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Fairness in Tax Policy

Testimony Before Subcommittee on Financial Services and General Government, House Appropriations Committee

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Document date: March 05, 2007
Released online: March 05, 2007

The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.

Leonard E. Burman is director of the Tax Policy Center and a senior fellow at the Urban Institute.


Abstract

In this testimony, Burman summarizes the trends in inequality, examines the role the federal tax system has played in mitigating inequality, and discusses the effect of the tax cuts enacted since 2001. He concludes that while the income tax system provides one mechanism of redistributing the gains of our dynamic free-market economy more equitably, the immediate benefits of the recent tax cuts have accrued disproportionately to those with very high incomes and have undermined tax progressivity. Without knowing how they will be financed, it is impossible to determine how these tax cuts will ultimately affect the distribution of economic burdens in the United States.


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Testimony

Chairman Serrano, Ranking Member Regula, Members of the Committee: Thank you for inviting me to share my views on fairness in tax policy.

As you are well aware, the issue of tax fairness is highly contentious and, unfortunately, economics provides little guidance. One personls idea of a fair tax system—for example, a flat tax on wages—epitomizes unfairness to those who believe in tax progressivity.

Defining fairness is tricky. Economists are mostly agreed on one notion of fairness—so-called horizontal equity—the idea that the tax system should treat similar people in a similar way. That means, for example, that the tax system shouldnlt discriminate between owners and renters, people with health insurance and people without, or those who choose to drive a hybrid car and those who drive an old clunker. Of course, the tax system does discriminate in each of those cases, always with the rationale that a higher policy goal is being advanced: building community (mortgage interest deduction), encouraging health insurance coverage (health insurance exclusion), and improving the environment and reducing reliance on foreign oil (hybrid vehicle tax credit). Thus, even when we have an objectively supportable standard, other goals may trump it and often do. The consequence is that neighbors with identical incomes might often pay very different amounts of tax.The more controversial notion is that of vertical equity—the idea that higher-income people should pay a larger share of their income in tax than those less able to pay. This concept underlies our progressive federal income tax, but all of the loopholes and deductions in the tax system can undermine progressivity. Also, an income tax violates horizontal equity in the sense that it taxes people who choose to save more than otherwise similar people who prefer to spend all of their incomes.

I believe that there is a compelling argument for a progressive tax system for several reasons. First, people vary widely in their abilities to earn income. If you did not know whether you were going to be a lucky person with high ability to earn income or an unlucky one with low ability and earning capacity, yould want a progressive tax system as a kind of insurance. Yould share a large portion of your income when things work out well in exchange for a higher after-tax income when you fall on bad luck.

Second, inequality has been growing in the United States and the tax system has developed into the prime instrument available to mitigate that trend. Inequality in the United States has not arisen from a reduction in work effort among the middle class. In fact, they appear to be working more hours than ever. Inequality appears to arise from various factors including technology, international trade, and a winner-take-all society in which top performers earn much, much more than everybody else. Those trends show no signs of abating, so the tax system might be the best instrument available to diminish after-tax inequality, even as pre-tax inequality is growing.

Third, even those who believe that it is fine for a small number of people to control more and more of societyls resources might have an interest in using the tax system to diminish inequality. Growing inequality can lead to a populist revolt against factors thought to be implicated, such as free trade and relatively unfettered markets. Increasing trade barriers and increased regulation could diminish the incomes of those at the top by much more than a modestly progressive tax system (and might not help those at the bottom either). The progressive income tax might be viewed as a mechanism to buy the support of ordinary working people for a system that disproportionately benefits a few high earners.

Unfortunately, recent tax changes have significantly undermined the progressivity of the tax system. What is more, since they were paid for with borrowed money, we wonlt know their full impact until the deficits are closed at some time in the future. Depending on how the tax cuts are financed, they could end up being even less progressive than current distributional tables imply, or they could turn out to be very progressive.

My testimony will summarize the trends in inequality and discuss some of the factors at play, examine the role the federal tax system has played in mitigating inequality, and discuss the effect of the tax cuts enacted since 2001. I finish with some concluding observations.

The complete testimony is available in PDF format.

The views expressed are those of the author and should not be attributed to the Urban Institute, its trustees, or its funders.



Topics/Tags: | Economy/Taxes


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