Tax carbon and consumption, not middle class income

U.S. President Joe Biden participates in a virtual Climate Summit with world leaders in the East Room at the White House in Washington, U.S., April 22, 2021. REUTERS/Tom Brenner
Editor's note:

This blog is the first in a series highlighting policy proposals from Richard Reeves and Isabel Sawhill’s 2020 A New Contract with the Middle Class.

On April 22, President Biden kicked off a virtual Leadership Summit on Climate by declaring that the U.S. will cut its global warming emissions in half by the end of the decade. This goal, as well as the summit, which included 40 world leaders, affirmed President Biden’s commitment to combatting climate change during his tenure. Another proposal at the core of Biden’s agenda is strengthening America’s middle class. In  A New Contract with the Middle Class, Richard Reeves and Isabel Sawhill argue for removing almost all income tax for the middle class, and recovering part of that lost revenue with a carbon tax and a progressive value-added tax (VAT). This policy would give the middle class a much-needed income boost while helping us reach our goal of reduced emissions.

The middle class is falling behind

The middle class has experienced much slower income growth than both the affluent (who have seen rising wages) and the poor (who have been helped by an expanded safety net). The household incomes in the middle 60 percent of the distribution have grown only about half as fast as those in the bottom and top 20 percent, once taxes and transfers are taken into account (Figure 1).

Middle Class income

Wages are the main source of income for middle-class families – more so than for the affluent, who get some of their income from capital, or for the poor, who receive a much higher share of their income from government transfers. But wage growth in the middle and bottom of the earnings distribution has been sluggish in recent decades. Even as wages picked up among the poor and the well-off in the recovery from the Great Recession, growth rates were much lower for middle-class workers – and that was before COVID-19 cratered the economy. Between 1979 and 2019, the middle income quintile experienced 6% median wage growth compared to 31% for the highest quintile during the same period.

Less upward mobility

Part of the American contract is that each generation will rise on the shoulders of the one before. But, as Richard Reeves and Isabel Sawhill argue in A New Contract with the Middle Class, this promise is not being fulfilled. Nine-in-ten Americans born in 1940 ended up richer than their parents; for those born in the 1980s, the number is 50 percent. About a third of the mobility drop can be explained by slower growth, but the rest is the result of rising inequality. People have noticed. Only about one-in-three U.S. citizens believe today’s children will be better off than their parents (and this was before COVID-19).

Fading American DreamFor the full selection of charts and figures, see A New Contract with the Middle Class.

Mobility during the working years has dropped, too. The chances of a middle-class earner (in deciles four through seven of the distribution) moving up to the top fifth of the earnings ladder, over a 15-year period, has dropped by 20 percent since the early 1980s.

So in recent decades, the American middle class has experienced slow income growth, near-stagnant wage increases, and declining odds of upward mobility. “Inequality is not a feeling; it is a fact,” argue Reeves and Sawhill. To help repair the economic contract with the middle class, they propose eliminating the income tax for most of the middle class.

Eliminate the income tax for middle class households and introduce a carbon tax

Given the economic trends described above, “the middle class deserves a tax cut.” Reeves and Sawhill propose eliminating income tax by raising the standard deduction for most middle-class families — specifically, any married couple making less than $100,000 a year or any single person making less than $50,000. This is an average tax cut of around $1,600 for middle-class families. It would also mean that for most Americans, “April 15 would be just another spring day,” as Columbia law professor, Michael Graetz puts it.

Taxes are important. They provide the resources for public goods to help those most in need and to invest in the future. Income tax accounts for about half of federal revenue. But some taxes are better than others. The burden should be shared fairly, and beneficial behaviors rewarded. To recover some of the lost revenue Reeves and Sawhill proposed two taxes in the Contract; one on carbon and one on consumption.

The carbon tax can help us better align our carbon emissions incentives as we work to combat climate change. It is estimated that a carbon tax starting at $25 a ton would generate roughly $1.4 trillion over a decade and cut emissions to about a quarter below 2005 levels. Some policymakers may be concerned about the distributional impact of a carbon tax given that low-income households tend to spend a larger share of their income on energy. To ensure that a carbon tax is progressive, Reeves and Sawhill propose pairing it with a household rebate targeted at low-income families, which can easily be covered by the large amounts of revenue generated by the tax. When thinking about the distributional impact of a carbon tax, it’s also important to note that there are health benefits accrued from reducing carbon emissions, and low-income households often disproportionately benefit from these health improvements. The health benefits from a reduction in air pollutants caused by a $25/ton carbon tax are in the order of 3,500 to 8,000 avoided cases of premature mortality and 90,000 cases of exacerbated asthma.

The second tax proposed is on consumption. A well-designed value-added tax (VAT) can both generate much-needed revenue and also be equitable. Reeves and Sawhill support a value-added tax (VAT) of 10 percent, which is about half the average rate in other OECD nations. As with the carbon tax, there are distributional concerns with a VAT. However, with a refundable tax credit for households and an exemption for small businesses, the VAT would still raise around $240 billion a year.

Build Back Better

Through a series of legislations, President Biden has shown that he is serious about his promise to build back better. The American Rescue Plan’s stimulus checks, expanded child tax credit, and expanded Earned Income Tax Credit will help middle class families recover from the COVID-19 recession. The $2 trillion infrastructure bill is a good second step toward strengthening the middle class and combatting climate change. Some have called the American Jobs Plan a “climate bill” for its emphasis on expanding clean energy. But Reeves and Sawhill believe their proposal in A New Contract with the Middle Class will help the US further curb its emissions and achieve its ambitious environmental goals. As our nation continues to rebuild from the devastating pandemic, they believe eliminating the income tax for most Americans and instead taxing carbon and consumption will help our climate and the middle class.