Introduction

This
literature review essay will be on the subject of taxation and income
inequality with respect to the United States. A closer look will be taken at
the United States taxation system and at the income inequality. Both of these
topics have been topics in recent years. The topic of the taxation system has
been heavily discussed by many parties. A common critique is the tax avoidance
by big companies. The second topic of this essay is the income inequality
within the United States. Terms such as the top 10% or 1% are often used to
describe the inequality within the United States. According to a study done by
Thomas Pikkety and Emmanuel Saez (2017), the top 10% earned 50% of all income
and the top 1% earned 20% of overall income. These numbers are from 2012. In
the same study it also says that the distribution of the United States is relatively
more unequal than other comparable economies such as the United Kingdom and
Germany. There is now also a new documentary brought out in 2017 that is called
Saving Capitalism where income inequality in the United States is an important
topic. There is little room for argument that both of these topics are relevant
in this time. I want to bring these topics together and take a closer look at
if there is a connection between the two. My research question therefore is: In
what way does the United States tax system contribute to wealth inequality in
the United States? Note that this question does not have the assumption that
there is a contribution. To research this question I will be needing more
background information on the principles of taxation (to later compare the tax
system to the principles and then to income inequality), more information on
the United States tax system and income inequality in the United States. This information
will be given in the theoretical framework. After the theoretical framework I
will answer my research question and then give my opinion on the tax system and
suggestions as how to improve the system.

Theoretical framework

Principles of taxation

Public
spending by the government requires taxation. It is therefore important that
these costs of taxation are minimized. With this in mind, there is a framework
that can be used to judge a tax system (Mirrlees et al., 2011). A tax system
should reach for a number of targets. The first target is that the unfavorable
effects of a tax system on the welfare and efficiency of an economy should be
minimized. The second target is regarding the administration of the taxes. The
administration should not be unnecessarily costly. A system with low
administration costs is better than one with higher costs. The third target
that should be reached for is fairness. In this context fairness means that
there isn’t any discrimination in procedures and that the appropriate
expectations are fair. The fourth target is transparency. A tax system that is
understandable for the public is preferred over one that isn’t. These targets
can be simplified into three words: simple, neutral and stable, as opposed to
complex, non-neutral and often changing systems.  

 

American tax system

The
economic definition of tax progressivity is when the tax rate increases as the
income or asset also increases. As opposed to a regressive tax rate; where the
tax rate decreases when the income or asset increases. There is also a flat tax
rate. A flat tax rate is a tax rate that is constant and is not influenced by
an increase or decrease in income. A flat tax rate of 20% means that every
person pays 20% of their income as tax, no matter if you earn 10.000 euro a
year or 100.000.

According
to Carbaugh and Ghosh (2011), the idea of tax progressivity has been supported
by economists and scientists from different ideologies. Supporters of
progressivity say that it allows for a maximum amount of tax to be collected
with a minimum amount of protest. This is because of the diminishing marginal
satisfaction of money meaning the more money a person has, the less
satisfaction an additional dollar has. Supporters of progressivity also argue
that a progressive tax rate reduces income inequality.

In the
United States, tax is levied on income, sales, property, payroll and import. There
have been six major tax reforms in the past 30 years, the last one being in
2005. There have been signs of people wanting a new tax reform to adapt to
globalization. Individuals, corporations, households and trusts have to pay
income tax in the United States tax system. Taxable income in the United States
is calculated by taking the gross income and subtracting exemptions and deductions
and personal exemptions (Pomerlau, 2016). Table 1 below consists of the tax
brackets for single taxable income in 2015.

Table 1

Rate

Taxable income
Bracket

Tax Owed

10%

$0 to $9,225

10% of taxable
income

15%

$9,225 to $37,450
 

$922.50 plus 15% of the excess over $9,225

25%

$37,451 to $90,750

$5,156.25 plus 25% of the excess over $37,450

28%

$90,751 to $189,300

$18,481.25 plus 28% of the excess over $90,750

33%

$189,301 to $411,500

$46,075.25 plus 33% of the excess over $189,300

35%

$411,501 to $413,200
 

$119,401.25 plus 35% of the excess over $411,500

39,60%

$413,201 +

$119,996.25 plus 39.6% of the excess over $413,200
 

 

The United
States tax system is one of many deductions, credits and loopholes. The income
tax brackets alone are not enough to judge the tax system on its progressivity.
It is important to define what exactly tax avoidance is and to separate its definition
from tax evasion. Tax evasion is intentional fraudulent behavior and is a
criminal offence, it is illegal. On the other hand, tax avoidance is legal and
is not a criminal offence. This is the most important difference between tax
avoidance and evasion. Tax avoidance is a reduction of the liability of the
taxpayer within the law (Dunbar, 2010).  

The United
States government uses the term ‘tax expenditures’ instead of tax avoidance. A
tax expenditure is a decrease in a taxpayer’s burden, these can be exemptions,
deductions and credits (Cole, 2015). Tax expenditure and tax avoidance have a
very similar definition, the biggest difference is that tax avoidance has a
negative connotation and is therefore often used to criticize. Tax expenditures
has a more neutral connotation.

To get a
better idea of the progressivity of the United States tax system, it is useful
to look at the average tax rate by income percentile. The data is given by the
IRS, the Internal Revenue Service.

Graph 1

 

Wealth inequality in the United States

In 2016,
Emmanuel Saez and Gabriel Zucman have concluded that wealth inequality in the
United States is relatively high compared to other countries and that it has
been growing since the 1970’s. In their research they have discovered two
trends with respect to income inequality. The first trend is that the top 0,1%
has enjoyed the most growth compared to other income percentiles. Where in the
late 1970’s their income share was 7%, in 2012 it was 22%. The second trend is
a so called U-turn in middle class wealth. The share of income owned by the
middle class increased until it hit its peak in the mid-1980’s. Since then it
has only declined. The wealth owned by the middle class today is the same as 70
years ago.

Graph 2

Using the
graph we can see the inequality of wealth quite clearly. The y-axis is the
share of total wealth and the x-axis is the share of household population
grouped by household income. Using the graph it can be seen that the top 1% of
the population (with the highest income) have 35,5% of total wealth and that
the lowest 20% have a share of -0,50% of total wealth. -0,50% is negative because
the lowest 20% of the population owe more than they own.

Progressivity and inequality

Discussion

In the
discussion section of this essay a provisional answer will be formulated to the
central research question. Afterwards it will be explained why the answer is
only provisional and what the limitations of this research are. Suggestions
will be made for future research and considering the limitations a hypothesis
will be formulated. Finally, there will be a suggestion for improvement of the
United States tax system based on a comparison with the basic taxation
principles as discussed in the theoretical framework.

The
research question of this essay is: In what way does the United States tax
system contribute to wealth inequality in the United States? A provisional
answer to this question can be formulated by using table 1, graph 1 and graph 2.
Table 1 shows that taxable income in the United States is progressively taxed; the
tax rate is higher if you are in a higher income bracket. At first sight this
information would give the answer that the tax system is contributing to wealth
equality instead of inequality, because the tax rate increases when income increases.
However this answer does not take into account the tax expenditures, also known
as exemptions, deductions and credits. These lower the taxable income
ultimately leading to having to pay fewer taxes.

 

 

Top 1%

Top 5%

Top 10%

Top 25%

Top 50%

Gross income split point 2015

$480,930

$195,778

$138,031

$79,655

$39,275

Table 2

The effect
of the tax expenditures can be estimated by comparing the tax rates listed in
table 1 to the average tax rates from graph To illustrate: table 2 shows that
to belong in the top 1%, a person must have an annual income of $480,930 or
higher. The average tax rate of a person with an income of $480,930 is 30.52%,
according to the tax brackets in table 1. The tax rate of people with an income
of $480,930 or higher is therefore at least 30.52%. In graph 2 it is shown that
the top 1% had an average tax rate 27.44%, which is lower than the tax rate
they were supposed to pay according to the tax brackets. This means that there
were tax expenditures that lowered the actual tax rate for the top 1%. Doing
the same calculation for the top 25% gives that the average tax rate of a
person with an income $79,655 or higher should be at least 19,74% according to
the tax brackets (table 1). When the tax rate in reality was 18% (graph 1).
This means that also for the top 25% there were tax expenditures that lowered
the actual tax rate. However this decrease in tax rate of (19,74-18) 1,74% is
lower than the decrease in tax rate for the top 1%, which is (30,52-27,44)
3,08%. This could be an indication that the tax expenditures (exemptions,
deductions and credits) favor the richer because 3,08>1,74. The reason why
this part of the answer is provisional is because it only compares two of the groups,
the top 1% and top 25%. More data from more groups need to be compared to reach
a complete answer. If then is found that the decrease in actual tax rate
increases as income increases, it can be said that the tax expenditures
contribute to income inequality. This is due to the fact that the richer have a
bigger advantage from tax expenditures than the poorer.

The second
part of the answer can be derived from graph 1. It shows that the tax rate
increases until it reaches the top 0,01% and top 0,001% income percentiles. The
tax rate is progressive up until this point. After that the tax rate actually
decreases and is therefore degressive, meaning that the higher the income, the
lower the tax rate. The top 0,001% have a tax rate of 23,93% which is slightly higher
than the top 5%, which have a tax rate of 23,68%. Because tax progressivity reduces
income inequality (Duncan and Peter, 2016), and because part of the United
States tax system is not progressive for the higher income percentiles (top
0,01% and 0,001%), it can be said that the tax expenditures for the higher
income percentiles (top 0,01% and 0,001%) do contribute to income inequality.
This part of the answer is also provisional because it can only be said with
certainty about the top 0,01% and top 0,001%. As mentioned before, more data
from more groups needs to be gathered and analyzed before the remaining part of
the United States tax system can be judged on progressivity and thus income
inequality.

Hypothesis

Based on
the provisional answer given above, a hypothesis can be formed.  The expected answer, or hypothesis to the
question: In what way does the United States tax system contribute to wealth
inequality in the United States?, is that the United States tax system does
contribute to wealth inequality within the country. This contribution happens
in a way where tax expenditures get more beneficial for the people with higher
incomes.

Opinion

For this
part of the essay a suggestion for a better tax system will be made using the
basic taxation principles and targets mentioned in the theoretical framework.
The targets that should be strived for are efficiency, administrative simplicity,
fairness and transparency. The United States tax system is not efficient because
of the consecutive changes that were made to the system and the continuing need
to change certain elements of the system. Improving this element is challenging
because there is a trade-off between redistribution and efficiency (Mirrlees,
2010). Regarding the second target, administrative simplicity, the United
States tax system is very complex. This is because of the many rules that apply
on different levels, federal, state and local (Dumiter, Berlingher, Opret &
Todor, 2016). Simplifying the system can be done by a better consolidation of labor
and wealth tax rates.  The third target,
fairness, is more difficult to judge. Fairness in the sense of wealth redistribution
is subjective to personal political beliefs and ideology and therefore has no
place in this essay. However, fairness in the sense of horizontal equity can be
improved. Horizontal equity is the concept that people with a similar income are
supposed to pay the same amount of taxes. The fourth target, transparency, can
be judged however. The tax system is not as transparent as it can be because
tax provisions have made it harder for taxpayers to understand how their tax
liability is determined. On top of that there is little explanation for the
reasoning behind the tax rules and it is unclear what other taxpayers have to
pay (Holtzman, 2007) .

 

 

 

 

References

https://www.washingtonpost.com/opinions/of-course-the-us-tax-system-is-broken-heres-how-to-fix-it/2017/05/05/401058aa-1d60-11e7-ad74-3a742a6e93a7_story.html?utm_term=.6f43e7f3d93e

https://finance.yahoo.com/blogs/the-exchange/u-tax-system-messed-174733252.html

2017 Tax Brackets

https://blackboard.uva.nl/bbcswebdav/pid-6946022-dt-content-rid-11564050_1/courses/2410E001.6011P0212Y.S1.EX00.2017/0.%20Mirrlees%20-%20The%20economic%20approach%20to%20tax%20design%20h2.pdf

https://www.degruyter.com/downloadpdf/j/jles.2016.17.issue-31/jles-2016-0001/jles-2016-0001.pdf

http://web.a.ebscohost.com.proxy.uba.uva.nl:2048/ehost/pdfviewer/pdfviewer?vid=1&sid=4b922e58-9bef-4f10-9186-812764a7c4e0%40sessionmgr4007

Dunbar: tax
avoidance http://heinonline.org.proxy.uba.uva.nl:2048/HOL/Page?handle=hein.journals/corbus12&id=69&collection=journals#

Alan Cole corporate tax and individual tax
expenditures: ttps://files.taxfoundation.org/legacy/docs/TaxFoundation_FF476.pdf

Wealth inequality in the United States since
1913: https://watermark.silverchair.com/qjw004.pdf?token=AQECAHi208BE49Ooan9kkhW_Ercy7Dm3ZL_9Cf3qfKAc485ysgAAAaIwggGeBgkqhkiG9w0BBwagggGPMIIBiwIBADCCAYQGCSqGSIb3DQEHATAeBglghkgBZQMEAS4wEQQMGatNffld_98xPY6jAgEQgIIBVQoUEKscx4kT-F5a_sUpKc53vUme4464NxJEZajqId6Q7F0aOrg7TeRPhcAenVyRKYJjU1A4nJVILBW4FCm-l6N2y7pAUnBrZn_2Vkjxxqa9Rkz_L9J6OkXSP2jwmgNMFu25c2rErKi65BkBGj03B2wT8S_IGuj5LK2IA43a-RFxxotPCZQXpyZ4gVWjCLXJzYyTSe61P4nk0Nf_VuxoazRHQ_x6uI1rORuL1GvAr29tAghp5B3exg9HokJP8QmSqqSaHGHOXQerhyVUKws4Mfy9r1xsWZ1CqVKYOzSkpZZ-nOgkFTDFsDWD-k3A1XaXlKHo496o9taV6b2kGg1YrcPKyHQqrT8hxbJFRnhqyoqYvaZqFUFr2aZLcU5206XCdpedNeaezCJtvoLhgu5p4b5H-_xrUhcwIns4t0hsPQfYafG3sNAIdwBF0uSpZNnfLHZQlRTx

Wealth inequality graph: https://www.statista.com/statistics/203961/wealth-distribution-for-the-us/

IRS Document

Income spit point: https://taxfoundation.org/summary-federal-income-tax-data-2017/

Relation progressivity and inequality: https://link-springer-com.proxy.uba.uva.nl:2443/content/pdf/10.1007%2Fs10797-016-9412-5.pdf

Challenges
in achieving transparency, simplicity and administering of the United States
tax code: http://www.emeraldinsight.com.proxy.uba.uva.nl:2048/doi/pdfplus/10.1108/02621710710748257