Five Reasons Income Inequality Happened and Will Continue

Friday, 28 Oct 2011 01:06 PM

 

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As if on cue for an Occupy Wall Street commercial, the latest Congressional Budget Office report highlighted the large crevasse between the upper 1 percent of U.S. households and the rest of us.

When it comes to income inequality, this is what U.S. politicians should be digesting now. While it's hardly a major revelation that for the top 1 percent of earners real after-tax income rose 275 percent between 1979 and 2007, the top 20 percent made more in after-tax income than the remaining 80 percent. That's quite a difference since the lowest-income group's median income only rose 18 percent.

Income inequality couldn't be more of a mainstream issue as some 70 percent of Americans surveyed want wealth shared more equally.

The reasons for the growing disparity, which the CBO, without irony, measured by an increasing "Gini coefficient," were buried deep in the report. It's how income was taxed that allowed the ultra-wealthy to keep more of what they earned compared to middle- or lower-class Americans.

INVESTMENT INCOME EARNERS ARE TAXED LESS

Most lower- and middle-class earners make their money from wages, which are subject to Social Security, Medicare, federal and state taxes. But income from businesses, capital gains and dividends may be taxed at lower rates. In the CBO study period, the share from capital gains and business income increased, meaning upper-income families reaped greater after-tax benefits just from the kinds of non-wage income they reported.

When you're on salary, you get taxed regularly through your paycheck. If you hold stocks, bonds, business equity and property, your capital gains — if any — can be delayed for years. Holding securities in tax-deferred retirement accounts can put off taxes for decades.

EXECUTIVES AND FINANCIAL PROFESSIONALS DID BEST

Again, no surprise here. But when you can structure your compensation so that it's tax-deferred, paid in stock options or paid as capital gains, dividends or carried interest, you can pay much less to Uncle Sam and keep more of your income. Long-term capital gains, dividends and carried interest are taxed at a maximum 15 percent rate.

When the bulk of your income comes in those forms, you avoid taxes at the maximum 35-percent marginal federal rate. So those at the top of the compensation pyramid not only made more in gross income, their overall tax rates were lower because of how their pay was received. Billionaire Warren Buffett is a good example. His average rate was 17.4 percent.

LOWER-INCOME HOUSEHOLDS PAY MORE IN PAYROLL TAXES

Since the highest earners were paying less in overall taxes because they were paid in non-wage income, their payroll tax rate was also lower. The CBO found that the lowest fifth of families paid an average 8 percent in payroll taxes while the highest-income group paid under 2 percent.

Why are the poor paying quadruple the amount of payroll taxes than the rich?

They are unlikely to report investment or business income at the lowest rates. Attention tax reformers: You could make a case that the wealthiest Americans are not paying their fair share for Social Security, Medicare, state and federal programs. But since the tax code allows them to avoid paying any more, it's perfectly legal now.

CONVERSION TO S CORPS ALSO HELPED WEALTHY

Those who ran their income through corporations (even small ones) reaped even more breaks by converting from a standard "C" to an "S" corporation. The S corporation essentially taxes business earnings at your personal rate in the year that you make the money. That opens up a number of ways to legally pare tax liability and gave many high-income households yet another loophole. I know, because I had an S Corp for years. "The observed growth in the conversion of C corporation income into S corporation income has contributed to the rapid growth in income for the highest-income households," the CBO reported.

THOSE WHO HAVE MOST LOOPHOLES BENEFITS MOST

It's a cumulative giveaway: The more deductions you can take at the most-favorable rates, the lower your after-tax income. Who did the best? No surprises here. "Employees in the financial and legal professions made up a larger share of the highest earners than any other group." Hello Wall Street and K Street.

In addition to these plums, if you were in the elite class that benefited from low rates and a bevy of write-offs, you had more money to spare to hire lobbyists to keep your after-tax income higher than wage earners. You and your affiliated special-interest groups were also able to donate copious amounts of money to Congressional candidates who want to keep the tax code working in favor of the well-heeled.

Unless you can find a way of living off of an investment portfolio, create an S corporation and avoid payroll taxes, you're going to pay more than your fair share of taxes. Has the Congressional debt reduction supercommittee considered this low-hanging fruit? There's no way to tell since their proceedings or minutes have not been made public. Lobbyists have had better access than other citizens.

Only one thing is certain. If the status quo prevails, the tax code will continue to serve as a wealth enhancer for the ultra-wealthy and corporations. Without meaningful tax reform, the gap between the 99 percent and the top 1 percent will widen from a chasm — to a canyon.

© 2014 Thomson/Reuters. All rights reserved.

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