The Role of Taxation in Reducing Inequality: a Case Study of the United States Hybrid Tax System

Wealth distribution around the world is becoming increasingly unequal. The wealthiest households have net worths growing at exponential rates faster than ever before, whilst the lowest-income families are dipping into “negative wealth,” where the value of their debt is greater than their assets. Due to increasing income inequality worldwide, governments employ progressive taxation systems to curb the disparity and redistribute wealth. 

In the United States, this is reflected through the Federal Reserve’s hybrid tax system, which employs both income and consumption taxes to support low-income households and maintain stable government funding. Though this system does have certain drawbacks, it is overall well-balanced, as it pertains to both the income inequality of the nation and the main function of tax: government revenue. This essay discusses the US’s hybrid tax system, including its operational specifications, what can be improved, and, ultimately, how it works towards reducing inequality while maintaining its primary goal. 

With the upcoming expiration of the Tax Cuts and Jobs Act (TCJA) in 2025, the US tax system is likely to face potential changes that could impact the priority of income inequality.  One major aspect of the TCJA was the reduction of the corporate tax rate from 35% to 21%. Although this positively stimulated US economic growth and made American businesses more globally competitive, it also exacerbated income inequality as it favored high-income households. As new changes may be implemented to this system, it’s incredibly important to recognize the benefits and flaws of the current taxation system so that the most effective adaptions can be selected.

Progressive Income Taxes

In order to analyze the effectiveness of the hybrid tax system, it is imperative to understand key terminology and taxation structure. Progressive taxation is a system in which the tax rate increases according to the taxable amount and is most evidently reflected in income tax. In the US, progressive income tax consists of seven brackets, ranging from a 10% tax for the lowest income group to 37% for the highest bracket. This tax, in particular, composes 45.3% of government revenue, reflecting the government’s dependency on progressive taxation. 

Income tax is crucial to reducing inequality as it enables the government to make sure that those who are earning more have to contribute a greater share of their wealth back to the community. This reduces inequality as revenue that comes from taxation is levied on public support programs such as social security, healthcare, and public education. This is evident in the US with the Child Tax Credit (CTC). The CTC, funded through progressive taxation, has lifted millions of children out of poverty by giving financial aid to low-income households. It provides tax rebates to low- and middle-income families whilst giving higher-income families minimal to none at all. Progressive systems like this create a support net for less wealthy households as they ensure resources are redistributed to foster equality and essential requirements are fulfilled for everyone.

Consumption Taxes

Another key aspect of the taxation system in the US is consumption taxes. VAT (value-added tax), which taxes goods and services at each stage of production till final sale, is used in most nations worldwide. GST (general sales tax) is similar, as both work at reducing inequality by broadening the tax base. Although it makes up 15.7% of government revenue, it is not as effective as income taxes in reducing inequality. This is because consumption tax is inherently regressive due to the contrasting spending patterns of high and low-income households. Furthermore, VAT systems often lack targeted redistributive mechanisms that can directly benefit low-income groups like income taxes do. 

The US is the only nation in the Organisation for Economic Co-operation and Development (OECD) and one of the few excluded from the group of 175 countries worldwide that have implemented a VAT or GST. Instead, it capitalizes on local and state sales taxes, which are also regressive in nature, as they disproportionately impact low-income individuals who spend a higher percentage of their income on essentials like food and housing. 

Source: Caragher, 2024 Key: 1. (blue - with VAT/GST) 2. (grey - no VAT/GST)

The Gini Coefficient

Overall, the income inequality in the US is based on its income and consumption taxes. While progressive income taxes work to redistribute wealth and reduce inequality, the lack of a value-added tax (VAT) or general sales tax (GST) places more reliance on regressive state and local sales taxes, which disproportionately burden lower-income households. This can be represented numerically by the Gini coefficient, which measures the distribution of income across a population by a rating of 0 (perfect equality) to 100 (maximum inequality). The Gini coefficient in the US in 2022 was 41.3. For reference, the lowest index is Norway with 22.7 whilst the highest is from South Africa of 63.0. Ultimately, the hybrid system in the US fails to attain higher levels of income equality, due to its regressive tax systems. 

Source: The Federal Reserve Bank of Saint Louis

The Future

As mentioned earlier, the TCJA act is expiring next year, which brings an opportunity for reform for the US government to capitalize on. One step could be revisiting the corporate tax rate to ensure a balance that maintains economic growth while reducing inequality between high and low-income households. Furthermore, by introducing a VAT, the government could broaden the tax base and align its system with that of other nations. Beyond tax reforms, substantial investments in social programs would also play a major role in reducing inequality in the future. All in all, taking action through tax reform and investment in social programs will be crucial for the US to create a fairer society and reduce income inequality over time.