THE APPROPRIATE ROLES FOR EQUITY AND EFFICIENCY IN A PROGRESSIVE INDIVIDUAL INCOME TAX.

• Author: Repetti, James R.

1. INTRODUCTION 524 II. RISING INEQUALITY AND ITS SOCIAL AND POLITICAL IMPACT 528 A. Growth in Inequality 528 B. Social Welfare Impact of Inequality 539 C. Inequality's Threat to Democracy 549 III. THE ROLE OF FEDERAL TAXES IN INEQUALITY: THE DECLINE OF PROGRESSIVITY 557 A. The Decline in Progressive Rates 557 B. Taxes Reduce Inequality 562 C. Redistributive Spending as an Alternative to Progressive Taxation 564 D. Uncertainties in Using Equity to Structure a Tax 566 1. The Government-Benefits Principle 568 2. The Ability-to-Pay Principle 570 3. The Equal-Opportunity Principle 571 4. Summary of Uncertainties in Using Equity to Structure a Tax 575 IV. UNCERTAINTIES IN USING EFFICIENCY ANALYSIS IN TAX POLICY 575 A. Introduction to Efficiency 575 1. Measuring Efficiency: The Excess Burden 575 2. Uncertainties in Determining the Excess Burden 577 B. Illustrations of Uncertainty About the Efficiency Effects of Taxation 578 1. Impact of Taxation on Growth 578 2. Efficiency Effects of Taxation on Labor Supply 583 3. Efficiency Effects of Taxation on Income from Savings 589 C. Summary of Uncertain Efficiency Effects 595 V. CONCLUSION 596 "In moderate states, there is a compensation for heavy taxes; it is liberty. In despotic states, there is an equivalent for liberty; it is the modest taxes." --Montesquieu (1) I. INTRODUCTION

   Concerns about the harmful effects of inequality have dominated tax policy debates for decades. Attention has often focused on the appropriate role for the individual income tax in redressing inequality. But plans to use a progressive income tax to reduce inequality have often clashed with worries about economic efficiency (2) Many have asserted that high tax rates in a progressive system harm our economy by reducing labor supply and savings. (3) Over 30 years ago, Peter Kilborn stated in the New York Times:

   Beneath the current Washington debate over raising taxes lies a fundamental change in thinking about the Federal tax system. In most previous discussions, there was a strong emphasis on redistributing income from the well-off to the less well-off. But now, the tax system is being viewed as a tool to build a more efficient economy, not a fairer one. (4) This debate has high stakes. An efficient tax system can improve a nation's standard of living by ensuring that taxes do not harm welfare. At the same time, tax rate progressivity can make important contributions to the well-being of citizens by helping to reduce inequality.

   In general, individual tax rates have decreased over the past 60 years in an attempt to increase efficiency. In 1956, the maximum statutory tax rate was 91%. (5) In 2020, the maximum rate is 37% (40.8% including the 3.8% Medicare surtax on investment income). (6) At the same time that our country was reducing tax rates, inequality increased, fueled in part by the declining rates. (7)

   There are several explanations for the focus on efficiency Predictions of gains from efficiency appear more certain than gains from achieving equity through progressive tax rates. Efficiency gains seem quantifiable while equity gains appear intangible and unmeasurable. (8) In addition, many forms of distributive justice underlie tax equity, and not all forms require progressive tax rates. (9) It is not surprising, therefore, that efficiency analysis currently dominates the debate among politicians and lawyers about the appropriate level of rates. (10)

   As lawyers and policy analysts, we need to be very careful about how we use efficiency analysis as a tool. (11) Lawyers have become accustomed in the courtroom to challenging the conclusions of experts that are framed in numerical analysis. We have learned that assumptions that underlie the specification of variables in the model significantly affect the outcome. But many lawyers and policy makers have embraced economic efficiency as providing the best case for selecting one form of tax over another without critically assessing its shortcomings.

   This Article suggests that, at least in the case of the individual income tax, the perceived certainty of efficiency is false. Efficiency analysis suffers from empirical and theoretical uncertainty similar to equity analysis because, like equity analysis, efficiency analysis is rooted in human experience. The "efficiency" of a tax system frequently refers to its "excess burden," which reflects the decrease in utility attributable to behavioral changes that would not occur in a tax-less world. The magnitude of the presumed efficiency gains or losses are quantified only by estimating these behavioral changes.

   Once efficiency analysis is understood as based upon predictions of human behavior, its problems become apparent. While the concept of efficiency is deceptively simple (minimize the behavioral response to a tax), the design of tax systems that accomplish this is difficult because human behavior cannot be predicted as a matter of theory. Taxpayer responses to taxation are empirical questions, but the empirical analyses of actual taxpayer behavior are frequently contradictory.

   The result is a surprising amount of uncertainty about the efficiency effects of progressive tax rates in the individual income tax. The empirical evidence suggests that individual tax rates have had little or no impact on labor supply in the United States. In addition, empirical studies have failed to show a clear relationship between individual income taxation and savings. Many feel that the weight of evidence suggests that taxes do not affect savings, but more research is necessary before we can be confident about this assessment.

   In contrast to the uncertainty about the harmful effects of progressive tax rates, there is significant empirical evidence that high levels of inequality harm our health, social well-being, political process, and intergenerational mobility.

   The clear harms from inequality and the uncertain harms arising from progressive tax rates, strongly support always giving equity at least equal weight with efficiency in formulating tax policy. But given the high level of inequality in the United States and the currently low and flat tax rate structure, equity should be given more weight than efficiency at this time.

   This Article proceeds as follows. Part II discusses various measures of inequality in the United States and the strong empirical evidence for the significant social and political problems associated with inequality. Part III then discusses evidence showing the extent to which reductions in tax rate progressivity have exacerbated inequality and explains that the ambiguous nature of various theories of tax equity may account for the reduced focus on tax progressivity. Part IV then explains, however, that many uncertainties also exist about the efficiency gains often attributed to reduced tax rates in an individual income tax. It notes that economists generally agree that individual income taxes do not reduce labor supply and that economists cannot agree whether taxes reduce savings, increase savings, or have no effect. Part V concludes the Article, observing that the empirical evidence for the harms attributable to inequality are much stronger than the empirical evidence about the harms from a progressive income tax. As a result, equity should always be given at least the same weight as efficiency But, at this particular time, policymakers should give equity more weight than efficiency given the currently high level of inequality in the United States and the currently low and flat tax rate structure.

2. RISING INEQUALITY AND ITS SOCIAL AND POLITICAL IMPACT

   1. Growth in Inequality

      One of the traditional roles of a progressive individual income tax has been to decrease inequality, (12) as well as to collect large amounts of revenue. (13) Inequality can be measured using income or wealth. Most data show that inequality has been growing in the United States. (14) The extent of the increases, however, has recently become the subject of heated debate. A recent article in The Economist stated: "Few dispute that wealth shares at the top have risen in America, nor that the increase is driven by fortunes at the very top, among people who really can be considered an elite. The question, instead, is by just how much." (15) This Part IIA describes some measures of the increases in inequality that have occurred in the past several decades. Part II.B then discusses the empirically quantified harms attributable to inequality.

      The studies that examine the rates of growth in income for the various percentile groupings of income generally show increased inequality. The most recent 2019 study by the Congressional Budget Office (CBO) compared the growth in household income before taxes and government transfers during the period 1979 through 2016. (16) The CBO found that real (inflation-adjusted) income of the top one percentile of households (ranked by their income) before taxes and government transfers grew by 218% from 1979 through 2016, while the lowest quintile and the middle three quintiles grew by only 33%. (17) The following CBO chart illustrates this development:

      The differences in cumulative growth after transfers and taxes for the various quintiles were not as large due to the ameliorative effects of transfer payments and taxes. The CBO found that the income after transfers and taxes grew by 226%) for the top one percentile of households ranked by their income, by 47% for the middle three quintiles and by 85%o for the lowest quintile. (19)

      The magnitude of the estimates, however, have to be viewed cautiously because there is significant variation among studies about the extent of growth rates. For example, a recent literature survey observed that while the CBO calculated that median income in the U.S. grew by only 51% during the period 1979-2014 (compared to 221% for the top one percentile), (20) five other studies estimated changes in median income ranging from a decrease of 8% to an increase of 37%...