Many a bitter fight is waged over tax policy. How high should sales taxes go? How should we tax personal income? What deductions should be allowed? Should all income regardless of the source be treated the same?
Most countries have a similar list of income classes: the poor, the working class, the middle class, the affluent, the rich and the superrich. The trends in the U.S. over the last 20 years for real, inflation-adjusted income are: the poor remain poor, income for the working class does not grow, the middle class shrinks in size, and the rich and superrich get richer. Look at the recent street-art from Greece about how the pie is divided.
Photo by Christoph Asche, HuffPost Germany, June 18, 2015
More of us are looking at whether the growing income gap is a time bomb and needs to be defused below it blows up.
And the best answer might be that it is time to increase the progressivity of our income tax and estate system.
There remains a lot of confusion in the public mind about the difference between a flat tax and a progressive tax system. Taxes increase in both systems as income grows. If the flat tax rate is 20%, a person earning $50,000 would pay $10,000 in taxes; a person earning $500,000 would pay $100,000.
A progressive tax calls for increasing the tax rate from say 20% to a rising rate as income grows. So the person earning $500,000 will pay more under a progressive tax than a flat tax. The rule may be to pay 20% on the first $100,000, and pay 30% on anything over $100,000. In this case, the rich person would pay $140,000 in taxes on an income of $500,000, compared to $100,000 on a flat tax of 20%. The rich persons 20% on the first $100,000 plus 30% on the remaining $400,000 = $20,000 + $120,000 = $140,000.
What is the ethical argument for charging a rich person a higher tax rate than the basic flat tax rate of say 20%? It is the view that lower income earners can barely afford to buy the needed food, clothing and shelter on their low income. Besides that, they pay as much as 10% sales tax on virtually everything they buy. Wealthy people pay the same sales tax rate but spend proportionately much less on consumption, so sales taxes are quite small in relation to their high incomes. Rich people can only spend so much on food and clothing. They save or invest the rest. A higher marginal tax rate in no way reduces their basic standard of living. It does not create a weekly budget crunch or a need to borrow more money at high interest rates. A progressive tax simply reduces savings and investments for the rich.
The U.S. uses a progressive income system with seven income brackets. The current marginal tax rate on the highest bracket is 39.6%. Figure 1 shows the tax rates on three income sources: income tax, corporate tax, and capital gains tax between 1916 to 2011. Let’s first focus on the income tax rate since 1945.
Note that the highest bracket rate varied considerably in the post-World War period.
chart by: Catherine Mulbrandon (visualizingeconomics.com)- click to enlarge
The income tax rate stood at 90% during 1945 – 1964. It dipped to 70% during 1965 – 1981. Then it dipped again from 1981 to average under 40%. Note that throughout the period marked by a very high marginal tax rate, the economy kept growing. Apparently investors continued to invest even when they had to pay a high marginal tax rate.
Many Republicans think that 39.6% is too high. They want to lower it or eliminate the progressive element entirely and return to a flat tax. They argue that the rich will still pay more taxes than the poor. But they ignore the fact that this reduces the total tax revenue. It leave less money for social benefit and earned income tax programs which help maintain a minimal standard of living for the poor and working classes..
Liberal Democrats on the other hand think the tax system isn’t progressive enough. The rich receive a lot of their income in capital gains, dividends or other clever sources. These are taxed at a much lower rate than normal income. With a maximum capital gains tax rate of 20%, wealthy people like Mitt Romney or Warren Buffet sometimes pay lower tax rates than their secretaries. It turns out that the average tax rate on the rich is about 24%, nowhere near the highest marginal rate of 39.6%.
Liberal Democrats make an ethical or social justice case that high income earners should be taxed at an even steeper progressive rate. They make the argument that low income earners are not paid more when their productivity increases. The profits resulting from higher productivity do not even go to the middle class. They only go to the rich and the superrich, the top 1% and especially the top .1%. Traditional Capitalism in the U.S. consistently resists letting workers participate in productivity gains, which keeps their incomes down and ironically requires the imposition of progressive taxes on the rich to support the necessary social programs. The rich come back with two arguments against progressive taxation. First, productivity gains are largely the result of capital and innovation. The workers are working the same but it is capital, not labor, that boosted worker productivity. Therefore capital (and the owners of capital) should receive the profits from productivity gains. This leads to the second argument, namely that higher taxation of the rich leads to less investment by the rich. Then the pie won’t grow as big. They even add a non-fact that all boats will rise with the tide. This has not happened for more than 20 years.
The rich basically want the non-rich to build a bigger pie which leaves them with more money to invest. They do not want any oversight or changes in how the larger pie is to be distributed.
I believe the pie distribution issue can no longer be ignored. Distribution is now the real issue, not the size of the pie. We hear more statements today that the rich have rigged the system. We hear that the three top men at the private equity firm Carlyle each took home $500 million of income this year. We hear that the compensation industry tells a company to pay more to the new CEO than his competitors, if they want the best new CEO. We know the rich use offshore tax shelters such as Swiss banks or Caribbean islands to avoid or minimize their taxes. It is estimated that loopholes and exemptions cost the public about a trillion dollars a year.
My argument is to not only keep our progressive income tax system but to increase its progressivity. This is long overdue. The Republicans have done everything to lower the marginal tax rate which stands at 39.6% on the highest bracket. In Scandinavian countries, the marginal tax rate on the highest incomes is around 50%. We need to move toward 50% and use more brackets to address the super-high income levels of the top 1% and .1%.
If we look at Figure 1, two other things should be observed. First, the corporate tax rate hovered around 50% between 1952 – 1986, then fell to 35% around 1986 and remained there. Corporations that once paid a 50% tax rate are not happy to pay today a 35% tax rate. They prefer to keep billions of dollars overseas that might otherwise be invested in the U.S. They won’t budget until the 35% tax rate is reduced by half or more Second, the capital gains tax fell to 15% by 2003 and remained there, although it has moved up recently to 20%. Why shouldn’t the tax on capital gains be raised to the normal income level? This is income for the rentier class who do little work while the working class puts in long hours and pays a normal tax rate.
Finally, we need to increase the estate taxes. If a husband and wife die in a car accident, their family will receive a tax bill on their estate. There will be no tax on the first $10 million of the couple’s estate. The rest of their estate is taxed at 55%. I think that the initial exemption amount is fair but I would advocate a higher tax rate on the remaining estate. Otherwise wealth continues to concentrate among the wealthy few and increase the size of the Plutocrat class, who live in a separate world from most people and whose interests are often contrary to the general welfare.
I invite readers to comment on this article. State where you agree or disagree. What might a fair income tax and wealth tax system look like?