9 Reform Proposals

Jennifer Schottmiller, George Belov, and Brad Smith

Introduction

In the United States, there are many different reforms that are discussed and argued that may reduce income inequality in the country. Some arguments that will be discussed are tax reform, financial literacy, residential segregation, retirement plans, social welfare programs, and minimum wage.

Tax Reform

Tax reform in the United States is a very controversial issue. There are many different arguments on how the tax system should be altered to reduce income inequality. A study conducted in 2017 viewed how different mixes of labor, consumption and capital tax rates, affected income inequality throughout different countries. Iosifidi and Mylondis found that increasing the tax burden on labor relative to capital leads to higher income inequality (Iosifidi 58). The United States currently relies heavily on consumption taxes and labor tax for revenue. As shown in the graph below, 48% of revenue tax in the United States currently comes from income taxes. This creates a huge burden on workers. Additionally, the next 35% of revenue taxes comes from payroll taxes, which are taken off consumers paychecks to fund programs such as social security (Policy Basics 1). While the labor tax is progressive, this causes many families a much lower taken-home income. This high tax rate has the ability to push low-income households into an even worse position. The higher income families may have to pay a higher tax rate, but since they have higher incomes, it is a lower proportion of their overall income, making it less of a burden for them (Policy Basic 1).

Additionally, the more we rely on consumption taxes relative to capital taxes, the higher the income inequality. This stems from lower-income families paying a larger portion of their income on sales tax on consumer goods, which causes them to pay a large fraction of their income on taxes. It should be noted that in all 50 states housing and food are exempted from this sales tax.  This exemption helps to alleviate some of the stress that comes from higher sales taxes for lower-income households, but they can still be hefty for households on other necessities. Relying on capital and labor taxes more than consumption taxes could help decrease income inequality (Iosifidi 62). Relying heaviest on capital tax rate for government revenue, compared to consumption and labor taxes may reduce income inequality. It may reduce inequality simply because it only taxes those who own capital would have to pay a higher overall amount of taxes, and shift the burden away from lower income families who typically cannot afford to own capital. It is how all these different tax rates can be proportioned to each other to help decrease income inequality, rather than looking at one single tax rate to be the solution (Iosifidi 65).

Another tax reform that has been getting more attention recently is a guaranteed income. Guaranteed income can also be known as a negative income tax, a social dividend, or universal basic income. Guaranteed income means that unconditionally, no citizen’s income will fall below the poverty line, meaning whether they work or not, they will still receive the same income (Widerquist 10). The advantage of this system is no citizen in the country would be living below the poverty line. A large disadvantage to this proposal is funding. While governments can increase tax revenue by taxing assets such as property, natural resources, or even inheritance, it would still not be sufficient to provide income above the poverty line for each citizen. If the tax rate increased significantly, the tax revenue may be able to pay for it, but politically it would be difficult to raise the rate by such an amount. Widerquist argues that offering just a guaranteed income may not work, since it may break the law of reciprocity. The law of reciprocity in this case states that people would work and pay taxes, and in return they would receive the guaranteed income to bring the household to the poverty line. The law of reciprocity could be broken by people choosing not to work, so they are not paying taxes, but still receiving the guaranteed income. If this law is broken it could cause issues with funding and longevity of these programs. People would be faced with two choices. The first choice being they can choose to not work, and receive only the guaranteed income. The second choice is to work, and receive a higher overall income. Guaranteed income can be a good policy to ensure every citizen is over the poverty line, but can be complicated by finding ways to fund a program that large as it may be an incentive for some to choose not to participate in the labor force.

Canada currently has a guaranteed annual income for citizens over the age of 65 (Murray 3). While this is similar to the Social Security programs in the U.S., it is different since they are guaranteed a specific amount, no matter how much they have made throughout their life like the United States program. This program has dramatically reduced the poverty rates for those who were eligible. Senator Segal states that it makes more sense to help those directly who are living below the poverty line, than trying to conduct top down aid to the poor. Some top-down programs could be attempting to decrease the high school dropout rates. While those programs may help some, they are more likely to benefit the better off citizens, and not give any relief to the lowest income households (Murray 5). These programs will not stop a teenager from dropping out of highschool to get a full-time job if they need to work to feed themselves and their family. A guaranteed annual income would benefit the lowest-income families by directly offering them relief instead of offering them programs that might not reach them. One disadvantage is that is does place a lot of trust in the hands of the citizens who are receiving the income, that they are using it for their family and not abusing the system by spending it on nonessential items.

Another tax credit system that could potentially reduce income inequality is the Earned Income Tax Credit (EITC). In an EITC program, a low-income family receives additional money transfer based off of the amount of income they earn.This system is currently used within the United States and in 2008 this program cost $51 billion, but was able to reach 25 million low-income families (Hoynes 1). It is considered a supplement to the income they have already earned. Hoynes, Miller, and Simon specifically focus on EITC effects on infant health. They found that the EITC did impact birth weight by reducing the chance of having a low birth weight, and increases the mean birth weight. They also looked at many externalities to eliminate other possibilities. The EITC impacts infant health through the three channels of income, maternal labor supply, and fertility (Hoynes 5). Implementing systems like guaranteed income or EITC, increases the income for low-income households. Both of these systems can reduce income inequality, as it is pulling the low-income households higher than they would be with just their own income. Both systems have positive effects on health of the families and may work to reduce the income inequality gap.

Perhaps one of the simpler ways to reduce income inequality is to make the current tax system more progressive. This would increase the tax rates on the very wealthy. Small increases in their tax rates, could raise large amounts of revenue for the government, unlike increasing the tax rates on the less wealthy which would create far smaller increases in revenue. For example, in the United States the top 1% of income earners receive 23.5% of all income in the country. “Increasing the average federal income tax rate on the top percentile from 22.4 percent (as of 2007) to 29.4 percent would raise revenue by would raise revenue by 1 percentage point of GDP” (Diamond 167). An increase of revenue by 1% point of GDP is a large amount, especially when the burden is put on the top 1% of income earners, who can easily afford to pay the tax. An increase of taxes of approximately 7% is a large increase, but the burden it places on them does not hold the same weight than if the lowest tax brackets tax rate was raised by about 7%. Diamond expresses that it is more optimal for a country to increase taxes on its top earners to be able to stabilize the taxes on the lower income households. This is very controversial as some do not see it as fair for one group to take most of the burden, but increasing taxes on lower income households can cause families standard of living to decrease. By placing the burden on higher income households, it allows the government to raise revenue to fund things such as welfare programs, that can help decrease income inequality. If the burden of paying for these programs was on the low income households, this could cause these families to be stuck in the same financial situation, instead of trying to increase their financial standing. By allowing some tax relief to the low income, it can decrease income inequality. Likewise, by imposing the tax burden on the highest income earners, it can also decrease income inequality as it will decrease their overall take home income and bring everyone closer to the middle.

Financial Literacy and Intergenerational Mobility

Another proposal to reduce income inequality in the United States is to increase financial literacy. An increase in financial development of a country can decrease income inequality in a country, as citizens can then use the new financial tools to their benefit. While ability to participate in this economy depends on financial literacy, it also depends on their access to financial markets as well. By increasing financial literacy, it can also increase intergenerational mobility as a newer generation will have a better chance at financial success if they are able to properly understand and utilize these tools. If they are able to increase their intergenerational mobility, over generations the income inequality will decrease as well. In the U.S. many people follow financial market movements and many news outlets create a lot of attention around it. There is a problem associated with it: there is a large group of people who believe that financial markets create outlook on the performance of the overall economy, but the health of the economy cannot just be traced through the financial market. There are many indicators, such as inflation, new jobs, credit index, average weekly hours and many others. But as many people have that belief about close association of financial markets and performance of the overall economy, many people can get easily caught up in euphoria and invest large portion of their wealth into the markets as they go up, without doing proper research, and in a lot of times people invest too late in the cycle, when the economy starts to slow down and more likely to lose as markets start going down, and in many times those people wait for too long in hopes to “break-even” and only sell when markets bottom out.

It used to be harder for lower-income households to have access to financial markets as there were high transaction costs. The development of the internet, higher competition and less regulations there are many new startups and companies that disrupting the industry with vision to bring access to everybody through offering low transaction costs and features that used to be available only to rich households. With development of the internet it is also easier to have access to become more financially literate: from niche investing websites to courses from leading universities, that can be taken online throughout any time-frame to suit any individual.

In countries where economic literacy is higher, income inequality is lower. If there were a way to increase economic literacy in a country, income inequality would at least grow at a slower rate, and give citizens the information and ability to participate in these markets if they have access to them (Prete 6). While those who are low in financial literacy can seek help from professionals, “only a small fraction of households consult financial advisers, bankers, certified public accountants, and other professionals, while the majority of households rely on informal sources of advice” (Lusardi 17). If households began to rely more on receiving professional financial advice, it could help them make smarter investments and decisions, even if they still have a low financial literacy rate on their own. Other programs can attempt to increase financial literacy, such as employer sponsored seminars of community classes. Most large firms offer education programs to explain their benefits and pension plans, but there is no conclusive evidence that these alter the attendees actions. Many of these seminars focus on educating about savings and retirement, and while the study shows that the least wealthy typically benefits the most, many of the attendees leave with the idea of how they want to change their financial actions, but few actually do it (Lusardi 22). Additionally, when financial literacy is very low, default enrollment in pension programs can be very beneficial and make the employees better off than if left to make the decisions themselves (Lusardi 25). While it does not increase individual financial literacy, it can reduce the income inequality by preparing them for retirement later in life.

In the research conducted by the St. Louis Fed, the data acquired from IRS shows that for households with income between $100,000 and $200,000 the participation in the stock markets varies state-by-state. For example in Connecticut, which is considered to be the state with households with high financial literacy, market participation is close to 50%, and it is only around 30% for household in Mississippi for the same income level, while on average participation in the whole country is about 40%. Another interesting point from this research is the fact that there are different levels of living costs between states, usually higher for states with high financial literacy, but higher income households in states with lower financial literacy, and lower costs of living, still have lower percentage of participation. The author of this research does make a comment that these numbers should be considered a lower bound because data is from tax filings to IRS, specifically taxable dividends, but pension funds and some IRA plans are not going to be included there, while some of the companies, especially in popular nowadays tech industry, don’t pay out dividends at all.

How Financial Literacy Can Impact The Whole Economy

Alan Blinder described his vision of what have led The Great Recession to be as impactful as it was and how the government response towards mitigating the effects of the financial meltdown. The Great Recession started as a perfect storm: public sentiment towards the economy, and particularly the housing market, was soaring sky-high while the complexity of financial derivatives was far too hard for the public to understand. There were 7 “villians” of the financial crisis of 2008, three of which are related to financial literacy: inflated prices of houses, heavy borrowing throughout the economy, and predatory lending. (Blinder, 28)

The general public fell into the belief that the housing prices are only going to go up, and started to borrow heavily on any terms available to buy more houses with an intention to sell them later at the higher price. As the financial institutions started to pack those mortgages into mortgage-backed securities and collateralized-debt securities and sell them back to various organization and institutions, that are managing retirement plans and district portfolios funded by taxes. There were many new laws to prevent something like this from happening again, such as Dodd-Frank act. Higher financial literacy can help to prevent something like this happening again, or at least reduce negative intensity.

As The Great Recession unrolled, many household went through hard times, and economy experienced soaring unemployment rates and slowed economic growth. Most of those losses affected the ability of individuals, especially soon-to-be retirees, to sustain needed growth of their retirement portfolios.

Well-Funded Retirement

People work hard their whole life to ensure a good and happy retirement. Some people don’t have a belief in the financial system and store their money under the mattress or don’t have any savings at all. Some store money in the bank, accumulating small appreciation every year with the belief that it’s better not to take any risks associated with stock markets and just go slow and steady. Others are less risk averse and plan foundationally for their retirement with various investment tools available: most well-known are 401(k) plans, Individual Retirement Account, or IRA, and fixed income, which include nearly risk-free treasury bonds, non-speculative corporate bonds and certificates of deposit, or CDs.

Investment plans are usually used by more financially-sophisticated individuals, while the majority of the public with any levels of saving choose to invest through 401(k)s and IRAs because they heard about them on TV and radio or read about it in finance related magazines and online outlets. For anybody expecting to live through the retirement, it is a good idea to save money and especially use these financial instruments since they provide various benefits, such as being tax deferred, because it substantially helps the compounding effect over long period of time, contribution match by employer, and various options designed to make the decisions easier and more efficient (irs.gov).

The main problem with these investment tools is that the individual has to make investment decisions largely based on his own knowledge and it can be very challenging for somebody far from the financial industry. Financial literacy is not included in the school program, and not many people decide to learn it on their own due to the complexity of financial tools and mechanisms.

A majority of people have to make their financial decisions based on whatever information they can find online or from sources such as finance magazines and TV channels, without making proper due diligence themselves. The biggest problem with this is “herding,” when people think that some people have better understanding of where markets are going to move and get themselves caught up in economic bubbles. People who get into the economic bubble are likely to lose most of their money at the end, while enjoying the idea that they are much more wealthier, while it still growing, which leads to bias economists refer to as a “wealth effect,” and those people are more likely to consume much more than they usually would resulting in smaller savings in the future.

Psychological Biases

Everyone, from sophisticated financial professionals to someone far from the financial industry, can be affected by psychological biases. People with higher financial literacy are more likely to know what kind of psychological biases they have, and can more easily avoid basing their decisions on them. Some of the well-known biases are the endowment effect, loss aversion, and status quo bias (Kahneman, 161). The endowment effect is causing people to value something they already own more, than they would value the same thing before acquiring it. To give an example of that: some company came out with a new lineup of devices and priced them at $1000 each, which seemed very expensive to you for something with the functions it has. Next weekend while dining at your favorite restaurant, you got placed in the pool of possible winners for one of those devices just due to the reason that you went for dinner there that night. Your name was picked out during the drawing and now you own that new flashy device with market value of $1000. While it would be reasonable to sell this device the next day, since you didn’t value it at the market price, but most people would just keep it.

Loss aversion refers to people much stronger preference to avoid losses than acquiring gains (Kahneman, 165). Many people involved in stock markets have experienced it: you buy a stock of a company that just released new line up of devices and you expect their stock to rally. Some days later, reviews and polls started to be posted all over the web, that these devices don’t offer many new functions and that many people don’t think they should worth the price company asks for them. The price of the stock tumbles and worth much less than you paid for it. While it would be a smart idea to close on that position and move on looking for better investment opportunities, many people would keep the position in hopes it will go back up and they would be able to break-even.

Status Quo bias is referring to the idea that people like to stay in the same state of affairs as  they are right now, rather than make any changes (Kahneman, 169). Imagine you just got hired at the company that offers to opt-in and invest the percentage of annual salary towards the 401(k). It is a big pack of documents you have to read and there is just too many entertaining events going in around town. You forget about it for couple of months, or even years, and miss out on recent gains due to the strong performance of the stock market. You meet up with your friend for dinner and throughout dinner you exchange some recent news and it is revealed that he was hired around the same time as you, but his company enrolls all new employees into investing percentage of their salary towards the 401(k) and gives them an option to opt-out later. Without even moving a finger or giving it any thought, he enjoyed the recent rally in the stock market and offers you advice to opt-in as soon as you can.

There are many other psychological biases, but this three are more common and have been extensively researched. Psychological biases can lead people to make many questionable decisions about their finances and can lead people to be on the brink of poverty. Government has an ability to put regulations in place to require companies, that offer retirement plans to their employees, to make enrollment as a default option to improve household participation rate in financial markets and more people would be better prepared for their retirement.

Households that participate in financial markets are likely to become more interested in how they can maximize their returns if they would see growth of their retirement plans and try to become more financially literate. Childrens in financially literate households are also likely to be more financially literate later in their lives if their parents would talk about investments between each other and show better savings habits. Better savings habit and more financial literacy is more likely to lead to their children attending colleges, and as college graduates are tend to receive higher wages, it would lead to higher intergenerational mobility.

Social Welfare Programs

Social welfare programs are one of the most common ways that the government attempts to reduce income inequality. The main purpose of welfare is typically to ensure that lower income households can meet their basic needs. In order to receive welfare a person generally needs to provide evidence that their household is under the poverty level. There are six major welfare programs that the federal government uses to decrease poverty: Temporary Assistance for Needy Families, Housing Assistance, Security Income, Earned Income Tax Credit, Supplemental Security Income, and Medicaid (Amadeo).

Welfare can be a controversial issue but if it is to be used in a way that reduces income inequality than it should be used in the most efficient way possible. When deciding the recipients of welfare the government will give it to who needs the resources the most. Children and homes with children are often the most benefited by social welfare programs. This is not just because we as a society value the wellbeing of children more than adults but also because children have a larger chance of strengthening their financial situation. (Gayle, George-Levi, et al, 283)

During the early stages of a child’s life their development is affected by their environment. The inputs that a child receives in these crucial years will effect them for the rest of their lives. Exposure to learning early on in childhood creates value for skills acquired, which leads to an enhanced motivation to continue learning. When children become competent in their social and cognitive skills it re-affirms their desire to learn more, later in their childhood. When children acquire more cognitive skills they will be more willing to continue their education past adolescence. The confidence earned early on in a childhood will accrue, benefitting a person’s late-stage childhood and henceforth their adulthood. Which is why it is important to invest in a child’s education as early as possible with programs like Head Start and pre-K.  (Heckman)

We can predict the type of environment a child grows up in by looking at their parents financial situation. By assessing the families income we can also infer the cognitive abilities of a child. Children with wealthier parents will have more resources but also tend to place more value on early education. According to James Heckman a child who falls behind the curve when it comes to cognition might never catch up. In order to catch a child up to normal cognition levels in formative years it takes extra tutoring and schooling. (Heckman)

The purpose of Heckman’s article is to illustrate how effective social programs can be when implemented for children. When it comes to enhancing the cognition of children the success is related to how young the child is when they receive these benefits. The younger the child is, the better. Studies show that children that receive benefits in pre-school will have a much higher cognition rate than children that receive the same benefits during normal schooling. The opportunity cost of investing in younger disadvantaged children is much higher and leaves them with more human capital. (Heckman)

Minimum wage

In order to suppress the growing rate of income inequality some economists propose an increase in minimum wage. The conclusion on if a raise on minimum wage decreases inequality varies from model to model. Some economists believe that the convergence of wealth equality in an economy is minimally affected by minimum wage.  Several countries have seen a reduction in income inequality following an increase in the minimum wage. Although, it is not justifiable to imply a causality we can say that countries with a higher minimum wage tend to have less income inequality. (Heckman)

The marginal productivity theory of wage inequality states affirms that the reason for income inequality is the gap between skill level. People that have a higher skill level will have a higher level of income. By increasing the income of low skilled workers we are taking money away from one sector of the economy, generally purchasing power, and giving it to low skilled workers. In theory, this would decrease the disparity between low-skill and high-skill workers. However, most people that earn minimum wage are not household earners. Minimum wage earners are generally teenagers whose main resources are being supported by their parents. (Litwin)

There can be problems associated with lifting minimum wage, as most of people working for the minimum wage are in service industry, and it would affect the ability of business owners to run them at substantial level and might lead to loss of those jobs completely (U.S. Bureau of Labor Statistic, 2017). Therefore, it would be a good idea for legislators to make deep research and run different models to test their hypothesis for possible raise in the minimum wage before hand. It is important to set new minimum wage to the point it would benefit workers, rather than have disastrous impact on how many jobs will be available.

Another problem for workers with low-income in service industry is receiving “tips.” It allows their employers to reap higher benefits due to paying lower wages, and moving costs on to customers. There is a room for government to step-in and put more regulations in place to make these workers better off. For example, setting wages for certain jobs in the industry, since these workplaces wouldn’t be able to remove these positions. There are could be other problems that can arise: employers would try to give workers different titles, or include their responsibilities onto other workers such as kitchen stuff.

Residential Segregation

Residential Segregation is the physical separation of groups into different areas. Our society tends to organize itself into neighborhoods with separate levels of income. When a person is born into a low income area they are statistically likely to earn less over their lifetime. Conversely, when a person is born into a high income area they are more likely to be a high earner during their lifetime. One of the main reasons a child born into a low-income area will have a tough time increasing their income level is because of the lack of educational opportunities in a low income area.

One of the reasons that the public education system falls prey to residential segregation is because the public school system is funded by property tax. An area with high property value will contribute more to the local public school. This means that poverty stricken urban areas will be underfunded compared to high income earning areas.

A well funded school can provide services to children that an underfunded school cannot afford. A well-funded school can afford better, more experienced teachers. As well as programs to help kids with learning disabilities. More funding means that a school can have a lower teacher-to-student ratio. Meaning that students will be able to receive one-on-one help with teachers. Funding can also provide both facility and materials needed for education. In poor areas, schools with the most high-need students receive the least funding, meaning that poor students desperately miss out in the education they deserve. (Barrett, 2018)

The inequality of funding that public schools receive contributes towards a lower intergenerational mobility. Children that are born and grow up in poor areas are now exposed to poor education are are less likely to invest in their education in the future. If they don’t have the ability or incentive to further their education then statistically they will earn less in the future. Without training or education it is harder to leave the low income area or invest in the area. This creates a cycle of poverty within an area. Unless this area is gentrified it will likely remain low income. This residential segregation relates directly to income inequality. If the poor are unable to increase their financial situation and the middle class are able to attain higher education than income inequality is likely to rise. (Watson, 2009)

There are also other factors that come into play: widening income distribution can cause high and low income families to choose neighborhoods that are more similar to their current situation, which would induce the effect of low tax income towards educational system in low-income neighborhoods and higher tax income to high-income neighborhoods. (Watson, 2009)

-Example of increased education and how it helps

-How to help the education system

U.S. Department of Education published a report, in which it states that about 40% of schools in low-income districts don’t get a fair share of tax income into their budgets, while it is clear that those schools need funding more than schools in high-income districts to help their students to get a good education. These schools are likely to hire inexperienced teachers, since their wage is lower, and after those teachers receive more experience they are likely to change to a different school for higher wages (U.S. Department of Education).

There is a lot of room for government to step in and improve conditions in underfunded schools. For example, a big part of U.S. discretionary budget is allocated towards military, and a lot less towards education.

-build assets for working families

-Unions

An essential part of increasing a person’s ability to gain wealth is their ability to build assets. An example of asset building would be owning a home, saving for retirement or investing in a stock portfolio. These things are common to the middle class but they are necessary to creating a more prosperous future for an individual. Assets can provide security for an individual. Those without assets are one crisis away from a financial disaster. One-third of American families are considered to be asset-poor. Meaning that they would not be able to make it 3 months without receiving a paycheck. If you rent a home and have no savings than being let go from your job could have disastrous effects to your situation. This is how assets can act as a cushion during a hard financial time. Of course asset building is very hard for a poor family and a defining feature of poor versus middle class is the accumulation of assets. New legislature may be able to provide new opportunities for the poverty stricken to save and meet financial goals. (Lohmer, 2008)

In Hawaii, government officials are working on passing a series of five bills that will make it easier for the working class to save. These bills will inventise saving and reward work. The bills work be creating a state earned income tax credit that matches saving accounts. The bills would also allow taxpayers to receive a portion of their income tax credit directly into their savings. The rest of the bills are created in order to improve financial literacy and asset building education. (Lohmer, 2008)

Income inequality has been growing in Hawaii for a long time. Homelessness and poverty have long been a problem in Hawaii as well. Coupled with a high cost of living, Legislators are hoping that creating asset building incentives will help low-income households build a more stable and secure financial future. (Lohmer, 2008)

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