A new study from the Congressional Research Service concludes that keeping the tax rate on capital gains far lower than the taxes on regular income for the wealthiest taxpayers is the primary thing that is driving income inequality in this country. The abstract:
This paper examines changes in after-tax income inequality among tax filers between 1991 and 2006. In particular, how changes in wages, capital income, and tax policy contribute to changes in income inequality is investigated. To examine the role of these three possible contributors to the increase in income inequality, the Gini coefficient is decomposed by income source using the method developed by Lerman and Yitzhaki (1985). The Gini coefficient of after-tax income increased by 15 percent (0.071 points) between 1991 and 2006. By far, the largest contributor to this increase was changes in income from capital gains and dividends. Changes in wages had an equalizing effect over this period as did changes in taxes. Most of the equalizing effect of taxes took place after the 1993 tax hike; most of the equalizing effect, however, was reversed after the 2001 and 2003 Bush-era tax cuts. Similar results are obtained with other inequality measures.
And from the text of the study:
CBO (2011) has documented that income inequality has been increasing in the United States over the past 35 years. Several factors have been identified as possibly contributing to increasing income inequality. This paper examines changes in after-tax income inequality among tax filers between 1991 and 2006. In particular, how changes in wages, capital income, and tax policy contribute to changes in income inequality is investigated. During this period,
there were changes in the sources of income that differed by income category and there were many changes in tax policy…
Three potential causes of the increase in after-tax income inequality between 1991 and 2006 are examined in the analysis: changes in labor income (wages and salaries), changes in capital income (interest income, capital gains, dividends, and business income), and changes in taxes…
The role of capital income and capital gains has recently been thrust into the debate over increasing income inequality with the OccupyWall Street movement and proposed legislation to increase the tax rate on carried interests received by private equity managers. CBO (2011) documents the increased concentration of business income, capital income, and capital gains between 1979 and 2007.
Capital income has generally been concentrated among higher-income tax filers. Capital income can be capital gains, dividends, and business income from partnerships and S-corporations. The number of partnerships and S-corporations has steadily increased between 1991 and 2006. The number of partnerships increased by 1.4 million over this period and the number of S-corporations increased by 2.2 million.3 Income from these types of business is reported on an individual tax filer’s tax return and is not subject to the corporate income tax. An increasing share of income for high-income tax filers is from capital income, which could be part of the explanation for the rising income of this group of tax filers and rising income inequality.
And here’s the critical part. Because many forms of investment income are taxed as capital gains at 15% or, starting in 2013, at 20% for the top tax bracket — still half of what it would be if it were taxed as regular income — the wealthy investing class has arranged their finances so most of their income comes in the form that is taxed the least, as capital gains. In 1991, 92% of all income was taxable at the regular rate; in 2006, that was down to 77%.
A return to the tax pre-2011 tax rates would shift the burden and make our tax system ever so slightly more progressive. It would also reduce income inequality. But the most important thing we could do is tax capital gains at the same rate we tax other forms of income. That would make the tax code considerably more progressive, boost federal revenue, reduce the deficit and reduce income inequality.