By Brian Daitzman
Inequality in the United States is not a predetermined fate but a result of deliberate policy choices. Various factors have contributed to increasing inequality, including tax policies favoring the wealthy and differences in taxing income types.
Tax Policies Favoring the Wealthy
U.S. tax policy, shaped significantly by the Bush 43 and Trump Administration tax cuts, has played a key role in redistributing wealth upward. The Bush-era tax cuts in the early 2000s reduced the top income tax rates, benefitting high-income earners.
The Trump Administration’s Tax Cuts and Jobs Act (TCJA) of 2017 entrenched these benefits by lowering corporate tax rates and further reducing taxes on high-income individuals. According to the Institute on Taxation and Economic Policy (ITEP), these policies widened the income gap at the expense of middle and lower-income Americans.
The wealthiest 1% received an average tax cut of $50,000, while the bottom 80% averaged only $645.
Disparities in Income and Investment Taxation
The U.S. tax system treats earned income and investment income differently. Earned income, such as wages and salaries, is taxed at higher rates than investment income, which includes capital gains and dividends.
For example, consider John Smith and Jane Smith.
John Smith is an office worker who has earned $70,000 annually since 1994. After paying his personal expenses, John has no money left to invest in the stock market. Once retired, John will depend on Social Security.
Jane Smith, who inherited money from her parents, has been investing $70,000 annually, regardless of market conditions, since 1994. She plans to depend on her investments for retirement in 30 years. Assuming an average annual return of 7% (a typical long-term return for the U.S. stock market), Jane’s investments would grow significantly over 30 years.
Using the formula for the future value of an annuity: 𝐹𝑉=𝑃×((1+𝑟)𝑛−1𝑟)FV=P×(r(1+r)n−1)
Where:
𝑃P is the annual investment ($70,000)
𝑟r is the annual return rate (7% or 0.07)
𝑛n is the number of years (30)
𝐹𝑉=70,000×((1+0.07)30−10.07)FV=70,000×(0.07(1+0.07)30−1) 𝐹𝑉=70,000×(7.612255−10.07)FV=70,000×(0.077.612255−1) 𝐹𝑉=70,000×94.46079FV=70,000×94.46079 𝐹𝑉≈6,612,255FV≈6,612,255
In 30 years, Jane’s annual $70,000 investment would grow to approximately $6.6 million.
Avoidance of Income Taxes by the Wealthy
Wealthy individuals often use loans to minimize their tax liability. For example, Jane Smith forms an LLC and creates a line of credit with the bank equal to $1,000,000 annually.
She secures this line of credit with cash and stocks.
Jane can access funds without triggering taxable events by taking loans against her investments rather than selling assets. Loans and interest payments are tax-deductible, allowing Jane to maintain her investments while living off borrowed money, which is not subject to income tax.
Here is how this works in practice:
1) Jane secures a $1,000,000 line of credit: She uses her cash and stock holdings as collateral.
2) Jane takes a $1,000,000 loan: She lives off this loan, using it for personal expenses.
3) Interest on the loan is tax-deductible: Suppose the interest rate is 4%.
Jane pays $40,000 in interest annually, which she can deduct from her taxable income.
Tax impact: Since the loan itself is not income, it is not taxed. The interest payments reduce her taxable income by $40,000.
Now, assume Jane has no other taxable income. Here’s what happens:
Without the loan interest deduction, Jane’s taxable income is $0.
With the loan interest deduction, Jane’s taxable income is still $0 because she has no other income to offset.
In this scenario, the interest deduction does not provide a tax credit or refund since Jane has no other taxable income. The primary benefit is that she avoids triggering taxable income by living off loans instead of selling investments.
Example of the Feedback Loop with Jane Smith
1. Initial Wealth and Investments: Jane inherits substantial money from her parents, allowing her to start with significant investment capital.
2. Consistent Annual Investments: Jane invests $70,000 annually in the stock market, achieving an average annual return of 7%. After 30 years, her investments grow to approximately $6.6 million.
3. Tax-Advantaged Borrowing: Jane forms an LLC and secures a $1,000,000 line of credit, using her investments as collateral. She lives off the loan, avoiding taxable income while enjoying the benefits of her wealth.
4. Reinvested Returns: The returns from her investments are reinvested, further compounding her wealth. Her ability to avoid income tax through loans allows her to reinvest more of her capital gains.
5. Wealth Growth and Tax Minimization: The preferential tax treatment of long-term capital gains and the ability to deduct loan interest from taxable income enable Jane to grow her wealth significantly while minimizing her tax liabilities.
6. Multi-Generational Wealth: Any remaining wealth can be passed down to her heirs with minimal estate tax impact due to legislative changes that have diluted the estate tax.
Result of Combined Policies
By leveraging these policies, Jane’s wealth grows exponentially.
Here is a simplified projection of Jane’s wealth over 30 years:
1. Initial Inheritance: $1,000,000
2. Annual Investment Growth: $6,612,255 (from annual $70,000 investments)
3. Total Wealth: $7,612,255 (excluding additional returns from reinvested gains and other investments)
4. By the end of 30 years, Jane’s strategic use of tax policies, investment returns, and tax-deductible loans results in a net worth far exceeding $7 million, highlighting the powerful feedback loop that favors the wealthy.
Inequality in the United States: A Choice, Not Destiny
Inequality in the United States is not an inevitable outcome but a product of deliberate policy choices that favor the wealthy.
By understanding the intricate ways in which tax policies, income disparities, and investment dynamics intersect, it becomes clear that addressing economic inequality requires comprehensive reform.
Only by rethinking and restructuring these policies can the U.S. hope to create a more equitable society where wealth and opportunities are accessible to all, not just a privileged few.
