Asymmetrical Information

There are two different arguments here. I agree with Nyhan, et al, on the matter of the percentage of the total tax burden. But progressivity is not measured by percentage of the total tax burden, so if you want to determine whether the tax system has gotten more progressive, that's a strawman.

As far as progressivity, I think the increased spread between the lowest and highest quintile is pretty good evidence that is has gotten ever so slightly more progressive.

To clarify: by "increased spread", I refer to the effective tax rates for each quintile.

The rich don't pay taxes - they collect taxes.

Roughly 25 cents out of every dollar you spend goes to pay the taxes you thought were being paid by the rich. Or do you really believe that the standard of living of the rich declines when you raise their taxes?

Its kind of funny really. Or perhaps Justice.

I'm sorry, but I just don't see the error the WSJ is supposed to have made. My sense of the editorial's purpose was NOT to demonstrate that the US tax system has become more progressive over time. Instead, the editorial rebuts the assertion that the tax system is not very progressive once social security and other payroll taxes are taken into account. If percentage of the total tax burden can be used as proxy for progressivity, the study upon which the editorial relies, clearly shows that our income tax system's progressivity is not materially affected by including or excluding payroll taxes in the analysis.

Perhaps the editorial should have only used the data for the most recent year instead of going back in time. (In doing so, the editorial writers would have raised the question that they had cherry picked the data.) At most, this seems a minor quibble when compared to the larger question. Just how much of the total tax burden can we fairly ask the top income earners to carry? When this question has been posed in the past, using income tax only data, advocates of even more progressivity have argued that ignoring social security taxes unfairly distorted the question. The study the WSJ cited may have put an end to this diversion. The percentage of the total tax burden borne by each quintile is virtually identical with and without payroll taxes taken into account.

The only progressivity in the tax code should be the second-order progressivity created by substantial personal exemptions, with the rate on each dollar of taxable income being the same regardless which quintile you are cowering in on April 15. We counter-revolutionaries want a flat tax.

"The only progressivity in the tax code should be the second-order progressivity created by substantial personal exemptions, with the rate on each dollar of taxable income being the same regardless which quintile you are cowering in on April 15."

There are two goals in designing an ideal tax system: that it be equitable and that it not distort economic activity. (Not everyone agrees with these goals. Some, for example, want the tax code to shape society by punishing some activities and rewarding others. Other people don't care about how fair the tax system is, they just want to raise revenue. Allow me to ignore these competing points of view for the purposes of this already too long comment.) Unfortunately, the goal of fairness is in direct opposition to the goal of a lack of distortion.

The reason these goals are in opposition to each other has to do with the way we've come to view "fair" when it comes to paying taxes. We could total up the costs of government and divide by the number of tax paying unit (individual or family) and let each taxpayer pay its pro rata share of the total. That would be fair in the sense each taxpayer paid the same amount. (Is it unfair that McDonalds charges each of its customers the same amount for a hamburger, regardless of the differences in the amount of income each customer earns?) When it comes to taxes, we view fairness in the terms of the economic pain it costs each taxpayer to pay. $1,000 to a poor man is "more" than it is to a rich one. So, we've sought to collect more, as a percentage of income, from richer taxpayers than from poorer ones to equalize the amount of pain caused by taxes.

The problem with this approach is that it distorts economic behavior. Just as a $1,000 costs the rich taxpayer less in terms of pain, the NEXT $1,000 of income is worth less to the rich than it is to the poor. The rich are already less inclined to pursue the next dollar of income than are the poor. Increasing marginal rates of tax on that next $1,000 of income simply increases the rich taxpayers' disincentive to go to the effort of earning additional income. If there were some sort of money tree, where any income not harvested by the rich would be available to the rest of us, this would not be a problem. Instead, the way the rich typically earn that next $1,000 of income is to employ poorer taxpayers.

We can have all sorts of arguments about how to best balance these two competing goals, fairness and lack of distortion. My sense is that most of the poor would prefer jobs to the psychic satisfaction they'd get from the knowledge that everyone's paying their "fair" share. YMMV.

David,

While I agree with most of your post, four points

1. Most economic analysis I have seen suggests that impact of marginal tax rates at current levels is quite small.

2. Your comment at the end is unclear. There is not an obvious link in my mind between the # of jobs for the poor and the marginal tax rates on the rich. I could understand an argument about income levels, but I don't see an obvious link to employment levels (driven by things like the minimum wage, ease of firing, wage stickiness ...).

3. Your final line seems unnecessarily dismissive. The benefit to the poor is not 'psychic satisfaction' but lower taxes/higher government services.

4. The pre-tax level of inequality has risen dramtically since the early 1970s. If we care at all about levels of inequality (as opposed to how progressive the tax code is in an absolute sense) that could lead one to favor increasing the progressivity of the code.

Tom

The argument is defective because in 1979 the top marginal income tax rate was 70%, so people simply didn't report income. They patronized the tax shelter industry instead.

In 1999 the top marginal rate was 39-1/2%, iirc. And, the dot com boom was producing millionaires too numerous to shake a stick at.

Since the end of WWII tax revenues to the Federal govt. have consistently been between 17-19% of GDP, each year with very few exceptions. With rates as high as 90% and as low as 28%.

So, I'd say that looking at the appearance of progressivity (i.e. the rates) is much less interesting than looking at who is paying that 17-19%. Lately, it's been increasingly the high income earners.

Patrick,

I read your paragraph:
"Since the end of WWII tax revenues to the Federal govt. have consistently been between 17-19% of GDP, each year with very few exceptions. With rates as high as 90% and as low as 28%."

as implying that tax policies do not effect revenue as a % of GDP. Is that your meaning?

The top marginal rates you refer are a limited measure of the overall tax policy.

Tom G

Tom - Thanks for the kind words and the civil response. Allow me to respond to your points:

1. Most of the economic analysis I've seen, too, does not show much of an impact of higher marginal rates. To this extent, the economic analysis does not correspond with my personal experience and observations. Just last week I had a client decline to pursue an opportunity because, "I won't make enough after taxes to make it worthwhile." (His words, not mine.) Most of my clients demand a higher rate of return from their next project than they do from their "core" income generating activity. In part, because they place a premium on time away from work and, in part, because they don't need the extra income to support their lifestyle. To be attractive, a potential income producing activity needs a fairly attractive return to overcome this inertia. Higher marginal rates means fewer activities will meet a client's hurdle rate.

2. The link between the number of jobs and higher tax rates is as follows: The opportunity my client turned down was to build a new outlet. He does high-end restaurants. Each has his "personal" touch. He had a new concept and a new location. In the end, he was unwilling to sacrifice the time (and risk the capital) for what he expected to keep after taxes. No new location, no new jobs. To the extent high tax rates cause entrepreneurs to not pursue new projects (whether that's opening a new location or just making one more sales call), the affects are felt by all the entrepreneurs employees. I suspect this "entrepreneur effect" is ignored by the economic analysis discussed in 1, above.

3. Yes, my closing line was dismissive. Perhaps too dismissive. I don't think we fully understand just how much work is NOT done (and how many jobs are lost) because of taxes. I suspect that, understanding this, most prospective employees would not mind if prospective employers had a zero marginal tax rate. In fact, this is what enterprise zones (and similar incentives) are all about.

4. Yes, if we care much about inequality we would tend to raise rates on the higher income taxpayers. My point is that doing so would distort economic activity. This approach might lead to greater equality at the cost of lower income for the economy as a whole. The question is how do we balance these two competing objectives. Again, I think that too much emphasis on equality will lead to a lower standard of living for us all -- but we'll have the good feeling that comes from knowing no one has more than we do. (Note: I'm not saying we've struck the wrong balance. I am saying we too often do not understand we are striking a balance nor do we fully understand what the tradeoffs are.)

Re; Response to the cost of taxation, in order;

1. Pass as much of the cost as possible along in higher prices.

2. Take maximum advantage of the tax code, to include exercising political power to manipulate the tax code.

3. Reduce payments to workers via lower wages, increased use of capital equipment, outsourcing to lower cost employees, and layoffs.

4. Decline new opportunities that appear less profitable due to higher tax costs.

5. Get out of the business entirely if the returns no longer outweigh the risks.

6. Last - always last - dig into one's own pockets to pay the increased taxes.

Bottom line; Progressive taxation does a whole lot of regressive damage before it ever reaches the point of being truly progressive. My personal belief is that very few taxes ever reach progressive. If anyone knows of any research in this area, I would be interested.

I am a bit sympathetic to Drum's article.

However, I lose all sympathy and get nervous when Drum starts talking about his tax ideas. Taxing capital and dividends at the same rate would have a serious negative impact on the economy.

Lower capital gains tax rate encourages risk and investment. When the capital gains tax rate increases, there is less investment. Just look at the changes in capital gains declarations after the last tax increase and then the tax cut.

The failure of the left to understand the risk of business investment is a bit frightening.

BTW, I would and have argued that the rise in income inequality is based more on demographics. The rise of the dual earner couple and the single mother is a large factor behind income inequality. The majority of households in the top quintiles have more than one earner while those in the bottom quintile often have less than 1 earner.

Hi all,

"Increasing marginal rates of tax on that next $1,000 of income simply increases the rich taxpayers' disincentive to go to the effort of earning additional income"

I've met very few rich people who would actually stop working because of taxes. This disincentive is so slight. Lets imagine the though process.. "oh, if I make another $300K, they will just tax it, so why bother, or I could put a down payment on that summer home....ok, back to work." Thats a rich person mentality. Thats why they are rich.

Do you really know someone who actually makes lots of money who has said to you "These darn taxes, I am just not going to stop making money this year"?

It simply doens't happen that much. Rich people stop working if they have enough money to do other things, not because the tax on the marginal income is too high.

Don't distort my words. I think taxes should be lower. Why? I like the allocation effect of when people are allowed to spend their money.

I just don't think that marginal tax rates are a very powerful effect on actual behaviour. (Seen that one lately, Jane?! hehehe) It seems logical, but in reality, its just not that strong.

In reality, rich people find something that works and then milk it until it no longer works, or they have enough money to keep them satisfied. At least the rich people I've met have done it that way. The fact they are taxed on their additional effort doesnt exert pull except at the very extreme - they either have enough money, or they dont. If they don't have enough money, they don't have enough money, and they go make more until they have enough. I think the overall effect is way, way smaller than is commonly thought.

"implying that tax policies do not effect revenue as a % of GDP. Is that your meaning?

"The top marginal rates you refer are a limited measure of the overall tax policy."

Any one thing is a limited measure of tax policy. However, the top marginal rate(s) produce incentives that the people with the highest incomes will respond to. As is shown by 60 years of evidence.

Why is it that noone ever considers how much the government spends when determining the "goodness" or the "rightness" of a tax? If your spending more then you earn, isn't all "extra" income a good thing? It seems all economic common sense goes out the window when reps start talking about taxes. I wonder if anyone runs a successful business by spending more then they take in, and then deciding to pay less then the minimum requirement on the debt(Bush tax cuts).

"Most of the economic analysis I've seen, too, does not show much of an impact of higher marginal rates. To this extent, the economic analysis does not correspond with my personal experience and observations."

I assume that "economic analysis" means looking at how large aggregate measures of investment and employment behavior change with various marginal rates. Is it possible that they don't see a change simply because since WWII the rates have never come down far enough for tax-avoidance to decrease?

Taking a different position, to me the fact that more people are left off the tax rolls implies that the federal tax system is more progressive than it was 20 years ago. To the fact that more of the nation's income is flowing to the top is a result of taking people off the tax rolls in my opinion. Hey, why should any employer pitch for higher employee salaries if his salary is the only one being taxed? If you want to see more income going to the lower income levels, put more people on the tax rolls.

Randy: What are you talking about?

Please provide data.

Sigivald,

Sorry, no data. I'd like to see some if anyone knows where it can be found.

Question 1; If progressive taxation is really progressive, why is the gap between rich and poor getting larger?

Question 2; Where does the tax money the rich turn in to the government come from?

Hypothesis; In real terms (standard of living), the amount of tax I pay is indirectly proportional to the power I have to adapt my income to a changing environment.

A simple example using only one element; Taxes go up, so prices go up. Only those unable to raise their wages in response to the increase in prices are effected by the tax. No matter how progressively a tax is defined, it is ultimately regressive.

Randy,
Could your point fairly be reduced back to elementary economics, that whoever has the least elasticity bears the brunt of the tax? For the same reasons that the employee pays "the employer's share" of Social Secuirty through lost wages, the bottom quintiles that pay no income tax are paying the top quintile's income tax through higher prices? The closer you are to being broke, the less elasticity your labor market participation has, so poorer people will tend to pay the brunt of taxes imposed on the rich?

It seems reasonable to expect tax burdens to be passed along, especially if we expect tax cuts to trickle down. Without checking numbers, I would guess that the taxes paid by the top quintile are greater than the total income of the bottom quintile, so the impact would be spread around those of middling income as their elasticities allow.

Empirical verification of the effect would be interesting to see, along with where the bulk of the tax burden ends up. The story is interesting, but real numbers could make it more compelling (or contradict it).

Zubon,

I like the way you say that. I'm just an amateur trying to make a point.

I'm guessing that the lower middle income probably does pay the greatest price (again, in real terms, not dollars) as income redistribution does exist but seldom reaches this group. The net effect may be that wealth is transferred from the lower middle class to the poor.

The point about trickle down is also interesting. I suspect that the costs of taxation trickle down a whole lot faster than the benefits of reduced taxation.

The reason the "gap" is getting bigger is that it is bound on the bottom ($0) and unbound at the top. And it doesn't matter anyway, because membership in any quintile is not permanent, it's fluid.

A good example is a non-working senior in college. They earn no income, and therefore are in the bottom quintile. They graduate and get a job. Now they have income of $30,000 per year. That does not improve the average income of the bottom quintile, it moves that individual into the 2nd or 3rd quintile. As long as there are people starting at zero, and the upper limit of income is unbound, the "gap" will continue increase.

Question 1; If progressive taxation is really progressive, why is the gap between rich and poor getting larger?

In addition to what markm said, "progressive taxation" simply means that the proportion of tax liability rises as some function of increasing income. The idea that it should also act as a social lawnmower is something different.

Whoops, that was mailman, not markm.

David,

And thank you in return for the civil reply.

I believe in the incentive effects you describe although I do put more faith in the statistical analyses on their small size than you do. The extent to which those effects could compound over time does give me some pause.

I also feel high levels of inequality may themselves do some damage, but that's just a guess. The economic data on inequality's impact on growth was much less clear the last time I touched the issue seriously.

Cheers,
Tom

Patrick,

"Any one thing is a limited measure of tax policy. However, the top marginal rate(s) produce incentives that the people with the highest incomes will respond to. As is shown by 60 years of evidence."

If you mean the evidence has shown the reaction to be small, I agree with you. The anecdotal example is of course the US in the 1990s after the Clinton tax increases.

Cheers,
Tom

Markm,

"Is it possible that they don't see a change simply because since WWII the rates have never come down far enough for tax-avoidance to decrease?"

I think it is likely that we would have seen the biggest effect going from very high to moderate. It seems unlikely to me that the big gain is hidden in going from high 20s to the teens.

On the flip side, I'd be open to any evidence that you have. Certainly there are stranger propositions that have some empirical merit.

Cheers,
Tom

"If you mean the evidence has shown the reaction to be small, I agree with you. The anecdotal example is of course the US in the 1990s after the Clinton tax increases."

Not at all. The key year was 1986, when the base was broadened and rates were reduced from a top of 50% to 28% (the number of rates was also reduced to two). That destroyed the tax shelter industry almost overnight.

It had continued to exist after the Kemp-Roth cuts reduced the top rate from 70% to 50%, but even when Clinton raised it to 39% it didn't make sense to shelter income. Raise it back to 50%, and you'd likely see its rebirth.

Okay, this is a long post and I apologize in advance if I haven't made myself clear but my eyes are starting to cross.

If memory serves, and I think it does, when Bush got his cuts to the income tax, they were cuts designed to lower the income tax of everyone who paid and to make the income tax rate more progressive. Some people at the bottom got dropped entirely (100% reduction), the next group didn't get 100% but they got a larger percentage drop than the group above them got, and so on.

If you graphed taxes paid against income earned, the new line crosses zero farther out than the old one (meaning you can earn more and not pay income tax on it) and has a sharper slope than the old line even though it is under it at all points until they both flatten out at their top rates. The sharper slope means it is more progressive.

Given that, if you compare any amount of money as a 'rich' persons income vs the same amount of money broken up over a number of poorer people as their combined income (people not so poor as to pay nothing under the old system) and look at income tax paid under the new tax system vs the income tax paid under the old tax system, what you will find is that everbody pays less under the new system but that the 'rich' guy didn't get as much of a break as the combination of poorer people.

Now whether the top quintile is actually paying a larger percentage of the total is not a matter of progressivity alone. The income tax IS more progressive than it used to be. But a recession, the dot.com bust, accounting frauds, 9/11, all of it combined to do some serious damage to economy at the beginning of Bushs first term and the high oil prices aren't helping the economy now. How this plays out in the quintiles is something we have to gather data and see. Nonetheless, the income tax IS more progressive than it was. That is how the cuts were designed.

As to why the gap between the top and bottom quintiles of income is growing, this is my opinion: Increasing the productivity of the workforce in a competitive environment increases the gap between the top earners and bottom earners.

First, some of those in the top 20% now weren't in the top 20% last time, so it isn't proof that the gap is growing between the rich and poor. To prove that, you need to follow the SAME people over their careers. What it is proof of is that top earners today are making more than top earners of a decade ago relative to the bottom earners. Once you look at it like that, it seems reasonable and indeed inevitable.

Let me point out that when talking about a quintile or 20%, they are not all Bill Gates or Warren Buffet or Paris Hilton. Most of these people are earning their income working for someone somewhere. As productivity increases, the people positioned to take advantage of it will generate more now than the productive people of a previous year. As long as the market is competitive and they have multiple companies willing to employ them making widgets, this increased productivity will be reflected as increased earnings. The bottom earners on the other hand do not benefit from much of the productivity increases since it is computer and automation related currently. The information age as they say. The guy loading boxes is still going to be loading about the same number of boxes and the cost of replacing him with another unskilled laborer hasn't gone up much. (Most people do not stay at minimum wage their entire life so it would be more accurate to say the guy loading boxes today is not loading many more boxes than the guy who was loading boxes ten years ago.) Thanks to improved inventory control (Walmart), they may be loading boxes more smartly at the warehouse but the number loaded hasn't changed much. Perhaps you will have one guy watching machines loading boxes as opposed to several guys doing it (or one cashier and a bunch of automated checkouts), but then he gets moved to a middle quintile and the unemployed ones have to take whatever jobs they can find. Their pay will increase according to economists I have read as the rest of labor goes up but only indirectly and not as much.

So, when you see that the gap between rich and poor has increased, it is actually a sign of a fluid economy with increasing productity. As long as the bottom is going up compared to the previous bottom, I don't have a problem with it. If the bottom actually declines, then that is a sign for govt intervention but decrying the gap between rich and poor is just class envy and really a cry to stop our economy growing.

As long as people make their money doing things that benefit the consumer (i.e. Bill Gates and not Tony Soprano), then that is good. And the better the system is in allowing them to use their skills or ideas, the more consumers will benefit from their work, and the richer they will get. This is a good thing and increasing income disparity is a byproduct of it.

CAL

Tom G: "It seems unlikely to me that the big gain is hidden in going from high 20s to the teens."

Tom, I'm not sure that even the teens are low enough. My wife fretted about income tax when our marginal rate actually was in the teens. Now it's in the 20's, and when I get a raise, the first thing she asks is what this would do to our taxes. It's irrational, sure, but if I make $4 more, she'll think more about the $1 (more or less) that the government gets than the $3 that we get.

I suspect there's a lot of others that feel the same way - because there's still lots of money going into municipal bonds and other tax shelters, lots of money getting transferred right out of the country, and lots of very smart people making big bucks by looking for more tax shelters.

Markm,

I think its perfectly rational to be concerned about that dollar. If I get robbed, I am concerned. Interesting that progressive taxation tends to breed Republicans. Kind of a balance of powers thing.

A couple of contrarian points regarding tax rates and the so-called 'disincentive' they create to employ and earn:

An employer with a higher marginal tax rate is more likely to hire additional workers because his after tax cost is lower. If I am a sole proprietor in a one-man shop and my marginal tax rate is 25%, perhaps I would not be willing to hire an employee because 75% of his nominal wages come out of my pocket. Rather, I would work harder myself. If, conversely, my marginal tax rate is 50% I may be inclined to hire an assistant because only 50% of his nominal salary comes out of my pocket, which might be worth the incremental leisure time an assistant would afford. Higher tax rates may make it more likely, rather than less likely, that companies add to employment.

Secondly, my father took a second job when I was a child to help make ends meet. This second job paid $4 per hour, a fraction of what his full time job paid, however it was necessary. Let's say he was in the 20% combined tax bracket at the time. Had taxes been lowered, to say 10%, the incremental after tax income he earned on his full time job would have been enough to eliminate the need for him to take the 2nd job, which he would have gladly quit. It this case, a higher marginal tax rate actually increased the incentive to go out and earn an extra few thousand dollars.

Wallster - Your first insight is flawed for the following reason: Unlike other partners in your business, Uncle Sam does not share in both profits and losses. He only shares in your profits. Thus, you have to fund 100% of an employee's salary and benefits. If, after paying those expenses out of your own pocket there is anything left over, Uncle Sam will come in to collect his share of the profit. Higher marginal rates do NOT lower your costs of hiring a worker. They simply reduce your upside without doing anything to protect your downside. I don't see how you can spin that as anything but a disincentive.

Your second insight is accurate, but it cannot be generalized beyond those at the very bottom of the economic ladder. When I was in grad school, I had three part-time jobs and my wife took in baby-sitting. I would have taken another job at almost any wage to help us feed our family of four. Since graduation, I've turned down lots of chances to make money on the side.

All this illustrates is the "declining utility" of money. After your basic needs are taken care of, you tend to value the next dollar of income less. You are less willing to work a second job or to work overtime (if you are compensated for overtime). A business owner is less willing to take on new risks or expend additional time (which might have created new jobs). All because, having had basic wants satisfied, the "utility" enjoyed by earning that next dollar is less than the utility from earning the first dollar. There is a NATURAL tendancy to quit seeking additional income (if it requires more work and/or risk). What do we do? We tax these "lower utility dollars" at a higher rate! Again, I don't see how you can spin this as being anything but a disincentive.

David - all businesses are in business with the intention of making a profit. If my company in the above example makes 100k per year pre tax, and I want to hire someone for 25k per year, the marginal after tax cost to me will be the 25k * (1-tax rate). If the business is losing money in the current year but has prospects of being profitable in the future, the effect of hiring someone will increase my net operating loss carryforward asset that I can apply to future years. If there is no prospect of being profitable, what would be the point of staying in business?

So, in any example except where a business has no prospect of earning profits now or in the future, and has no way of realizing its NOLs for tax purposes (selling out to a profitable entity), increased tax rates ABSOLUTELY reduce the cost of hiring an additional worker.

On the second point, I do see how increased marginal tax rates can be a disincentive to additional work, however my point was to point out that tax rates can be a incentive to work, where an individual has an after-tax income figure that they'd like to obtain. If you want $500k after tax, you need to make $800k pretax. If rates were increased, you would need to work harder to make $900k in order to keep $500k. I'm not going to tell you that increased marginal rates are ALWAYS an incentive to earn more, but I do think that they are an incentive more often than supply-siders would like to admit.

Would you suggest taxing 'higher-utility' dollars more than 'lower-utility' dollars? I know the libertarians on this board would disagree with me, however I would like to believe that we live in a society compassionate and ethical enough to realize the benefit of taxing income used for luxury or wealth accumulation at a greater rate than we tax the income used for sustinence.

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