased national debt, slashing of welfare and aid programs, increased economic inequality. Individuals of lower levels of income saw slight increase to their taxes along with a planed decrease in welfare spending.

Leading into the 2000s, it could be seen that the poverty gap was growing at an alarming rate, and each of the presidents attempted to make tax changes to lessen or reverse the effects.  In general, the presidents collectively tried lower tax rates on low-income and mid-income classes while increasing tax rate of high-income classes in an attempt to reduce inequality. We directly look at the impacts of the Economic Growth and Tax Relief Reconciliation Act, and Tax Cuts and Jobs Act. Under the Bush presidency lower income individuals saw gains to their income because of things such as family credit and work credit which replaced the standard deduction. Wealth individuals however also saw gains during this time period with individuals like Warren Buffet using the system to his advantage and “paying less than his secretary in taxes.” The Bush administration did little to close the growing income gap with these tax policies providing benefits to both classes of people. The Obama administration attempted to lower taxes on the middle and lower classes while raising taxes on wealthy individuals. The effect on inequality however is that same as the Bush administration, doing little to decrease growing income inequality. Contrary to this policy incumbent President Trump would lower corporate tax rates mitigating the effects of the Obama administration policy. This again gave benefits to wealthy individuals who have historically gained from corporate tax cuts.

In all, the period from WW1 to the early 2000’s saw many drastic changes in the United States Tax policy. These changes contributed to different ways to income inequality over time and lead us to where we are today. With the greatest growth in income inequality occurring during both during and after the Reagan administration. Although presidents have attempted to fight this growing income inequality most have been met with the same result. And the Gap keeps growing.

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Income Inequality and Intergenerational Mobility by John Kane, editor is licensed under a Creative Commons Attribution 4.0 International License, except where otherwise noted.

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