Income Inequality on Course to Hit Record Levels Thanks to Tax Compromise

With a tax bill tilted to benefit the wealthiest Americans poised to pass Congress this week, U.S. income inequality will exceed the records set in the months preceding the crash of 1929 and the financial crisis of 2007. One key to that shift -- a tax code modification that will enable people with larges estates pass them on to their heirs at the lowest tax rates in decades.

Income inequality is already extreme even within the highest level of incomes. According to The American Interest, in 2004, the top 25 hedge fund managers combined to earn more than all of the CEOs from the entire S&P 500. In short, America is becoming a country where a handful of people get extremely wealthy, while the other 99% tread water at best.

But thanks to some clever spin, the party that is pushing tax relief for that tiny fraction at the top has been able to convince a big chunk of that 99% to support tax policies that aren't in the best interests of the majority of Americans. Because let's be clear: If the wealthy aren't paying their fairs share of taxes, the rest of Americans will have to make up the difference.

Passing on Fabulous Wealth Nearly Tax-Free

This compromise tax bill -- which, if passed as is, will add $858 billion to the deficit -- will offer a sweet deal to heirs of large estates. According to the The Washington Post, the package would exempt as much as $5 million from the inheritance tax, and tax the portions of estates in excess of that amount at just 35%. Based on those numbers, the Tax Policy Center concludes that in 2011, the estate tax will bite the fewest inheritances of any year since 1934 -- except for 2010, when there was no estate tax at all.

To get an idea about how many people this limited estate tax will touch, in 2009, just 4,296 people died leaving estates greater than $5 million, according to BloombergBusinessweek. And for those few, there are still options to reduce the tax burden on their heirs, such as Grantor Retained Annuity Trusts. In a GRAT, parents loan stocks or shares of a private business to the trust at the lowest interest rate legally allowed by the IRS -- now 1.8%. If the value of those assets increases over time, the trust's beneficiaries reap any benefit above that interest rate.

While President Obama and Democrats sought to limit the use of GRATs, they failed. As Jennifer Immel, senior wealth planner at PNC Wealth Management, proudly bragged to BloombergBusinessweek, "That's a wonderful technique for parents looking to pass assets on to children at nearly zero [tax rates]."

Those tax benefits come on top of the favorable treatment already embedded in the tax code for the richest 1%, who get most of their money from investments, rather than wages. The average American earns 64.5% of their income from wages, while a mere 18.1% of it derives from business ownership or capital investments, according to BloombergBusinessweek. By contrast, those in the wealthiest 1% derive 53.6% of their income from business and capital investments. Wages account for a mere 35.3% of their income. That why the 15% tax on dividends and capital gains is so valuable to them.

A Democracy Where Votes Are Counted in Dollars

All this clever tilting of the tax code to favor the richest 1% will only exacerbate America's already growing income inequality problem. As I wrote in an August 2009 DailyFinance article, one of George W. Bush's many lousy legacies was a level of income inequality greater than in the Roaring '20s. In 2007, for example, the top .001% of American earners took home 6% of total U.S. wages -- about twice the figure for 2000. That year, the richest 0.01% (the 15,000 richest families) had 6% of national income, six times their 1% share in 1974.

In a supposedly democratic political system, how do economic policies flourish that favor a few thousand individuals at the economic pinnacle at the expense of the majority? It is simply a matter of creating effective myths and causing them to be repeated over and over on TV, radio and the Web, in newspapers and magazines.

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Those messaging machines are paid for through a system that gives even more power to those willing to write the biggest checks. The New Yorker's Aug. 30, 2010 edition did a brilliant job of profiling the Koch brothers, the billionaire owners of Koch Industries, who quietly invest vast sums of money to promulgate messages that help their businesses while harming the rest of us.

The ancestral source of those myths is America's parent -- the U.K. -- which continues to pay for a flourishing monarchy. It's no wonder that U.S. news networks were instantly obsessed with the engagement of Prince William. A commoner, Kate Middleton, was about to marry into a royal family with limitless economic support from its subjects: Such Cinderella stories allow everyone to imagine that they might someday be so lucky. The mythic power of Miss Middleton's long-odds victory in the royal marriage lottery sends a subtle messages that helps preserve the British monarchy: This could happen to you -- but only if you keep the system in place that allows the winners to win big.

It's essentially the same idea that the U.S. income inequality messaging machine has been spewing out for decades: Go along with economic policies that help a few thousand people to get and pass on fabulous levels of wealth, because you never know -- you might be one of them someday.

Of course, most Americans won't -- and they won't even come close -- because the system is stacked against 99% of us, thanks to the millions of Americans who buy into those messages, and vote to keep giving themselves the short end of the economic stick.

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