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In his State of the Union speech Tuesday night, President Barack Obama plans to put forth a plan to try to slow the widening gap between the richest and poorest Americans.
Widely seen as a nonstarter among the Republicans who now control Congress, the proposal targets the lingering financial setbacks inflicted by the Great Recession on all but the wealthiest American households. Even as the unemployment rate has fallen and the overall economy picked up steam, the wage gap between the richest and poorest continues to widen.
That disparity in wealth distribution was underway long before the financial crisis of 2008 sparked a global downturn. Between 1979 and 2011, the average after-tax income for the bottom 20 percent of U.S. households rose by 48 percent, according to Congressional Budget Office data. The top 1 percent saw their incomes rise by 200 percent during the same period.
The White House is proposing to use changes in the U.S. tax code to slow or reverse that trend. A key provision would close an inheritance tax loophole that benefits the wealthiest Americans the most. After raising those taxes, the plan would use the money to give middle-class families a tax break for expenses such as education and child care.
Here's how the overall plan would work:
How does that inheritance tax loophole work, exactly?
If you buy a stock for $10 and it increases in value to $100, you have to pay tax on that increased value—known as a capital gain—when you sell it. But if you hang on to it until you die and leave it to your kids or grandkids, Uncle Sam gets cut out of your will. The capital gains meter gets reset at $100 for your heirs and they only pay capital gains on any value above $100.
While anyone can leave money to their kids, the wealthiest have a lot more capital gains to shelter from taxes. Of those who got an inheritance, the average amount among the top 5 percent was $1.1 million, according to the latest Federal Reserve data. The average amount for heirs in the next 45 percent of the wealth ladder was $183,000. For those in the bottom half of households, the average inheritance was just $68,000.
But doesn't raising the capital gains tax discourage investment and hurt the economy?
That's clearly one of the strongest arguments from advocates of low capital gains tax rates, but there's little evidence of a link between the two. President Obama wants to increase the top rate on couples with incomes above $500,000 to 28 percent—where it was during the Reagan administration. (The top rate has already been raised from 15 percent to 23.8 percent during the Obama administration.)
That means a couple that generates $100,000 in capital gains from an investment would pay another $4,200 in taxes—and still make $72,000 on their investment. It's hard to see why they would sit out the chance to make $72,000 because of the extra $4,200 it will cost them.
More broadly, opponents of the increase argue it would act as a headwind to the overall economy. But looking back over the last 60 years, some of the biggest advances in real gross domestic product have come in years when the capital gains tax was highest. So the "growth killer" argument is a tough one to make.
Some proponents of closing the inheritance loophole argue that the tax dodge itself is a significant economic damper because it encourages wealthy households to hang on to their appreciated assets until they die—just so they can escape the inheritance tax. That "lock-in" effect, these analysts contend, keeps capital from flowing where it could be more productive and help spur economic growth.
What else would the plan do?
Obama also wants to raise fees on the biggest financial firms, those with assets of more than $50 billion. That idea could generate some support from Republicans who opposed big bank bailouts during the financial crisis.
And the president wants to boost retirement savings among middle-class households by automatically enrolling people in an individual retirement account if they don't have a retirement plan at work. The proposal would also expand access to plans for some part-time workers.
This just looks like the same old proposal by Democrats to raise taxes. Haven't they gotten over that?
The plan isn't designed to raise the overall revenue the government collects—just to raise taxes for the rich and cut taxes for households further down the economic ladder. Those tax breaks would come in the form of credits—money you get to deduct right from your tax bill—for specific households.
Those provisions include a new $500 tax credit for families with both spouses working, which phases out for incomes up to $210,000. The White House estimates some 24 million couples would get all or part of the credit.
Parents would get a bigger tax credit—$3,000 more per child under age 5—to help pay for child care. That would help another 5 million families, the White House says.
The plan would also consolidate six education tax breaks into two, an idea some Republicans have supported.
But these tax credits are only available to people who earn enough income to owe taxes. So if you don't make enough money to owe the IRS, you won't get any of it back
So this won't help people at the very bottom of the economic ladder?
For those households, the White House is seeking to expand the earned income tax credit that helps the lowest-income workers. (The current income limits top out at $52,427 for a married couple with three or more qualifying children.) The EITC is a "refundable" tax credit—which means you get paid the credit even if you don't earn enough to owe taxes.
The White House also wants to expand the credits for low-income households that aren't raising children and make permanent parts of the EITC and the child tax credit set to expire after 2017. That would help some 16 million people in low-income working families—including 8 million children, according to the Center on Budget and Policy Priorities.
If the idea is to close the wealth gap, would it work?
It might help, but there are longer-term forces at work that won't be changed by tinkering with the tax code. For a variety of reasons, for example, the average middle-class family has seen wages rise little—if at all—since the Great Recession, even as corporate profits have increased and the stock market has produced solid gains.
Those hoped-for wage gains may yet happen—as the ongoing drop in the jobless rate forces employers to boost paychecks to recruit new hires or keep the workers they've got. But the wage gap between the richest and poorest households has been widening since the 1970s.
And the wealth gap is even wider when measured in the total net worth of the richest Americans. As of 2013, the top 3 percent owned some 54 percent of all assets and the next 7 percent held another 21 percent of the nation's wealth, according to the Fed's Survey of Consumer Finances.
That left just a quarter of all assets for the bottom 90 percent.
CORRECTION: An earlier version of this story incorrectly stated the net return on a hypothetical investment under the proposed new capital gains tax.