Absent Major Change, High Wealth Inequality Will Likely Remain the Norm

President Obama has claimed that income inequality is the “defining issue of our time.”

There is no doubt that income inequality is growing. A recent CBO report that traced market income (before taxes or government transfer payments) shows that 80 percent of U.S. households had a smaller share of market income in 2007 (before the Great Recession) than in 1979. Even the top 20 percent, taken as a whole, increased its share of market income by less than half a percentage point. The winners were the top 1 percent of earners. Their share of market income leaped from 10.5 percent in 1979 to 21.3 percent in 2007.

With changes like these in the distribution of the rewards of the American economy, the president and many on the left call for redistributing income from those at the top to those in the middle and bottom. But they seldom mention the extent to which income is already being redistributed by government action. In fact, the bottom 60 percent are already made better off by the tax and transfer system. According to the Congressional Budget Office, in 1979 households in the bottom 20 percent had only 2.9 percent of market income, but after government taxes and transfers (including the cost of health insurance) they had 7.1 percent of income, a boost of around 150 percent. In 2007 the tax and transfer system again more than doubled the share of income going to the bottom 20 percent, although the amount of redistribution was somewhat less than in 1979. Similarly, the tax and transfer system boosted the share of income going to households in the second and third quintiles in both 1979 and 2007. In 2007, even the fourth income quintile enjoyed a net gain of nearly 1 percentage point, going from 19.0 percent of market income to 19.9 percent of post-tax, post-transfer income.

By contrast, the top 20 percent and especially the top 1 percent of earners incurred major reductions in income after taxes and transfers in both 1979 and 2007. In 2007 for example, the top quintile’s after-tax, after-transfer income declined by about 12 percent, from 59.9 percent of market income to 52.7 percent after taxes and transfers. The reduction in market income by the operation of the tax and transfer system was even greater for households in the top 1 percent,about 27 percent in 1979 and about 20 percent in 2007. Thus, the impact of the government tax and transfer system is to take income from the top, especially the top 1 percent, and use it in part to increase the income of households in the middle and bottom. CBO estimates that about 60 percent of the equalizing effect was due to transfers and about 40 percent to taxes, both of which diminish income inequality.

There are no objective criteria for judging how much income redistribution government should aim to achieve through its tax and transfer programs. As a result, many or even most Democrats argue that the systems should transfer more income by imposing even higher taxes on the wealthy and providing even more transfer benefits to households in the middle and bottom of the income distribution. Republicans, however, argue that taxes are already too high and that there is already enough distribution of income.

For the foreseeable future, it seems unlikely that Democrats are going to get their way. The size and future growth of the federal government’s debt, although temporarily in decline as a national issue, is still a major problem and can be expected to return to prominence in the near future. Meanwhile, Republicans will continuously invoke the debt as a reason to observe the strict terms, especially regarding discretionary spending, of budget deals over the past four years. New spending is not in the cards. With Republicans now controlling both the House and Senate, it also seems unlikely that legislation to increase tax rates on the wealthy could be enacted.

If the nation is to make progress in reducing inequality and increasing opportunity, it will have to come primarily from two sources—more effective use of the resources now available to promote education and work, and a stronger commitment to education and work by individuals and families. It’s a two-way street. Education has always been a major key to economic mobility for individuals and demographic groups, but despite almost permanent reform since publication of the Nation at Risk report in 1983, schools are doing little to equalize opportunity across income groups. Recent research shows that children from poor and minority families come to school already behind their classmates from more affluent homes, and the schools actually increase these differences in achievement.

Inequality and poverty could both be substantially reduced if more adults were married and had two incomes, but the trends in declining marriage rates and growing rates of nonmarital births have been progressing for four decades with no reversal in sight.

Unless we can develop new and more effective programs to boost the education and skills of those in the bottom 40 percent of the income distribution or unless individuals and families can make better choices about their own education, work, and marriage, inequality will continue to be a major outcome of the American economy and government will be able to do little more than it is doing now to reduce it.