Increase in the top income tax rate substantially alter income inequality

The high level of income inequality in the United States is at the forefront of policy attention. This analyse focuses on one potential policy response: an increase in the top personal income tax rate. We conduct a simulation analysis using the Tax Policy Center (TPC) microsimulation model to determine how much of a reduction in income inequality would be achieved from increasing the top individual tax rate to as much as 50 percent. We calculate the resulting change in income inequality assuming an explicit redistribution of all new revenue to households in the bottom 20 percent of the income distribution. The resulting effects on overall income inequality are exceedingly modest.

That such a sizable increase in top income tax rates leads to such a limited reduction in income inequality speaks to the limitations of this particular approach to addressing the broader challenge.

The analysis prompts a follow-up question: if a reasonable expansion in educational attainment would not substantially reduce overall inequality, what would? An obvious candidate policy to consider is raising top income tax rates. We thus investigate whether a large increase in marginal tax rates at the top end of the income distribution would have a more notable effect on inequality than the increase in educational attainment previously analyzed.

A Simulation Exercise

There’s a simulation exercise using the TPC microsimulation model to examine how the distribution of post-tax income would change under three tax schedule scenarios:

1. Raise the top individual income tax rate from 39.6 percent to 45 percent;
2. Raise the top individual income tax rate from 39.6 percent to 50 percent; or
3. Raise the top individual income tax rate to 50 percent for income greater than $1 million for joint filers and $750,000 for single filers.

Let’s restrict the attention to changes in the top marginal tax rate and do not consider other options, such as scaling back exemptions to expand the tax base or applying the highest income tax rate to households at lower levels of income.

The initial analysis does not adjust for any behavioral responses to the change in taxes (i.e., we assume households will earn the same pre-tax income regardless of the change in the top marginal income tax rate). In these results the only effect on household incomes  and on the corresponding income distribution  is the reduction of post-tax income by households subject to the higher tax rate. We subsequently model explicit redistribution of the new tax revenue and behavioral responses among high income households.

Increasing the top income tax rate from 39.6 to 45 percent would increase the income tax burden of households in the 95-99th percentiles of income (as defined before taxes are paid) by an average of $3,508. Households in the top 1 percent would see their income tax liability go up by $58,233 on average. And households in the top 0.1 percent would experience an average income tax increase of $297,582.

A larger hike in the top income tax rate to 50 percent would result, not surprisingly, in larger tax increases for the highest income households: an additional $6,464, on average, for households in the 95-99th percentiles of income and an additional $110,968, on average, for households in the top 1 percent. Households in the top 0.1 percent would experience an average income tax increase of $568,617.

How would these reductions in after-tax income affect overall income inequality?

To answer that question, we calculate the Gini coefficient on the full distribution of post-tax income under the three different tax policy scenarios. (The Gini coefficient is an index that ranges from 0, if everyone had the same earnings, to 1, if a single person had all the earnings and everyone else had none.)

Perhaps surprisingly, increasing the top marginal tax rate to 45 percent or 50 percent has a trivial effect on overall income inequality. This can be seen in Table 1 below. Under current tax provisions, the after-tax Gini coefficient is .574. This compares to a Gini of .610 calculated over pre-tax income. Raising the top income tax rate to 45 percent reduces the Gini coefficient only from .575 to .573. Raising it to 50 percent brings the Gini to .571. If the 50 percent top tax rate is applied to income only above $1 million for married filers and $750,000 for single filers, the resulting Gini is .572

In this analysis it is simulated the effects of increasing the top income tax rate under three possible reforms: (a) raise the top individual income tax rate from 39.6 to 45 percent; (2) raise the top individual income tax rate from 39.6 to 50 percent; and (3) raise the top individual income tax rate to 50 percent for income greater than $1 million for joint filers, $750,000 for single filers. We calculate the resulting change in income inequality under these scenarios assuming an explicit redistribution of all new revenue to households in the bottom 20 percent of the income distribution. The resulting effects on overall income inequality are exceedingly modest, with changes in the Gini coefficient of less than 0.01. That such a sizable increase in the top personal income tax rate leads to a strikingly limited reduction in overall income inequality speaks to the limitations of this particular approach to addressing the broader challenge.

It also reflects the fact that the high level of U.S. income inequality is characterized by a wide divergence in income between higher-income households and those at the middle and below. The top income tax rate only applies to households above the 95th percentile of income. To be sure, there might be good reasons to increase top income tax rates for other purposes beyond reducing income inequality for example to raise much needed revenue for the federal government. In addition, the tax-and transfer policies analyzed would provide substantial benefits to low-income households if the revenue were explicitly redistributed.

Thus, the results do not speak to the desirability of the tax-and-transfer policy, just to the fact that even a significant tax increase on the highest-income households and transfer to low-income households has a small effect on overall inequality. This analysis, coupled with the previous one, in turn leaves us with the open and important question: if neither a substantial expansion in education nor a big increase in the top marginal tax rate would significantly affect measured income inequality, what would?