Income gap, tax policy closely linked

People are becoming increasingly aware of the income gap – the growing spread between incomes at the top and the bottom.

Proposed solutions range from levying a higher income tax on the wealthy to raising the minimum wage to doing nothing in the belief the market take care of the problem.

The gap would be even wider without the effect of the tax system, according to a new study by Federal Reserve economists.  It focuses on the federal and state income tax and levies on consumer purchases.

Income taxes are usually designed to impose higher rates on upper income people, those with the ability to  contribute to government revenues, and lower rates on people with modest incomes, whose ability to contribute is limited.

The study finds that federal taxes cushion the impact of the growing income gap while state taxes on average make the gap even greater.  But the performance varies from one state to another.

Without a sales tax, much of the effect of federal taxes on households comes from work-related taxes.  Lower income people may pay little or no income tax, though they are likely to pay payroll and gasoline taxes.  The Earned Income Tax Credit, which can be paid to lower wage workers, also cuts the gap.

At the state level, both income and sales taxes affect the gap, as does the gasoline tax.  Some states, including Maine, have their own EITC.

State tax systems provide greatly varying results.  At one end is Minnesota, which increases by more than 18 percent the federal tax effect in compressing the income gap, and at the other is Tennessee, which counteracts the federal gap-narrowing effect by 33 percent.

Maine adds 3.5 percent to the federal gap reduction effect.  One positive aspect of the Maine system, 

according to the study, is that food is not subject to the sales tax.  Exempting clothing would also reduce the gap as it does in some states.

Perhaps the most significant tax falling more heavily on lower income people than the wealthy is the gasoline tax.  Like food, gasoline can be a necessity of life.

Interestingly, the increase in upper end incomes has some influence on reducing the gap.  As more people move into the top federal tax bracket thanks to their gains, they pay a higher percentage of their income in taxes.

The tax system could have an even more significant effect on reducing the income gap.  At the federal level, the income tax on the wealthiest could be increased.  French economist Thomas Piketty, one of the most well-known experts on the gap, advocates a drastic levy at the top. 

Investor Warren Buffett, one of the wealthiest people in the world, favors increasing the EITC, which would bring up the bottom and, because it is paid to workers, would encourage people to seek employment.  He opposes merely increasing the minimum wage, which he says would cut employment.

Some current proposals to modify the income tax would have the effect of increasing the gap   between lower income people and those at the top.  Abolishing the income tax, as proposed by Maine Gov. Paul LePage, would clearly increase the income gap.  State taxes do that in all nine states that have no general income tax. 

While eliminating the income tax may have little effect on those at the bottom end of the income scale, who pay little even now, it would allow incomes of those at the top to increase.

Even the seemingly more modest proposal to impose a so-called “flat” tax, under which the same rate applies to all, would have a similar effect.

Are there possible changes to federal and state taxation, even without increasing the rates, that could have a more impact on reducing the income gap?

At the federal level, a tough reform of loopholes, so-called tax expenditures, could have a major effect.  The more they are eliminated, the more the wealthy pay, but it might even be possible to lower everybody’s income tax rates.  

That’s less drastic than Piketty’s proposal, but would have a somewhat similar effect.  But reform discussions now seem to focus more on rates than on the loopholes protected by well-funded lobbyists.

Right now, none of the states without an income tax offers workers an EITC.  Without imposing a new income tax, they could cut the gap by adding such help for lower income workers.

Sales tax exemptions for non-essential items could be eliminated in many states.  And states tagging onto the federal system could close some of its loopholes.  Both could be done in Maine.