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The Hidden Truth About Taxing the Wealthy

December 10, 2012 By Justin Caron, Fellow

Whether or not you’ve been closely following the back and forth of the negotiations over the fiscal cliff, you are probably familiar with the conservative resistance to taxing the rich. Fiscal conservatives have long held that taxing the wealthy is a recipe for economic disaster. However, as a recent report by the Congressional Research Service (CRS) shows, the evidence points to the contrary.

An uproar from conservative legislators eventually led to the report being pulled. Fortunately, it can still be found here. (pdf) The report concludes that changing the top tax rates not only “had little association with saving, investment, or productivity growth,” reductions in these rates have made a significant contribution to the growing concentration of wealth at the top of income distribution.

Since the end of the "Great Recession", the top 1 percent of earners have captured 93 percent of income gains in the first year of the U.S. economic recovery with subsequent years painting a similar picture. Put another way, the top 1 percent earns about one-sixth of all income while the top 10 percent earns roughly half. Additionally, the top 1 percent of households has more wealth than the bottom 90 percent.

These numbers reflect a trend in growing income disparity that began roughly during the economic downturn of the 1970s. Prior to that, post-war wages on the bottom were rising at a faster rate than those at the top.

A state-by-state analysis (pdf) from the Center on Budget and Policy Priorities has demonstrated that income inequality has grown in nearly every part of the country since the late 70s. While Minnesota fares better than most states on the issue (ranking roughly between 30th and 35th in the nation on various distributional comparisons), data show income disparity has still grown by a worrying amount.

As distasteful and unjust as this growing income disparity may be, what may be even more troubling is that, according to a growing body of research by the Brookings Institution, many top research universities and others, increasing inequality is also harmful to the economy. Last year, economists at the International Monetary Fund determined (pdf) that bolstering economic expansion and reducing inequality were likely “two sides of the same coin,” further stating that the severe income disparities in the United States could, over the long term, shorten the country’s economic growth by as much as a third.

A more recent study conducted by the Organization for Economic Cooperation and Development has pointed out the negative economic consequences of pay inequality and has suggested making substantial changes to taxation and spending policies to address the growing income gap.

Fueling this inequality is the decline in tax rates for the nation’s wealthiest individuals and households. According to the Congressional Budget Office, federal taxes in 2009 were at a 60-year low. As a matter of course, the term “tax rate” has traditionally referred to the average tax rate, or taxes as a share of total income. The broadest measure of the tax rate is calculated by dividing total Federal revenues by the country’s gross domestic product. In 2011, that number was 14.8 percent. By comparison, this is lower than the Reagan-era average of 18.2 percent, while the average since World War II stands at 18.5 percent.

All this lends credibility to the very reasonable policy prescription of a modest tax hike on the wealthiest earners in order to ease the country’s fiscal woes. It is also precisely what makes the CRS report so damaging to the conservative line on taxes and fiscal policy. Addressing structural inequality is more than an issue of fairness in taxation, it’s an economic necessity.

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