Why Raising Tax Revenue is Hard

scrooge-mcduckReuters blogger Felix Salmon contends that our tax system encourages income inequality because it generates more revenue for the treasury.

[W]hen you have a progressive tax system, especially when there are surcharges on people making seven-figure incomes, you also have a system where for any given level of national income, the greater the inequality, the greater the government’s tax revenues. And indeed federal revenues have been rising faster than median wages for decades now, thanks to the rich getting ever richer.

Given the government’s insatiable appetite for cash, it’s only natural that it would prefer to tax plutocrats, spending some of that money on poorer Americans, rather than move to a world where poorer Americans earn more (but still don’t pay that much in taxes), and the plutocrats earn less, depriving the national fisc of untold billions in revenue.

The government’s interests, then, are naturally aligned with those of the plutocrats — and when that happens, the chances of change naturally drop to zero.

Kevin Drum looks at the numbers, though, and contends this is nonsense.

Federal Tax RatesHere’s why: although the top 1% (the four richest groups in the chart) has a lot of income, the 60-80th percentile has about the same amount.  That’s because although their incomes are a lot lower, there are a lot more of them.  So what happens if that group loses, say, 10% of its income and it goes instead to the very tippy-top earners?  Answer: total revenue to the government goes up about 1%.  The same is roughly true for the other income groups as well.

In other words, the federal government doesn’t have much of an incentive to maintain lots of income inequality.  Not much fiscal incentive anyway.  For the most part, the political incentives swamp the fiscal ones, and unfortunately they aren’t very closely balanced.  Pursue policies that raise middle class wages, and the effect is so diffuse and so slow that hardly anyone notices.  Pursue policies that benefit the rich and you get immediately showered with oceans of campaign contributions.  That’s mostly what motivates our political economy, I think, not tiny changes in the total tax take based on changes in income inequality.

A blogger at The Economist argues that the problem is income taxes themselves.

Deficit Reduction OptionsIf the government is desperate for cash, it’s hard to beat the $324 billion per year that would pour in from a 5% VAT.

So if Congress needs all that money, then why doesn’t it adopt a VAT, or something similar? Mr Salmon’s logic would seem to suggest that it’s because the rich understand that a government dependent on them for revenue will continue to enrich them. As such, the rich will actually fight to prevent a less progressive tax system. I’m not sure this is borne out by experience.

Instead, I think that there are serious political difficulties in raising taxes broadly to fund social insurance programmes in a highly unequal society, because the social insurance is perceived as redistributing income over the population, rather than across time. Broad-based tax systems are how most European countries finance their social safety nets; nearly all of the redistributive effect of government programmes results from spending rather than tax policies.

There are all kinds of historical reasons for this, but one key thing to note is that pre-tax inequality in Europe is far lower than in America. Social insurance is much more about redistribution of resources over time than across the population. You pay taxes understanding that you’ll rely on services, be they health care, unemployment benefits, or pensions, at some point in the future. In America, by contrast, the rich will pay far more than they’ll ever demand from the government, while the poor will receive more than they’ll pay in (though Social Security is a bit of an outlier here).

The end result is a society which is reluctant to tax itself, since much of the voting public perceives government taxation and spending as giveaways to the non-taxpaying poor.

This is also, incidentally, a core issue in the current health care reform debate.

Story via memeorandum. Scrooge McDuck drawing by Don Rosa via Who’s who in Duckburg

FILED UNDER: Economics and Business, US Politics, , , , , , , , , , , , , , ,
James Joyner
About James Joyner
James Joyner is a Security Studies professor at Marine Corps University's Command and Staff College and a nonresident senior fellow at the Scowcroft Center for Strategy and Security at the Atlantic Council. He's a former Army officer and Desert Storm vet. Views expressed here are his own. Follow James on Twitter @DrJJoyner.

Comments

  1. Dave Schuler says:

    In my view a VAT is a terrible idea, at least in the United States. Without a consensus in favor of limited government, clearly absent now, a VAT does nothing to curb the appetite for additional revenue while providing the Congress with the ability to raise enormous amounts with very small increments in the rate. That’s effectively a license to steal.

    To the inserted table I’d add a transaction tax on the sales of equities and similar financial instruments, means-testing Medicare and Social Security, and raising FICA max.

  2. Dave Schuler says:

    Other spending cut options include abolishing agricultural subsidies or, at the very least, means-testing them and abolition of defined benefit pension plans for federal employees.

  3. Alex Knapp says:

    *sigh* I really wish people would stop assuming that the income tax is the only tax. Our tax system is not progressive if you look at effective tax rates for all local, state, and federal taxes vs. income quintile.

  4. Dave Schuler says:

    Our tax system is not progressive if you look at effective tax rates for all local, state, and federal taxes vs. income quintile.

    Sauce for the goose. Citation?

    Just for the record note that I mentioned raising FICA max in my comment above. In my opinion that would eliminate whatever lack of progressivity exists in present tax codes.

  5. sam says:

    This is also, incidentally, a core issue in the current health care reform debate.

    I had a thought the other day: Our fee-for-service model of health care delivery is a kind of evil VAT system: at every point along the way, a cost is added. (Does that sound right?)

  6. steve says:

    I hope you saw Frankel’s suggestions. We need for more of these ideas to be on the table. Alex is correct that we should look at the total tax package.

    We need to redo the whole tax system. Its complexity favors the rent seekers. I would favor doing away with the business tax. It is a relatively small, about 12% IIRC, contribution to our revenue. Next, we should make the bulk of our taxes come from some sort of consumption tax, like a VAT. It would be relatively easy, IMHO, to have this work without being too regressive.

    Capital gains rates should be at the same rate as the consumption tax. If you look at the market or at GDP, it responds transiently to expected changes in capital gains. Over the long haul it does not seem to matter much, as long as it is not exorbitant. Besides, why should hedge fund managers pay lower rates of taxation, and I am at the top, than I do.

    Lastly, keep the death tax, actually a tax on estates. I prefer taxes on consumption rather than earning. You dont earn the estate someone else leaves you. Also, we decided to rebel against royalty long ago. The absence of a death tax lets money concentrate into the hands of a very few. This always leads to major rent seeking and a distortion of our politics.

    Steve

  7. PD Shaw says:

    I’m far more inclined to believe in unintended (or unconsidered) secondary consequences of public policies contributing to income inequality than some internal dynamic of incentives.

    Take for example the mortgage interest deduction, which is part of a whole host of popular programs to encourage home ownership, but which tend to provide far more benefits to the wealthy and encourage risk at the margins. Occam’s razor tells me that this simply popular policy.

    (And to add to Dave’s suggestions, I would propose capping the home mortgage deduction, and taxing insurance benefits)

  8. Dave Schuler says:

    Funny you should mention that, PD. I just posted a more complete rundown of my preferences on cutting spending and raising revenues over at my place.

  9. PD Shaw says:

    I agree with Alex that state and local taxes tend to be regressive.

    According to the Institute on Taxation and Economic Policy, the average state and local tax rates are:

    Top 1% of income = 6.4%
    Middle 20% of income = 9.7%
    Bottom 20% of income = 19.9%

    Obviously states differ and the linked report does a state-by-state analysis. Also, federal income taxes tend to reduce these inequalities.

  10. Dave Schuler says:

    My question is whether on net taxes are progressive, regressive, or neither. My recollection is that on net our tax system is very slightly progressive but, if somebody has evidence to the contrary, I’m certainly willing to be convinced otherwise.

  11. That was an easy google, Dave. If this is correct.

  12. Might relate to this map: Food Stamp Usage Across the Country

    Los Angeles enrolls half those eligible, Missouri enrolls almost all. The worst position to be in would be the bottom income quintile, without the transfers.

  13. Dave Schuler says:

    With your caveat, the way I read that post, total taxes are slightly progressive with the exception of the lowest quintile and the issues with that quintile are almost entirely a result of issues at the state and local level. A fair statement?

  14. It seems that if the poor are taking advantage of their potential governmental wealth transfers, then the whole tax/benefit system is progressive.

    The tragedy might be … I know one guy who can’t navigate services for essentially the same reason he can’t navigate the job market.

  15. Drew says:

    As anyone who has attempted to inspect tax data knows, getting proper aggregations and comparisons is a nightmare.

    However, if you look at the chart on page 1 in the document PD cited earlier the total state and local tax as a percentage of income (after Fed offset) declines from 11% for the lowest 20% to about 5.5% for the top 1%.

    In the Tax Policy Center’s: “Tax Facts,” we see that combined Federal taxes as a percentage of income increases from 4.3% in the bottom 20% to 25.8% at the top.

    So it appears the lowest to the highest rate runs from about 15% up to 30%, all types of taxes considered. That’s progressive.

  16. Drew says:

    PS –

    I believe this very subject was covered here at OTB a number of months ago. The usual suspects came out whining about the regressive taxes.

    But even after including all sales, property, excise etc taxes the progressivity of the system was demonstrated by the economist being commented on.

    Maybe James has the relevant archived thread.

  17. PD Shaw says:

    Drew, my regular contention is that I’m ambivalent about the progressivity of the federal income tax or the existence of “lucky ducks” given the large number of taxes, many regressive, paid for by lower income individuals. As you note, the state and local effects are moderated by the federal tax effects. That’s really the only point I have to make.

  18. Drew says:

    PD –

    I was just doing the math, that’s all.

    I think the Alex’s of the world are factually incorrect when they invoke (“sigh”) regressive taxes as a counter to the observation of Federal income tax progressivity. The numbers shift, but progressivity is still there in a big way.

    I did wonder why your stats varied from mine. You must have been looking at a different table.

  19. Alex Knapp says:

    Drew and Dave,

    Others beat me to it, so you can use their cites. When you put together state, local, and federal taxes, all income quintiles have a tax rate between 28 and 31%. That’s not progressive. It’s not regressive, either.

    In fact, we are currently living in a flat tax country.

  20. Drew says:

    Alex –

    As I noted, getting apples to apples comparisons seems to be such a nightmare on this topic. You’d think it would be easy given its public policy focus.

    In any event, the Fed numbers I cited are compiled from the source I noted, which in turn has taken them straight from govt budget and IRS tables.

    On the State and Local side I’m using the numbers from PD’s reference.

    Now, we could always do the old does it pass “snicker test.” Here’s some numbers; I’ll round a bit to make things easy.

    Household A makes $350,000. They pay 20% on the gross in Fed taxes, and 5% in state income taxes after the Fed deduction. They pay 6% on a $100K b ase in social taxes. They pay $8K in property taxes. They save $20K, and spend the balance. On that balance they pay an averaged 6% in regressive sales, excise etc taxes. The total taxes? $110K on $350K = 31%.

    Household B makes $35K. They pay 4% in Fed taxes, and 4% in state taxes after the Fed deduction. They pay 6% on $35K in social taxes. No property tax and save nothing. They spend the balance and are subjected to 6% regressive sales, excise etc taxes on what they spend. They pay $6.4K in taxes on that $35K in income, or 18%.

    That looks alot closer to my base data than others. You can play with the assumptions if you like, but I’d say my hypothetical A pays more in property taxes. Even if you jigger with the 6% regressive taxe rate its hard to come to any other conclusion that the overall system is highly progressive.

  21. Andy says:

    Here are some CBO numbers (excel file) that show marginal and effective federal taxes for various family situations (single, family, elderly, no children, etc.)

    I think it’s pretty clear that federal taxes are progressive to varying degrees. I’m not sure how one can make comparisons adding in state and local taxes considering those vary so widely.

  22. sam says:

    @Drew

    Household B makes $35K. They pay 4% in Fed taxes

    I don’t think you factored in the FICA tax, did you? Just asking, just asking. (Put down that wedge.)

  23. Drew says:

    Sam –

    This is the new, gentleman Drew.

    Yes, I included 6% for “social taxes.”

    Here’s really where I’m going with this. I have no doubt there are advocacy studies out there that make dubious assumptions or impute taxes on the lower quintile. But the base tax rates I cited come straight from data tables, so I think we can conclude they are not manipulated. And we can fiddle with my assumptions.

    But even so, if you go back to the math I did on the $35K guy, for them to pay the same percentage of income as the $350K guy they’ve got to pay about 20% tax rates on all of there disposable income purchases. That’s where the sales taxes, excise taxes etc fall. Those are sin tax rates.

    Said another way, you’d have to convince yourself that this lower income quartile spends an extraordinary fraction of its disposable income on liquor and cigarettes. Its a novel way to argue tax policy……..I guess.

    Almost always, in my experience, the deemed lack of progressivity argument is really a thinly veiled call for higher tax rates on upper income groups. I look at it the other way. I sand bagged my estimate of the $350K guy so the percentage would look lower on the upper income guy. I’ll bet a $15 – $25K property tax bill is more like it. So he/she is paying a third of their income to government entities.

    I can see no reasonable argument that a person should have to pay more than a third of their income to the government. Unless you simply are a collectivist.

  24. sam says:

    I’m not entering the lists of the progressive vs regressive fight. I think we have a pretty progressive tax system, myself. Just a minor quibble, though. For the 35K folks, you say they pay no property taxes, but unless they’re living in the woods, they rent, and renters pay the landlord’s property tax, right? Just a little, little quibble. Not sure it makes a whit of difference.

  25. Drew says:

    Sam –

    I knew someone would bring that up. I’d be careful. Next, the price of groceries includes the grocer’s property taxes, and the price of electricity contains the utilities carbon taxes……….and on and on.

    You get the point.

  26. sam says:

    I do get it. But then I would point out that a few states, eg, Massachusetts, allow renters to deduct a percentage of their rent paid (up to a dollar maximum) from their gross income as a kind of “property tax deduction.” (When I lived in Mass, the argument was, well homeowners get to deduct their property taxes, and renters are paying the property tax on the apartment, etc, etc.) Again, I don’t think this makes much difference to your argument, just sayin’.