Question

(Related to the Chapter Opener on page 600) An article in the New York Times noted that a proposal by 2016 Democratic presidential candidate Hillary Clinton would "increase taxes on the wealthiest Americans to combat a widening gap between rich and poor." a. Currently, does the effect of federal taxes make the distribution of income more or less equal? Briefly explain. b. What are the benefits and drawbacks of using the federal income tax code to reduce income inequality?

Short answer

Federal taxes generally make the distribution of income more equal due to the progressive tax structure. The benefits of using the federal income tax code to reduce income inequality include promoting economic fairness and reducing wealth concentration. However, the drawbacks include the discouragement of investment and entrepreneurial activities, tax evasion, reduced work effort and potentially slower economic growth.

Step-by-step solution

Understanding Effects of Federal Taxes

The federal taxes generally make the distribution of income more equal. This is primarily because the United States has a progressive tax structure. Meaning, higher-income individuals pay a larger percentage of their income in taxes compared to those with lower income. Thus, this nature of the U.S. tax system tends to redistribute resources from higher-income to lower-income individuals, making the income distribution more equal.

Benefits of Using Federal Income Tax

There are several benefits associated with using the federal income tax code to reduce income inequality. The primary advantage is to promote economic fairness by imposing higher tax rates on those with higher income. It also helps to reduce the wealth concentration in the hands of a few wealthy individuals and contributes to reducing income gaps. This could contribute to social stability.

Drawbacks of Using Federal Income Tax

There are various drawbacks as well. High taxes on the wealthy could discourage investment and entrepreneurial activities. Taxpayers might look for ways to dodge taxes if they feel their earnings are being excessively taxed. Additionally, it might also discourage work effort and productivity among high-earners. Lastly, it could lead to slower economic growth as it reduces the incentive for wealth creation.

Key concepts

Progressive Tax Structure

At the heart of the federal income tax system in the United States is the progressive tax structure, a system designed to levy higher rates of taxation on those with greater income. The intention behind this approach is to ensure that those who have more financial capacity contribute more to the governmental funds. It operates on the principle of ability to pay, ensuring that as a person's earnings increase, they pay a higher proportion of their income in taxes.

The progressive system includes tax brackets, which categorize income ranges into segments; as one's income ascends through these brackets, they encounter a higher tax rate. This is in stark contrast to a flat tax, where everyone pays the same rate, regardless of earnings. The progressive nature of the tax is essential in moderating income disparity as it effectively levies heavier taxes on the rich and lighter ones on the poor, ensuring a fair collection based on an individual's financial strength.

Redistribution of Income

Income redistribution refers to the transfer of income from wealthier segments of society to poorer ones through various fiscal policies; one of the primary policies used for this purpose is taxation. The federal income tax plays a monumental role in this redistribution. High-income earners not only face higher tax rates but also contribute to funding welfare programs and social initiatives that largely benefit the lower-income groups.

Through these mechanisms, the government aims to even out the economic scales, providing social benefits such as unemployment insurance, healthcare, and educational programs. Redistribution is fundamental to maintaining a certain amount of social cohesion, as it attempts to provide a safety net for the most vulnerable and create opportunities for upward economic mobility.

Economic Fairness

Achieving economic fairness is an ideal wherein every individual receives an equitable opportunity to succeed, unobstructed by skewed wealth allocation. The progressive tax structure is a tool for facilitating such fairness. It posits that those with greater wealth have benefited disproportionately from public goods, like infrastructure, education, and social systems, and therefore should contribute a larger share to sustain these services. However, 'fair' is subjective, and views differ on how much tax variation is justifiable.

While many view progressive taxation as a fair approach to sharing the cost of societal benefits, critics often contend that it could penalize success. Thus, economic fairness, in the context of taxes, strikes a balance between ensuring a productive society where success is attainable and instituting an equitable contribution system where standards of living can be elevated for all.

Wealth Concentration

Wealth concentration refers to the degree to which a country's wealth is distributed among its population. In many cases, if left unchecked, wealth tends to become concentrated in the hands of a few. This concentration can lead to a variety of social and economic problems, such as reduced consumer spending, decreased social mobility, and even political instability as the wealthy have more influence over public policy.

Progressive taxation serves to temper this wealth concentration by redistributing some of the financial resources of the wealthiest toward broader public use. This is grounded in the belief that excessive wealth concentration undermines the collective prosperity and democratic principles. The tax code, therefore, is a critical instrument in attempting to prevent the deepening of economic divides and ensuring a more even distribution of resources.

Investment and Entrepreneurial Activities

While taxation is essential for public services and infrastructure, it’s crucial to consider how it impacts investment and entrepreneurial activities. High tax rates could be seen by businesses and investors as a barrier to innovation and expansion because it reduces the amount of post-tax income available for reinvestment. Critics argue that excessive taxation might stifle the entrepreneurial spirit, leading to decreased economic dynamism. Economies thrive on new ideas and business ventures that create jobs and spur growth.

Consequently, policymakers must find a balance between collecting adequate revenue through taxes and fostering an environment conducive to risk-taking and investment. This includes considering incentives, such as tax credits or deductions for research and development and startup costs which can help promote innovation while still maintaining a progressive tax framework designed to support economic fairness and curb wealth inequality.