Role of Taxation in Family Inequality

Posted: https://www.ncfr.org/policy/research-and-policy-briefs/role-of-taxation-family-inequality-possibilities-for-reform

Published: December 20th, 2024

Highlights

• Federal tax policy plays a critical role in promoting and responding to the financial security of families, which has cascading effects on the mental and physical health of families and children. Yet tax reforms over the past 40 years have provided disproportionate tax relief and support to high-income families relative to low-income families, which has furthered income inequality and reduced intergenerational mobility.
• The 1-year expansions of the Child Tax Credit and the Child and Dependent Care Tax Credit provide blueprints for tax reforms that promote family functioning and well-being by providing general income support to families across the income spectrum and reducing child care costs.
• Reducing tax expenditures that disproportionately benefit wealthy families and expanding tax credits and deductions that center on family functioning, caregiving, and labor force participation may help level the economic playing field so all families benefit from tax policies.

Abstract

Federal tax policies can play a crucial role in promoting families’ health, education, and social mobility outcomes. Although some tax policies (e.g., Earned Income Tax Credit, Child Tax Credit) have provided critical income support for families with children, other tax reforms over the past 40 years have disproportionately benefited wealthy families, further widening income and wealth inequality in the United States. Reforming tax policies to support the flourishing of families across the income spectrum, ensure tax fairness, fund expanded child and family tax benefits, and reduce ethno-racial income and wealth inequality, which holds promise for advancing family well-being.

Introduction

Over the past 40 years, families in the United States have experienced widening income inequality and increasing financial hardship. Income inequality in the United States is the highest of all industrialized democracies, and the wealth gap between America’s richest and poorest families more than doubled from 1989 to 2016.¹ Despite the idea that one can achieve “the American dream” of social and economic mobility through hard work, extensive research finds that Americans experience less mobility within and across generations than their peers in economically similar nations.² Moreover, U.S. childhood poverty has remained high, with an average poverty rate of nearly 20% over the past two decades. Yet in 2021, childhood poverty dropped by 46%, largely due to significant increases in the value of and expanded eligibility for tax credits like the Child Tax Credit, the Child and Dependent Care Credit, and COVID-19-era stimulus payments. With the expiration of those tax credits in 2022, childhood poverty once again increased nationwide,³ revealing the important role of tax policy in mitigating poverty and the income and wealth inequality experienced by children and their families.

Reducing poverty and income and wealth inequality is critical because of the associated deleterious health, educational, and intergenerational economic outcomes for children and families who live in poverty.^4, 5 Some economists and political scientists also show that income and wealth inequality harm the social, political, and economic fabric of the United States.⁶ While researchers and policymakers have devoted considerable attention to individual and family behavior change as paths to reducing family poverty (e.g., delaying childbirth, getting married, increasing educational attainment),⁷ federal tax policy also shapes and conditions family poverty and income and wealth inequality. The purpose of this policy brief is to add to the discourse on reducing family poverty by providing an overview of some of the most salient tax policies for the promotion of family equity. Given the growing ethnoracial diversity of American families, the report also considers how tax policies may contribute to racialized income inequality and how such policies can advance racial justice.

Overview of U.S. taxation of individuals and families

Families in the United States directly interact with the federal tax system through the tax code administered by the Internal Revenue Service (IRS). In 1913, the 16th Amendment to the U.S. Constitution established payment of taxes on individual and family income and wealth. The Revenue Act of 1913 established a graduated rate structure with increasing marginal tax rates (see Table 1) starting with a 1% tax on annual incomes greater than $3,000 ($90,000 in 2023 dollars) and the highest marginal tax rate of 7% on income greater than $500,000 (more than $15 million in 2023 dollars). By 1932, the highest marginal tax rate had increased to 63% on income above $1 million (about $21 million in 2023 dollars) and remained at or above that rate until 1980.

Beginning in the 1980s, congresspeople sought to lower federal income and wealth taxes, particularly on wealthy families and corporations, motivated by the theory that this would spur economic growth and shared prosperity.⁸ By 2023, there was a 10% tax rate on the first $22,000 in taxable income, and the highest income tax rate stands at 37% for taxable income greater than $693,750 for married couples. Research, however, shows that the tax policy reforms of the past 40-plus years have led to increases in income and wealth inequality.⁹ Meanwhile, attempts to create and expand programs to support the economic well-being and advancement of low- and moderate-income families (e.g., Child Tax Credit, childcare funding, education funding) have been thwarted.¹⁰

Considering the ways a well-crafted tax and transfer system can reduce income inequality, economic hardship, and poverty,¹¹ tax legal scholars have called for reforms that foster horizontal and vertical equity. Horizontal equity holds that individuals and households with similar financial resources should have the same tax burden. Vertical equity relates to the fair spread of taxes paid across individuals and households with different financial resources and posits that tax policy should advance social welfare by taxing those with fewer resources at a lower rate than those with more resources.

Some recent tax reforms point to the possibility of expanding investments that support horizontal and vertical equity and family financial well-being, while other reforms may further contribute to income and wealth inequality. For example, the Tax Cuts and Jobs Act of 2017 (TCJA) led to several policy changes with effects on families, including changes in tax brackets, increases in the standard deduction and the elimination of personal and dependent exemptions, and increases in the value of the Child Tax Credit. Some of these provisions, such as the Child Tax Credit expansion, reduced tax burdens among families with children, and other provisions, such as the elimination of the dependent exemption, increased families’ tax liabilities in some cases. The TCJA example illustrates how numerous tax provisions may intersect to shape tax liabilities and overall tax equity. Because the effects of tax policies differ by income level, type of income, filing status, and number of children, this report also highlights how certain provisions have an impact on particular populations. Given the complexity of tax policy, the report is not exhaustive. Table 1 provides definitions of common tax concepts referred to throughout the brief.

How child- and family-related federal tax provisions affect family financial well-being

In the United States, many social benefits are administered via the tax code; as a result, the availability and size of tax benefits for families with children can promote financial well-being and mitigate poverty. Tax benefits for families with children include the Child and Dependent Care Credit (CDCC), the Earned Income Tax Credit (EITC), and the Child Tax Credit (CTC).

Congress first established the CDCC, a tax credit based on household income and child care spending, in 1976 to help offset the costs of child care. Yet the size of the credit has never reflected the true cost of care. For example, while the federal benchmark for affordable child care has been set at a maximum of 7% of family income since 2016, as of 2018, median child care prices for one child accounted for between 8% and 19% of median family income, depending on child age, provider type, and county population size.¹² Accounting for the CDCC, which is capped at the lesser of $600 per child or $1,200 per family for most taxpayers, does not bring median costs of care for one child below 7% of the median family income for a family of any size in any U.S. county that is seeking any mode of care. The CDCC’s support is especially limited for low-income working parents because it is a nonrefundable tax credit, so offsets income taxes owed. With a lack of affordable child care many families patch together paid and unpaid care arrangements, and research on early childhood suggests that unstable child care arrangements can have a negative impact on children’s cognitive and behavioral development and lead to stress and job loss among parents.¹³

The EITC and CTC tax policies support working families with children. By reducing taxes and increasing income via tax refunds, these refundable tax credits help families make ends meet and reduce poverty, food insecurity, material hardship, and other financial stressors.¹⁴ As such, an extensive line of research has found that the EITC and CTC are associated with various positive maternal outcomes, including reduced maternal stress, increased maternal mental and physical
health, and various positive perinatal health outcomes.¹⁵ Research also documents relationships between the EITC and infant and child outcomes, such as declines in low infant birth weight, improved noncognitive skills, decreases in obesity, reduced child maltreatment, and positive educational and employment outcomes.^{16, 17}

However, the value of the EITC and CTC are partially determined by labor market earnings, and research shows that Black and Latine families receive less on average per child. Black and Latine families earn lower average earnings in a racialized and discriminatory labor market, and their families are slightly larger than White families. These circumstances drive inequality in who receives the EITC and CTC, also illustrating how ethno-racial income inequality intersects with the tax code to deliver less benefit to Families of Color.¹⁸ Furthermore, families who experience significant earnings reductions and families with caregivers who do not work in the paid labor market (e.g., caregivers, disabled parents, retired grandparents raising grandchildren) may receive little to no benefits from the credits.

The EITC and CTC also present various administrative challenges related to eligibility that can preclude families from receiving benefits, such as when multiple adults raise a child, but only one can claim the child, and it is unclear who can and should.¹⁹ Moreover, tax law bars all undocumented immigrant parents from receiving the EITC and allows them to claim the CTC only if their children have a legal immigration status, regardless of how long they have lived in the United
States. Given the extensive evidence of how the EITC and CTC have a positive impact on children and parents, tax policies and administrative practices that result in uneven receipt of the credits by race, family type, and immigration status can further exacerbate family income and wealth inequality.

Finally, taxpayers who are ineligible for the EITC or CTC may claim the Credit for Other Dependents (COD). Yet, the COD is a $500 nonrefundable credit that provides little to no support to low-income families who may be financially supporting children and relatives.

Potential reforms to child- and family-related tax benefits

The 2021 expansion of the CTC, under the American Rescue Plan Act of 2021 (ARPA), was heralded as one of the largest, albeit temporary, antipoverty interventions in U.S. history, and it aligned with the recommendation for a child allowance in the National Academies of Sciences, Engineers, and Medicine’s A Roadmap to Reducing Child Poverty.²⁰ As a fully refundable tax credit delivered via monthly paym0nts, the expanded CTC provided ongoing income stability and reduced food insufficiency, financial insecurity, and material hardship among families with children.²⁰ The expanded CTC helped to compensate the work of unpaid caregivers, which is critical to family well-being and the U.S. economy.²² Research also suggests that the expanded CTC had stronger effects for Black and Latine families,²³ who were disproportionately impacted by the economic fallout of the COVID-19 pandemic.

Congress failed to extend the expanded CTC after 2021, primarily due to disagreements about whether a permanent expansion should include a work requirement.²⁴ While the 2021 CTC expansion potentially discouraged labor force participation among some recipients, studies examining the impact of the expanded CTC on employment did not find significant impacts.²⁵ Still, how parental employment would respond to a permanent policy is an ongoing debate,²⁶ and policymakers should closely examine potential effects on parents’ and children’s health, education, social well-being, and employment outcomes in determining whether the CTC expansion should be made permanent.²⁷

The positive impacts of the expanded CTC built on the EITC in providing low- and moderate-income working families with vital income support that translates to various cascading positive effects for parents and children. Still, administrative challenges to benefit uptake can result in many families—
particularly the most economically and socially vulnerable—encountering significant barriers to obtaining the credit. As a potential solution, the National Taxpayer Advocate (NTA) proposes separating the EITC into two separate credits—a worker credit and a child credit—to make them easier for families to understand and claim. The NTA also recommends updating the rules to allow for a primary carer to claim the credits, thereby allowing families to decide for themselves who can claim the EITC and CTC based on caregiving responsibilities instead of the residency, income, support, and relationship tests currently used by the IRS.²⁸ Several researchers and advocates have also proposed merging this new child portion of the EITC with the CTC to create a unified child benefit, creating an ongoing universal child allowance to support families with children.²⁹

In addition to the CTC, ARPA also expanded the CDCC, making it fully refundable for the 2021 tax year. Under this temporary expansion, working families could receive up to $4,000 in CDCC benefits for each of up to two qualifying individuals. As low-income working families tend to spend a greater portion of their income on child care, making this refundable credit permanent could support families most in need of care assistance while encouraging employment. Also, a fully refundable CDCC would narrow the gap eligibility between Black and White households by two percentage points and between Latine and White households by one percentage point.³⁰ The associated increase in eligibility rates across all family types is substantial, constituting 18% of existing childcare spending and 10% of adjusted gross income.

Last, expanding the COD and making it fully refundable may help offset taxes and provide income support to multigenerational families. Further research is needed to determine an adequate size of the credit.

Uncovering Disparate Federal Tax Preferences, Penalties, and Audits

Federal tax policy can help reduce income and wealth inequality by establishing policy that advances both vertical and horizontal equity. Graduated income tax brackets, which result in higher rates of taxation on higher income and wealth, promote vertical equity. Ensuring that different sources of income are taxed at similar rates and that similarly structured families pay similar tax rates promotes horizontal equity.

A growing body of research has illustrated how income and wealth inequality has deleterious impacts on family and child well-being and provides support for significant policy changes.³¹ Income and wealth inequality structure the unequal distribution of family and community resources, which leads to low-income families and Families of Color disproportionately experiencing social, economic, environmental, and political contexts of precarity, deprivation, and insecurity.³² For example, research has documented links between income inequality and income and racial disparities in access to high-quality K–12 education and health care.^33,34 As such, income inequality is a driving force for the intergenerational transmission of poverty and economic hardship, as low-income families and Families of Color are less likely to attain the education, skills training, and health care necessary for economic security and upward mobility.³⁵

Although the United States generally has a graduated federal income tax structure, various provisions in the tax code disproportionately benefit wealthy families and White families while failing to fully account for the expenses and responsibilities that Families of Color and working women with children are more likely to experience.³⁶ Specifically, wealthy families disproportionately benefit from various tax provisions that reduce the amount of tax a family owes and revenue the government collects. For example, income from capital gains and qualified dividends is taxed at a lower rate than wage income, and about 75% of this tax provision accrues to those at the top 1% of the income distribution, and 92% of it to White individuals. Taxing capital gains and dividends at the same rate as wage income would generate an additional $145 billion in annual federal revenues. In addition, the qualified business income deduction, which allows eligible individuals to deduct up to 20% of business income, compounds these inequities, as 90% of the $57 billion in reduced taxes is realized by White households.³⁷

High-income and White families also disproportionately benefit from the mortgage interest deduction (MID), which allows families who itemize their deductions to subtract mortgage interest from their taxable income. The MID results in up to $47 billion in foregone revenue annually, with 84% of MID tax reduction accruing to White households and 79% to the top 10% of all earners.³⁸ The majority of low- and moderate-income homeowners do not benefit from this tax expenditure as they do not financially benefit from itemizing their deductions, and families of all income backgrounds that rent are not eligible for a comparable deduction for their housing expenses. To address these inequities, the MID could be eliminated altogether or reformed to allow low- and moderate-income homeowners to claim a portion of the MID if they do not itemize their deductions and a new renter tax credit could be established to support renters.

Furthermore, stratification along axes of race, class, and gender shapes families’ decisions about work and their access to financial resources. The tax and legal scholar Dorothy Brown illustrates how various provisions in the federal tax code disproportionately benefit White families and penalize Black families.³⁹ For example, Brown shows how married Black couples disproportionately experience “marriage penalties” compared to their White peers. A marriage tax penalty occurs when a couple pays more income tax when they marry and file a joint return than they did when they were not married and filed separate returns.

Marriage penalties are highest when the tax unit consists of two wage earners with similar incomes. A larger proportion of Black married couples than White married couples have similar earnings; therefore, Black couples are more likely to experience marriage penalties, a prime example of horizontal inequity. As marriage penalties tend to be larger when children are present, Black families with children may face especially large increases in tax rates following marriage.⁴⁰ Furthermore, the penalty is more pronounced among EITC-eligible families with children.⁴¹ While some research suggests that income taxes are not a primary driver of marriage decisions,⁴² reforming the EITC into two separate tax credits, as described earlier, would promote horizontal equity by treating single and married individuals similarly.

Emerging research also suggests that low-income families and Black families are disproportionately audited by the IRS, despite race-neutral audit selection processes.⁴³ A significant proportion of taxpayers selected for audit have fairly accurate returns, yet many may not know how to respond to the audit process, which can result in fines and tax debt.⁴⁴ A prominent contributor to these disparities is the IRS’s additional scrutiny of tax returns that claim the EITC, and research suggests that Families of Color, particularly Black families, may encounter more complex filing scenarios if multiple family members are involved in caregiving for children.⁴⁵

Although there is nascent research examining the role of tax debt on family well-being, a growing line of research has linked non-wealth-building debt (e.g., credit card debt, child support debt) to decreases in parental psychological wellbeing, positive parenting, and children’s socioemotional wellbeing. Tax debt therefore may also have deleterious effects on parental and child well-being.⁴⁶

Reducing Wealth Inequality Through the Estate Tax

Research has linked wealth inequality to income inequality by illustrating that families with greater wealth are able to utilize their wealth to invest in their children’s education, shield their children from economic hardship, and support their children’s wealth-building prospects.^47,48 Thus, parents can pass down financial (in)security and class position by transmitting financial capital and wealth. As a result, as one family provides a “good start” for their children, barriers to social mobility among low-income and low-wealth families increase.

Historically, founders of the U.S. political and economic system recognized how wealth transfers and the inheritance of status could reproduce family inequality, and U.S. lawmakers throughout history have advocated for policies that would foment equal opportunity based upon merit. One such popular policy proposal was the taxation of wealthy estates. The federal government levied several short-term estate taxes during the nation’s early history. The Revenue Act of 1916 established the modern and permanent estate tax after several decades of political advocacy during the late 19th century and amid growing concerns about concentrated wealth and power.⁴⁹

The estate tax is a tax on the net value of the estate of a deceased person before the estate’s assets are passed to the decedent’s heirs. The tax is levied on total wealth holdings (i.e., assets minus liabilities) above a specified amount after accounting for various credits and deductions. The estate tax has a graduated structure, taxing wealth above certain thresholds at higher marginal rates.

The estate tax has been rolled back considerably over the past 40 years. Between 1942 and 1976, estates valued in excess of $60,000 ($324,647 in 2023) paid an initial tax rate of 3%, and estates valued above $10 million ($54 million in 2023) paid a maximum marginal tax rate of 77%. Reforms from the late 1970s to 2017 pushed the exclusion limit to nearly $13 million in 2023 and lowered the maximum marginal rate to 40%, leading to significant foregone tax revenue.⁵⁰

Revitalizing the estate tax to its graduated structure could generate the revenue necessary to fund investments in children and families. Researchers at the Brookings Institution have found that, all else equal, returning to the 2021 version of the estate tax would generate about $128 billion in additional revenue above the $17 billion collected in 2019,⁵¹ enough to offset the $110 billion allocation to the 2021 expanded Child Tax Credit. The reform would lower the estate tax threshold back down to $1 million and return the highest marginal rate to 55%. Under this reformed structure, the highest average tax rate would be 18.8%, and smaller estates with a gross value between $1 to $2 million would only pay an average tax of 5.5%.

Conclusion

Over the past 40 years, U.S. federal tax policy has shifted the tax burden away from wealthy families without providing comparable investments in the financial well-being of low- and moderate income families and their children through tax credits and deductions. This policy shift to reduce the income and wealth taxes for wealthy Americans has helped entrench income inequality and created a budget context that is unable to make critical investments in the well-being of children and families. Acknowledging the compounded impact of various forms of social stratification could help achieve a more inclusive tax system that assures equitable resource distribution across all societal tiers. Revenue from a reformed estate tax and the elimination or reduction of tax expenditures that disproportionately benefit wealthy families could instead provide tax relief to support the flourishing of families across the income spectrum, to advance tax fairness, to fund expanded child and family tax benefits, and to reduce ethno-racial income and wealth inequality. Further research is needed to evaluate all the costs and benefits of the various reforms discussed.