Enforcing
Our Progressive System
In taxation, as in many things, the way the system is supposed to work
is not the same as the way it actually does work. We are supposed to
have a progressive tax system, in which people who earn more income pay tax at
higher rates than those who earn less. In practice, many people with high
incomes pay much less than you would think, which means that the working middle
class pays too much.
The idea behind the progressive tax system is that the burden of providing
government services should be distributed based upon the ability to pay and the
relative financial benefit that people receive from being able to do business
in the stable environment that our government supports. The ability-to-pay
concept is a notion of economic efficiency: If the government needs $1,000 and
can take it either from someone who earns $20,000 per year or someone who earns
$200,000 per year, the population is better off if the government takes the
$1,000 from the person who earns $200,000 because she will (on average) suffer
less pain from the loss. In other words, society is better off overall if the
government collects relatively more from higher-income individuals than from
lower-income individuals.
Relative social benefit is a notion of fairness. If you took two babies born in
a poor nation, such as Chad, and auctioned off the right for one of them to
grow up in America, the child who was destined to become Bill Gates would
presumable be willing to pay more than the child who was destined to become a
Wal-Mart cashier. The latter child certainly is still much better off in
America than in Chad, on average, but the child destined to become Bill Gates
would be better off to the tune of $30 billion. The progressive tax system runs
that auction retroactively, effectively saying, "Bill, this country has
been very, very good to you, so we're going to ask that you give a little extra
in return." This concept does not mean that talented, hard-working people
should be prevented from earning and keeping a lot of money. It just means that
efficiency and fairness both dictate that those wealthiest individuals should
pay a relatively larger share of the cost of running our society - the society
in which they have prospered and have been able to use their talents.
Parts of our tax system are not progressive at all. All workers pay 7.65% of
their wage income in employment taxes - in fact, double that amount if you take
the view (as most economists do) that the employer's share is passed through to
the employee as lower wages. However, 6.2% out of that 7.65% does not apply to
wages above $97,500. As a result, people earning more than $97,500 in salary
actually pay employment taxes at a relatively lower rate than people who earn
less than that. Furthermore, people who receive their income from sources other
than wages do not suffer any employment tax on that
income.
Similarly, sales taxes are not progressive. Given that everyone in a particular
town generally pays sales tax at the same rate and that people with very high
incomes generally do not ever spend all of their money, higher-income
individuals may pay relatively less sales tax. Because of this effect, a family
earning $40,000 a year will spend about 10% of its income on state and local
taxes (state income, sales, property, gasoline excise, etc.), while a family
earning over $100,000 a year will pay a little over 7%. Families earning more
than that pay a progressively smaller percentage.
Nevertheless, the progressive income tax part of the system operates, for the
most part, in the way that you would expect. In 2005, looking at adjusted gross
income (that is, income before personal exemptions and itemized deductions),
families earning $20,000 paid federal income tax at an average rate of 5%,
families earning $40,000 paid it at an 8% rate, families earning $100,000 paid
13%, and those earning $200,000 paid 20%. At that point, however, the
progressivity curve starts to flatten out. The rate of tax on families who
earned over $500,000 in 2005 hit 24%, a relatively small increase over the $200,000
group, and the rate of tax dropped to 23.5% for those earning over
$5,000,000 and to 21% for those earning over $10,000,000.
Why are top rates so low? In large part, it is due to the special low rates
that apply to capital gains and dividends. Families
earning less than $50,000 a year derived about 1% of their income from those
sources in 2003 (and another 11% of their average income from pensions and
IRAs, for which these favorable rates provided no extra benefit), while families
earning over $1,000,000 obtained 35% of their income from those sources.
Recently we've learned how the "carried interests" trick allows wealthy
hedge fund managers to pay tax on their income
at a rate of only 15% - a far lower rate than what their secretaries pay.
That's just the latest in a long line of devices by which people manage to pay
less tax than you might think.
So, a family earning $40,000 a year pays, on average, 7.65% (or 15.3%,
depending on how you look at it) employment tax, 8% federal income tax, and
about 10% state and local income tax when they spend their money, for a total
of about 25.65% (or 33.3% if you take the view that an employer passes its
portion of the employment taxes on to its employees). A family earning
$4,000,000 a year, or 100 times as much, pays employment tax of about 0.62%,
state and local tax of perhaps 6%, and federal income tax of 24%, for a total
of some 30.62%. That may or may not be progressive at all, depending again on
how one views the employer portion of the employment taxes. At best, it's
certainly not very progressive.
The Shared Economic Growth proposal would get rid of the special favorable
rates for capital gains and dividends, shutting down a string of schemes such
as carried interest taxation and causing all income to be subject to the same
progressive rate structure. It would also impose a small supplemental tax of
7.5% (not much more than the 6.2% portion of employment tax that does not apply
to income over $97,500) on income over $500,000. That would make our system
about as progressive in reality as the rate tables make it look on the surface.
Progressivity
and Growth
Data spanning the full history of the American income tax shows that
progressive tax rates are not inconsistent with healthy growth. To the
contrary, sharing the rewards of work a bit more broadly appears to help
growth. As the chart above shows, overall growth was strong while top marginal
rates were high. As the chart below shows, income growth for the top 1% is not
linked to income growth for the bottom 99%. Enforcing progressivity, if done in
the context of providing fair opportunity to the 99% rather than providing
handouts, seems to promote growth.
Wouldn't society's overall happiness be maximized if families earning $40,000 a
year were taxed at a lower rate than families earning 100 times that much? If
we give more working Americans a chance to earn healthy after-tax income for
their efforts, wouldn't that be the best way to give everyone a real incentive
to work hard and contribute to society? Wouldn't it be more fair if, for the
benefit of living in the American economy, a two-earner family earning $40,000
paid a lower percentage of their income than a family earning 100 times that
much? The Shared Economic Growth proposal would make progressive taxation a
reality.
Wouldn't that be better?
.
An approach he concluded would provide better returns for investors,
more jobs for Americans, and encourage entrepreneurial spirit. While
common sense is increasingly uncommon in the current tax debates,
everyone seems to agree that we need to bring the cash
held offshore by American corporations back home. In that spirit, I
offer the following suggestions (to be coupled with Mr. Johnston's
proposed accumulated earnings proposal):
