First, reductions in some transfer payments haven’t hurt the living standards of most low-earners. The prime example is the welfare reform act of 1996, which reduced transfers to single mothers but induced many of them to find jobs that left them better off economically and, probably, psychologically.
Second, Americans aren’t trapped in one segment of the income distribution. A Tax Journal analysis of individual income-tax returns found that 58 percent of those in the lowest income quintile in 1996 had moved to a higher income segment by 2005. This comports with common experience. We move up and down the income scale in the course of a lifetime.
Finally, the inflation adjustment used in the CBO analysis was the Consumer Price Index. But that tends to overstate inflation — as any index tends to do, since it measures the cost of a static market basket of goods and services. A study by Chicago economist Christian Broda found that prices for goods purchased by low-earners have been rapidly decreasing, while prices for goods of high-earners have increased. Kids’ school clothes may be cheaper at Walmart than they were years ago, while prices at Neiman Marcus keep increasing.
So if the question is how to compensate for increasing income inequality, higher tax rates on high-earners won’t do much — and could be counterproductive if they diminish economic growth.
A better way is suggested by supercommittee Republicans: Limit future increases in transfer payments to affluent households, and cap deductions for home-mortgage interest and state and local taxes, which are hugely lucrative for high-earners and worthless for low-earners who don’t pay income tax.
These proposals won’t eliminate income inequality. Much of the increased inequality comes from the huge increases for those in the top 1 percent of earners. But we wouldn’t be better off if Steve Jobs had never existed.
Keeping entitlements as they are and raising tax rates on high earners is a recipe for European-style stagnation. Ryan and the supercommittee Republicans point toward a better way.