The creation of the individual and corporate income taxes was largely motivated by concerns about equity. At the turn of the 20th century, the federal government relied on regressive tariffs and excise taxes for most of its financing. Progressive Democrats and Republicans rallied around the new income tax and the required three-quarters of the states quickly ratified the amendment enabling the new legislation. Initially, the individual income tax was a 1 percent levy on the incomes of the wealthy, with a 6 percent surtax on the super-rich. U.S. entry into World War I vastly increased federal revenue needs and the top income tax rate rose to 77 percent in 1918.

For its first 30 years, the income tax remained a “class tax,” affecting only a small sliver of the population with very high incomes. World War II again increased the federal government’s revenue needs and the innovation of payroll tax withholding made the income tax into a “mass tax,” affecting most working people in the country. Nonetheless, the income tax has remained progressive: It claims a much larger share of income from those at the top than at the bottom of the income distribution. And, indeed, the income tax now serves as an important income supplement for low-income working families.

Some argue that the need for a highly progressive tax has never been greater. Economic inequality has been rising since the 1970s and is now at levels not seen since the eve of the Great Depression. Myriad factors have contributed to this trend, including rising returns to higher education, technological change, increased globalization, the declining role of unions and other institutions, the evolution of a winner-take-all society where top performers earn much, much higher rewards than those near the top, and the erosion in the real value of the minimum wage.

While the ideal response to extreme inequality is to address the underlying impediments to success, it is clear that the tax system can play an important role in mitigating income disparities, especially in the short- to medium-term. The question for economists is the cost of progressive taxation, that is, how much can the income tax reduce inequality? The question for policymakers is how much the tax system should reduce inequality given those costs and social values about fairness.

This article examines trends in economic inequality and the role of the tax system in reducing it. Part II provides an historical and international perspective on inequality. Part III looks at the role of taxes in mitigating inequality and how that has changed over time. Part IV considers the trade-off between the gains to social welfare from a more equal distribution of incomes and the economic costs of using the tax system to reduce inequality. Part V discusses the important role that the income tax now plays in providing a safety net. The last Part offers some concluding observations.