Tax Policy and the Growing Income Gap

Most people think of tax policy as a partisan deal: lower tax GOPers, and higher tax Democrats. It is in principle, but for the last 50 years, both Democratic and Republican presidencies saw income and estate tax codes shifting to favor the wealthy. In 1963 the top marginal income tax rate was 91%. Over the following 5 decades it fell to 39.6%, and a range of other tax breaks were created.

While 91% marginal tax rates might be extreme, a majority of the wealthiest Americans' wealth was never through income alone. Today's tax code offers one of the lowest top tier marginal tax rates in the developed world, and further preferential tax treatment for the wealthy through policies such as performance pay, capital gains deductions, mortgage interest deductions, and a lax tax haven policy.

Here are the largest ways that tax policy creates economic inequality:

"Performance Pay"

Performance pay is a tax loophole through which corporations can make unlimited deductions for CEO compensation. While corporations can normally deduct up to $1 million in salary for CEO's, performance pay allows corporations to increase payment on the condition that the CEO meets certain performance measures. Performance pay is all tax deductible, saving corporations tons on their taxes.

2013 marked the first time since the Great Depression that 50% of income went to the top 10% of earners. While performance pay is more of an issue related to the top 1% or .01% of earners, it definitely contributes to income-based inequality.

A recent report at the Institute of Policy Studies details the role of performance pay in the nation's largest food chains.

Starbucks is a case in point of how performance pay can be used to skirt your taxes. Howard Schultz, CEO of Starbucks received $1.5 million in salary for 2012 and 2013, yet during the same period took in a whopping $236 million in stock and performance pay. The total savings to Starbuck's taxes: $82 million. All twenty of the largest members of the National Restaurant Association have benefited from this loophole.

You may think this is more of a corporate tax issue, and less of an issue regarding high-earners. But the extent to which performance pay tax code enables ludicrously high earnings for CEO's, who in turn take advantage of other tax loopholes is an important part of how performance pay is related to economic inequality.

Capital Gains

America's ratio of income to wealth has exploded in recent decades. In the 1970's wealth accounted for 250-300% of the value of the income of Americans. Today wealth accounts for 400-600% of income. The preferential tax treatment of capital gains is perhaps the single largest driver of this explosion in wealth.

Long term capital gains are profits from sales of stocks and bonds held for over a year. This form of capital gains is taxed at 15% when the stocks and bonds are sold. For high-earners who can live on a small segment of their wealth, capital gains enable skipping out on the highest tax brackets. Through holding stocks and bonds longer, the 15% tax on capital gains can often be negated with rates of increase outstripping 15% in a year.

The history of capital gains tax treatment mirrors the greater trends of exponential growth in wealth for the highest net-worth individuals. In 1997, the Taxpayer Relief Act lowered capital gains from 28-20%. In 2003, the rate lowered again to 15% for those whose highest tax bracket is 15%, or 5% for those whose highest tax bracket is less than 15%. This tax can be deferred even farther through the use of charitable trust, private annuity trust, or several other financial arrangements.

Capital gains enable wealth to grow exponentially,particularly high-wealth individuals who don't receive a majority of new earnings in the form of salary. An extreme example involves Warren Buffett in 2007. In 2007, Buffett noted that his secretary pays 30% of her income in taxes. Due to preferential tax treatment of capital gains, Buffett only paid out 17.7% of his earnings in taxes. Buffets taxable income: $46 million.

Mortgage Interest Deductions

Mortgage interest deductions allow homeowners to deduct interest from loans on their first and second homes. Interest is deductible on the first $1 million of debt used in buying, building, or improving a home. The first $100,000 of home equity debt is also deductible. A second tax incentive for home ownership includes the ability to deduct up to $250,000 (or $500,000 for filing jointly) of capital gains for the sale of real property. If you haven't heard of this deduction, it's a big deal. Recent estimates state the five-year costs of mortgage interest deductions in lost taxes exceed $1 trillion.

The first clue as to how this tax treatment favors the rich is in the "first or second" clause. Not many Americans have second homes. For those who can utilize the deduction close to it's full potential, the interest on a $1 million dollar home loan can be massive savings. At 5%-6.5% interest on a mortgage, borrowers can deduct $50,000-$65,000 in taxes yearly.

Perhaps this is why the average mortgage interest deduction for incomes between $40,000 and $75,000 is only $523; while households in the top 1% average $6,507 in yearly mortgage interest deductions (including households whose residence is already paid for).

Mortgage interest deduction was originally added to the tax code to encourage home ownership. Recent studies, however, claim that it only encourages the building of larger houses, and home ownership amongst high earners. This is evident in the 18% increase in house sizes in the nation's most affluent neighborhoods since 1980. Average home size in these neighborhoods has increased from 1,750 square feet in 1980, to 2100 square feet in 1990, to 2,500 square feet today. Nearly half of all mortgage holders take advantage of the deduction, and those who can often use it on second mortgages as well. In non-affluent neighborhoods, the trend in house growth was not evident over the same period.

Tax Havens

Tax Havens involve shipping money or opening dummy corporations in low or no-tax locations. The equivalent of the economies of the EU, Russia, and India are held in tax havens worldwide, many of which are located in small but ludicrously wealthy island nations. Delaware is an example of a tax haven in the US, with 945,000 companies registered in the state, though the state population is only 912,092. These companies are legal entities, but largely just a front through which corporations and individuals can hold money in a location with preferential tax treatment. The Corporation Trust Center, at 1209 North Orange St. Wilmington, DE is one of the largest groupings of dummy corporations, with over 285,000 companies registered to one address. 83 of the 100 largest companies in the US have subsidiaries in tax havens.

Due to the immense amounts of money in tax havens, havens aren't simply a domestic income gap issue, but a global aid issue as well. According to a recent report by the Tax Justice Network (assuming a low estimate of wealth offshore in tax havens and an average 30% tax rate on this income in home countries) unreported income could generate up to $189 billion a year. This is double the amount that all OECD countries spend on overseas development assistance in a year.

Recently, increased scrutiny has been applied to tax havens, as the IRS technically requires US citizens to report income derived anywhere in the world. Enforcement efforts, however, have a long way to go. As recently as 2008, a whopping 43% of U.S. multinational corporation profits were found in just a few tax havens (Bermuda, Ireland, Luxembourg, the Netherlands, and Switzerland). In recent years, foreign governments have taken advantage of the desire of high-earners to find tax friendly locales, and there has been a marked increase in the number of accelerated citizenship programs for individuals willing to invest in foreign countries. Needless to say, tax havens are a massive contributor to economic inequality, and have been perpetuated by the lack of aggressive U.S. tax code enforcement.

The Big Picture:

Thomas Piketty, a 42-year-old French economist's recent book Capital in the 21st Century details the true and rising state of income inequality in America today. Piketty's basic argument is that when capital gains are increasing in value at a much faster rate than the overall economy, inequality is produced. To put this in perspective, when most capital gains are reported by only 1 out of 100 Americans, the earnings of 99 people stagnate, while the income of 1 person expands exponentially. Piketty also notes that the last prolonged period when inequality wasn't growing were the first few decades after World War II. Economic inequality today is a product of these 60 years in exponential growth for the wealthiest Americans.