Tax Reform and Income Inequality
By Alan L. Feld, Boston University School of Law
The federal income tax ranks high among the methods available to government to reduce income inequality. Its progressive rate structure and certain credits and deductions oriented to low income families suggest a mildly redistributive effect. But the income tax structure also shores up the wealthy and increases economic inequality. It taxes income from working more heavily than income from owning. Ownership of investments is concentrated among the very wealthy and their income benefits heavily from low or sometimes nonexistent taxation.
The tax structure produces this result primarily in three ways.
First, wages from work incur tax when received. Gains from investments, in contrast, avoid tax when earned and incur tax only when the owner sells or exchanges the property. Until then, the untaxed gains earn more gains for the owner. Tax experts refer to this deferral as the realization requirement. Tax law extends this benefit in some cases by allowing owners to make certain kinds of exchanges without tax, enabling an owner in effect to sell an investment without incurring tax on gain and investing the proceeds in a new investment.
Second, when the investor dies the untaxed gain escapes tax forever. The heirs treat the investments as if they had paid cash for them.
These two rules often lead investors to hold onto property longer than prudent investing otherwise might mandate. The investor can avoid tax year-by-year under the realization rule and then wipe it out completely on death. A sale looks less attractive because it incurs tax. Tax experts refer to this as the lockin effect.
Third, if the owner sells an investment held for more than a year at a gain, she can qualify for a tax rate substantially lower than the ordinary rate for wages. Corporate dividends also enjoy the lower rate. Some supporters of a lower rate argue that it constitutes a needed cure for the lockin effect, fixing the unwanted side effects of tax benefits with yet another benefit.
Tax reform could change this pattern.
First, it could modify the realization requirement by taxing gain on investments when earned. It may be difficult to ascertain and measure the gain on certain investments like real estate. But for stock and securities traded on public markets, the owner can readily determine the amount of gain (and loss) at the end of the year. As a first step, tax reform should tax that net gain. Other mechanisms can apply to hard-to-vale assets. Tax reform also should eliminate the benefits now granted to “like-kind” tax-deferred exchanges.
Second, death should trigger the final accounting for an investor who has deferred tax for a lifetime. The investor’s final tax return should include all the previously accrued but untaxed gains.
Third, the ordinary tax rates should apply to capital gains. An income tax should measure the extent by which a person has been enriched in the course of a year. Wages and gains on investments both have that effect and should pay tax at the same rate. As for the lock-in effect, current taxation of gain would eliminate the lock-in and that argument for a lower rate disappears.
Real tax reform can and should treat income from work and income from investment more equally. Congress has the power to do so and thereby to reduce economic inequality. A Congress interested in tax reform should do so.
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