The Redistribution Fallacy

The Redistribution Fallacy

By James Piereson
September 1, 2015
Commentary Magazine



Hillary Clinton launched her presidential campaign last spring by venturing from New York to Iowa to rail against income inequality and to propose new spending programs and higher taxes on the wealthy as remedies for it. She again emphasized these dual themes of inequality and redistribution in the “re-launch” of her campaign in June and in the campaign speeches she delivered over the course of the summer. Clinton’s campaign strategy has been interpreted as a concession to influential progressive spokesmen, such as Senators Elizabeth Warren and Bernie Sanders, who have loudly pressed these redistributionist theCmes for several years in response to the financial meltdown in 2008 and out of a longstanding wish to reverse the Reagan Revolution of the 1980s. In view of Clinton’s embrace of the progressive agenda, there can be little doubt that inequality, higher taxes, and proposals for new spending programs will be central themes in the Democratic presidential campaign in 2016.

The intellectual case for redistribution has been outlined in impressive detail in recent years by a phalanx of progressive economists, including Thomas Piketty, Joseph Stiglitz, and Paul Krugman, who have called for redistributive tax-and-spending policies to address the challenge of growing inequalities in income and wealth. Nobel Laureate Robert Solow, of the Manhattan Institute of Technology, put the matter bluntly last year in a debate with Harvard’s Gregory Mankiw, saying that he is in favor of dealing with inequality by “taking a dollar from a random rich person and giving it to a random poor person.”

Public-opinion polls over the years have consistently shown that voters overwhelmingly reject programs of redistribution in favor of policies designed to promote overall economic growth and job creation. More recent polls suggest that while voters are increasingly concerned about inequality and question the high salaries paid to executives and bankers, they nevertheless reject redistributive remedies such as higher taxes on the wealthy. While voters are worried about inequality, they are far more skeptical of the capacity of governments to do anything about it without making matters worse for everyone.

As is often the case, there is more wisdom in the public’s outlook than in the campaign speeches of Democratic presidential candidates and in the books and opinion columns of progressive economists. Leaving aside the morality of redistribution, the progressive case is based upon a significant fallacy. It assumes that the U.S. government is actually capable of redistributing income from the wealthy to the poor. For reasons of policy, tradition, and institutional design, this is not the case. Whatever one may think of inequality, redistributive fiscal policies are unlikely to do much to reduce it, a point that the voters seem instinctively to understand.

One need only look at the effects of federal tax-and-spending programs over the past three and a half decades to see that this is so. The chart opposite this page, based on data compiled by the Congressional Budget Office, displays the national shares of before- and after-tax income for the top 1 and 10 percent of the income distribution from 1979 through 2011, along with the corresponding figures for the bottom 20 percent of the income distribution. For purposes of this study, the Congressional Budget Office defined income as market income plus government transfers, including cash payments and the value of in-kind services such as health care (Medicare and Medicaid) and cash substitutes such as food stamps. The chart thus represents a comprehensive portrait of the degree to which federal tax-and-spending policies redistribute income from the wealthiest to the poorest groups and to households in between.

The chart illustrates two broad points. First, the wealthiest groups gradually increased their share of national income (both in pre- and after-tax and transfer income) over this period of more than three decades. Second, and more notable for our purposes, federal tax and spending policies had little effect on the overall distribution of income.

Across this period, the top 1 percent of the income distribution nearly doubled its share of (pre-tax and transfer) national income, from about 9 percent in 1979 to more than 18 percent in 2007 and 2008, before falling back after the financial crisis to 15 percent in 2010 and 2011 (some studies suggest that by 2014 it was back up to 18 percent). Meanwhile, the top 10 percent increased its share by one-third, from about 30 percent in 1979 to 40 percent in 2007 and 2008, before it fell to 37 percent in 2011. Through all this, the bottom quintile maintained a fairly consistent share of national income.

Many will be surprised to learn that the federal fiscal system—taxes and spending—does not do more to reduce inequalities in income arising from the free-market system. Yet there are perfectly obvious reasons on both the tax and the spending side as to why redistribution does not succeed in the American system—and probably cannot be made to succeed.

The income tax yields revenues to the government through two main sources: progressive taxes on ordinary income (salaries and wages) and taxes on capital gains (with the latter taxed at somewhat lower rates to encourage investment). For most of this period, taxes on capital gains have yielded less than 10 percent of total income taxes and about 4 percent of total federal revenues. In terms of the income tax, most of the action is in taxes on ordinary income.

The highest marginal income-tax rate oscillated up and down throughout the 1979–2011 period. It began in 1979 at 70 percent during the Carter presidency. It fell first to 50 and then to 28 percent in the Reagan and Bush years. It rose to 39.6 percent in the 1990s under the Clinton presidency, and went down again to 35 percent from 2003 to 2010. It is now back up to 39.6 percent. The highest rate on capital gains moved within a narrower band, beginning at 28 percent in 1979 and falling as low as 15 percent from 2005 to 2011. The highest rate is currently 23.8 percent.

Over this period, regardless of the tax rates, the top 1 percent of the income distribution lost between 1 and 2 percent of the income share after taxes were levied. In 1980, that group claimed 9 percent of before-tax income and 8 percent of after-tax income. In 1990, the figures were 12 percent before tax and 11 percent after tax. In 2010, the figures were 15 percent before and 13 percent after.

The top 10 percent of the income distribution generally lost between 2 and 4 percent of its income share after taxes were levied. That is probably because those households take a greater share of their income in salaries rather than capital gains compared with the wealthiest Americans.

At the other end, the poorest quintiles gained almost nothing (about 1 percent on average) in income shares due to cash and in-kind transfers from government. In 2011, for example, the poorest 20 percent of households received 5 percent of (pre-tax) national income, and 6 percent of the after-tax income.

Many in the redistribution camp attribute this pattern to a lack of progressivity in the U.S. income-tax system; a higher rate of taxation on the wealthy should solve it, they think. But the United States is already a highly taxed country with a highly progressive tax rate. Indeed, income taxes in the United States are at least as progressive as those in many other developed countries. The highest marginal rate in the States was 35 percent, from 2003 to 2012; today it is 39.6 percent for top earners—not far out of line with those of America’s chief competitors, including Germany, France, the United Kingdom, and Japan, where the highest marginal rates range between 40 and 46 percent.

A 2008 study published by the Organization for Economic Cooperation and Development found that the United States had the most progressive income-tax system among all 24 OECD countries measured in terms of the share of the tax burden paid by the wealthiest households. According to the Congressional Budget Office, the top 1 percent of earners paid 39 percent of the personal income taxes in 2010 (while earning 15 percent of the country’s overall before-tax income) compared with just 17 percent in 1980 and 24 percent in 1990. The top 20 percent of earners paid 93 percent of the federal income taxes in 2010 even though they claimed 52 percent of before-tax income. Meanwhile, the bottom 40 percent paid zero net income taxes—zero. For all practical purposes, those in the highest brackets already bear the overwhelming burden of federal income tax, while those below the median income have been taken out of the income-tax system altogether.

There is a more basic reason that the tax system does not do more to redistribute income: The income tax is not the primary source of revenue for the national government. In 2010, the federal government raised $2.144 trillion in taxes, with only 42 percent coming from the individual income tax. Forty percent came from payroll taxes, 9 percent from corporate taxes, and the rest from a mix of estate and excise taxes. Since the early 1950s, the national government has consistently relied upon the income tax for between 40 and 50 percent of its revenues, with precise proportions varying from year to year due to economic conditions. For several generations, progressive reformers have looked to the income tax as the instrument through which they aimed to take resources from the rich and deliver them to the poor. But in reality, in the United States at least, the income tax is not a sufficiently large revenue source for the national government to do the job that the redistributionists want it to do.

And here’s the rub: Payroll taxes fall more heavily upon working- and middle-class wage and salary income earners than upon the wealthy, whose incomes come disproportionately from capital gains or whose salaries far exceed the maximum earnings subject to those taxes. In 2010, the wealthiest 1 percent paid 39 percent of income taxes but just 4 percent of payroll taxes. The top 20 percent of earners paid 93 percent of the nation’s income taxes but just 45 percent of payroll taxes. Meanwhile, the middle quintile paid 15 percent of all payroll taxes—but just 3 percent of income taxes. In other words, the more widely shared burdens of the payroll tax tend to mitigate the progressive effects of the income tax.

An increase in the top marginal tax rate from 39.6 to, say, 50 percent might have yielded around $100 billion in additional revenue in 2010.(This assumes no corresponding changes in tax and income strategies on the part of wealthy households and no negative effects on investment and economic growth, which are risky assumptions.)

That would have been real money, to be sure, but it would have represented only about one half of 1 percent of GDP (using 2010 figures) or less than 3 percent of total federal spending. This would not have been enough to permit much in the way of redistribution to the roughly 60 million households in the bottom half of the income scale.

Turning to the spending side of fiscal policy, we encounter a murkier situation because of the sheer number and complexity of federal spending programs. The House of Representatives Budget Committee estimated in 2012 that the federal government spent nearly $800 billion on 92 separate anti-poverty programs that provided cash assistance, medical care, housing assistance, food stamps, and tax credits to the poor and near-poor. The number of people drawing benefits from anti-poverty programs has more than doubled since the 1980s, from 42 million in 1983 to 108 million in 2011. The redistributive effects of these programs are limited, however, because most funds are spent on services to assist the poor and only a small fraction of these expenditures are distributed in the form of cash or income.

As it turns out, most of the money goes not to poor or near-poor households but to providers of services. The late Daniel Patrick Moynihan once tartly described this as “feeding the horses to feed the sparrows.” This country pays exorbitant fees to middle-class and upper-middle-class providers to deliver services to the poor.

Why have matters devolved in this way? The American welfare state was built to deliver services rather than incomes in part because the American people have long viewed poverty as a condition to be overcome rather than one to be subsidized with cash. Many also believe that the poor would squander or misspend cash payments and so are better off receiving services and in-kind benefits such as food stamps, health care, and tuition assistance. With regard to aid to the poor, Americans have built a social-service state, not a redistribution state.

Social security is the only substantial federal program that transfers money income from one group to another, in this case from workers and employers to retirees. It is by far the largest of all federal programs, claiming $850 billion—24 percent—of the federal budget in 2014. It is paid for by a payroll tax split equally between employees and employers. As of 2014, about 59 million Americans were collecting benefits under Social Security, with an average benefit of $1,260 per month. Social Security has a progressive benefit formula and contains a feature (Supplemental Security Income) that provides cash benefits to elderly, blind, or disabled persons with incomes below the poverty line. Nevertheless, in spite of these features, it was designed to provide income for retirees, not to redistribute income from the wealthy to the poor, and it continues to function in this way.

The National Bureau of Economic Research has concluded that the program transfers income in various complex ways but does not transfer it from the rich to the poor. As one NBER study bluntly stated: “Social Security does not redistribute from people who are rich over their lifetime to those who are poor. In fact, it may even be slightly regressive.” This is partly because wealthier recipients tend to live longer than others and partly because they are more likely to have non-working spouses also eligible to collect benefits.

Medicare and Medicaid, two other expensive programs that together claim nearly 25 percent of the federal budget, provide important health-care services to the elderly and the poor—but no actual income. The flow of money through these health-care programs, more than $850 billion in federal funds in 2014 (plus another $180 billion in state funds for Medicaid), goes mainly to hospitals, nursing homes, pharmaceutical companies, doctors, insurance companies, and health-maintenance organizations. Both programs have been plagued by fraud and corruption since their origins in 1965 because some doctors, nursing-home entrepreneurs, and other providers have sought to manipulate the system for financial advantage and in many cases have succeeded all too well. No one has ever attempted a study of the redistributive aspects of the flow of funds from Medicare and Medicaid, but one surmises from the nature of these payments that most of the money goes to those in the upper reaches of the income distribution.

The federal government does provide cash assistance to the poor and near-poor through two programs. The first is Temporary Assistance to Needy Families (TANF, popularly known as welfare), which currently provides cash benefits to about 4.5 million households at a cost of $17 billion per year to the federal government and about $14 billion (in 2014) to various state governments. The second is Supplemental Security Income, which provides cash benefits to the disabled poor in 8.5 million households at a cost of about $50 billion per year to the federal government. These numbers work out to about $7,000 (on average) per year per household under TANF and $6,000 per year per household under SSI, in each case around half of the average benefit under Social Security.

Lower-income working families are also eligible to receive rebates on payroll taxes through the Earned Income Tax Credit. The House Budget Committee estimated that 28 million taxpayers took advantage of this program in 2011, at an estimated cost of $60 billion to the federal government in rebated taxes (with the average family with children receiving $2,900 in tax rebates).

And so, of the $800 billion spent on poverty programs in 2012, less than $150 billion was distributed in cash income, if one includes as cash benefit the tax rebate under the EITC. That is a grand total of 18 percent of the whole. The rest was spent on services and in-kind benefits, with the money paid to providers of various kinds, most of whom have incomes well above the poverty line.

With respect to the recipients of federal transfers, the CBO study reveals a surprising fact: Households in the bottom quintile of the income distribution receive less in federal payments than those in the higher income quintiles. Households in the bottom quintile of the income distribution (below $24,000 in income per year) received on average $8,600 in cash and in-kind transfers. But households in the middle quintile received about $16,000 in such transfers. And households in the highest quintile received about $11,000. Even households in the top 1 percent of the distribution received more in dollar transfers than those in the bottom quintile. The federal transfer system may move income around and through the economy—but it does not redistribute it from the rich to the poor or near-poor.

It is well known in Washington that the people and groups lobbying for federal programs are generally those who receive the salaries and income rather than those who get the services. They, as Senator Moynihan observed decades ago, are the direct beneficiaries of most of these programs, and they have the strongest interest in keeping them in place. The nation’s capital is home to countless trade associations, companies seeking government contracts, hospital and medical associations lobbying for Medicare and Medicaid expenditures, agricultural groups, college and university lobbyists, and advocacy organizations for the environment, the elderly, and the poor, all of them seeking a share of federal grants and contracts or some form of subsidy, tax break, or tariff.

This is one reason that five of the seven wealthiest counties in the nation are on the outskirts of Washington D.C. and that the average income for the District of Columbia’s top 5 percent of households exceeds $500,000, the highest among major American cities. Washington is among the nation’s most unequal cities as measured by the income gap between the wealthy and everyone else. Those wealthy individuals did not descend upon the nation’s capital in order to redistribute income to the poor but to secure some benefit to their institutions, industries, and, incidentally, to themselves.

They understand a basic principle that has so far eluded progressives: The federal government is an effective engine for dispensing patronage, encouraging rent-seeking, and circulating money to important voting blocs and well-connected constituencies. It is not an effective engine for the redistribution of income.

James Madison wrote in the Federalist Papers that the possession of different degrees and kinds of property is the most durable source of faction under a popularly elected government. Madison especially feared the rise of a redistributive politics under which the poor might seize the reins of government in order to plunder the wealthy by imposing heavy taxes. He and his colleagues introduced various political mechanisms—the intricate system of checks and balances in the Constitution, federalism, and the dispersion of interests across an extended republic—to forestall a division between the rich and poor in America and to deflect political conflict into other channels.

While Madison’s design did not succeed in holding back the tide of “big government” in the 20th century, it nevertheless proved sufficiently robust to frustrate the aims of redistributionists by promoting a national establishment open to a boundless variety of crisscrossing interests.

The ingrained character of the American state is unlikely to change fundamentally any time soon, which is why those worried about inequality should abandon the failed cause of redistribution and turn their attention instead to broad-based economic growth as the only practical remedy for the sagging incomes of too many Americans.

Footnotes

1. This assumes no corresponding changes in tax and income strategies on the part of wealthy households and no negative effects on investment and economic growth, which are risky assumptions.


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