Monday, November 17, 2014

Our hugely progressive tax code

A newly-released study by the Congressional Budget Office was designed to demonstrate that the inequality of income distribution in the U.S. has declined in recent years, thanks to increased transfer payments and higher tax rates on the rich. As Mark Perry notes, "Almost half of the income inequality between the highest and lowest household quintiles disappears when we adjust for government transfer payments and federal taxes. Before taxes and transfers, the average income of a household in the top 20% is 15.1 times greater than the income of a household in the lowest quintile, but that ratio drops to only 7.8 times after adjusting for transfers and taxes."

Reasonable people can disagree about whether a reduction in inequality achieved in this manner is a good thing or not (I'm in the disagree camp). In any case, the U.S. income tax code remains highly progressive, especially when one factors in the effects of income redistribution. That's illustrated in the chart above, which shows the percentage of total federal taxes paid divided by a comprehensive measure of income which includes labor income, business income, capital gains realizations, dividend income, and retirement income, plus all government transfer payments. The bottom one-fifth of income earners pay an average federal tax rate of only 2%, whereas the top 1% face an average federal tax rate of almost 30%. It's much worse in states like California, where top income earners also face a state income tax rate of 13.3%. Moreover, rates in the charts above for "the rich" would be higher today, thanks to a new top federal income tax rate of 39.6%, and an additional medicare tax of 0.9% for couples earning over $250K.

Mark also notes that because of the relatively high level of transfer payments these days (which are now at all-time highs relative to disposable income), well over half of all taxpayers receive more in transfer payments from government sources than they pay in taxes. That's illustrated in the chart above, where each bar represents the average household income in each quintile minus government transfers received. Furthermore, Mark notes that "the top 20% of American “net payer” households finance 100% of the transfer payments to the bottom 60%, as well as almost 100% of the tax revenue collected to run the federal government."

The chart above tells the same story, even though it is more narrowly focused, since it excludes employment taxes, business income, and transfer payments. It looks only at the percent of total federal income taxes paid by the 25% of income earners. Here we see that the top 25% of income earners pay almost 90% of federal income taxes.

How can anyone argue that the rich aren't paying their fair share? A great majority of the people are net recipients of the money paid by a relatively small majority. If anything, we have a potentially destabilizing situation, in which a large majority receive much more from the government than they pay in, and they can vote themselves still more of the money earned by a small minority. That's a classic "tyranny of the majority."

Supply-siders have argued for years that the steeply progressive U.S. tax code, with its myriad deductions, transfers, and subsidies, is extremely inefficient, and anti-growth. It's a major headwind to economic progress, and it most likely hurts the very people it's purportedly designed to benefit: the middle class. Why? Because the U.S. economy is arguably missing out on some $2 trillion each year in income—most of which would likely accrue to the middle class—because of, among other things, very high marginal tax rates and extremely burdensome regulations that discourage work and inhibit new business formation.


William said...

I don't know if the charts include "Income Tax Credits" or if they come under a category of "transfer payment".

But one reason the middle groups pay so little federal income tax is that income tax credits have proliferated in the past 10 - 15 years. Some examples: Education Credits for Students, Earned Income Tax Credit, Child and Dependent Care Credit, Adoption Tax Credit, Credit for the Elderly or Disabled, Home Energy Tax Credits, Retirement Savings Contributions Credit, Hybrid / Electric Car Credit, Home Energy Tax Credits, etc.

Benjamin Cole said...

When people are productive, they should not be taxed.

I would like to see deep cuts in FICA taxes and the elimination of corporate income taxes.

Frozen in the North said...

It would be interesting to look at the growth in tax paid Vs income and revenues. Your point is clear, rich people pay too much taxes. They receive most of the benefits of growth for the past 10 years. What is truly sad is how many Americans earn so little that they are not eligible to pay federal income taxes... That could be another way of looking at the problem.

You could have said that in single line.

Scott Grannis said...

Frozen: not sure I agree. As I noted in the post, those who have been hurt the most by sub-par growth are the middle class. The poor as well, of course. It's all about the "missing" GDP, or the missing income.

Also: When the tax code is hugely progressive, that means that marginal tax rates are very regressive. Those on the bottom rungs of the income ladder find that their marginal tax rates are much higher than those on the top. (For many of the lower and lower-middle class, marginal tax rates can be over 100%) A very progressive tax system necessarily makes it harder for the poor and the middle class to become rich.

Frozen in the North said...

Sorry I really meant the "vanishing" middle class. There is no doubt that the old style blue collar worker is a disappearing staple.

the rich will always be rich (well at least until the revolution...when the next batch!) the poor are forever screwed, that's a fact, if you have no education, little skills and are good with "you want fries with that!" America is not a great place. Its the middle class that is shrinking fast.

100% of the middle classes revenues is income, and that's shrinking because of the low growth of new jobs in the "higher income" middle class segment.

The problem is structural, these higher paying jobs have bee shifted to China/Vietnam and Indonesia.

Finally, the Mr Cole I would say that productivity is a strange word to use. Steve Job was highly productive and was paid a $1 a year. I believe the same is true for Warren Buffet. However, I object to the salary of M&A bankers -- when stats demonstrate that 90% of M&A deals are failure -- so the bankers were not productive (in the conventional sense) since the created net negative to the economy as a . As a banker I know that most of my work is a waste... that the deals are do are never going to achieve what they say they will (the management).

There is no correlation between taxation and productivity. There is simply no empirical evidence!

OH in ND said...

We do not live in a class system so the poor can become rich and the rich can become poor and they often do. Certainly you know several people personally as examples as do the rest of us. I think one of Scott's points is that the progressive tax system makes the occurances of poor to rich less frequent than there would otherwise be. And maybe rich to poor as well due to the tax on income which would have become investable (at risk) capital.

Hidden in the statistics of the 1% is that they are virtually all different poeple each year with only a small handful of perpetually rich. Most of the 1% achieve that status one time in life due to the sale of a family buisness or farmland. Unfortunately the IRS is there to confiscate a preponderance of their once in 2 or 3 generation windfall.