Progressive Taxation: Practical Pitfalls

Quiz: in 2001, according to the IRS, what percentage of the highest-earning Americans paid 50% of the individual income tax dollars collected by the federal government?

  1. The highest earning 5% of Americans paid half of all income tax dollars in 2001.
  2. The highest earning 10% of Americans paid half of all income tax dollars in 2001.
  3. The highest earning 25% of Americans paid half of all income tax dollars in 2001.

Sorry, it's a trick: the answer is "none of the above". The highest earning 4% of Americans as measured by adjusted gross income paid half of all the individual income tax in 2001 (IRS spreadsheet here). By the way, the cut-off income for the top 4% was $140,721. If we jump down to a cut-off income of $56,085, we find that the wealthiest 25% are covering 82.9% of individual income tax receipts.

So you're not going to run out and have a pity party for these high-earners, who are also probably among the wealthiest Americans. I understand. My point is actually about pragmatics rather than fairness.

I think that those who favor both progressive tax rates and redistributive government spending face a dilemma that is seldom, if ever, acknowledged. To the extent that a person

  • favors progressive tax rates,
  • doesn't want to cut government spending,
  • doesn't want to finance government spending by borrowing, and
  • doesn't want to increase the tax burden on the middle and lower classes,

that person is committed to hoping that the highest earners continue to earn at least as much in the future as they do now. If the highest earners fail to earn as much in the future as they have thus far, then at least one of the above points must be sacrificed. It seems counter-intuitive that "progressives" would have to root for the wealthy, doesn't it? But the unavoidable fact is that those who earn the most are the cash cow that gets milked to provide the butter and cheese for entitlements.

There's another way to look at this problem as well: by depending on the highest earning 4% of Americans for 50% of government revenues from income taxes, we make the federal government highly vulnerable to a downturn in the fortunes of the wealthiest people. I heard or read that a large part of California's fiscal woes stemmed from precisely this problem: steeply progressive state income tax rates made the state government dependent on the wealthiest individuals. The .COM bust hit this group of people extremely hard, such that they earned a good deal less and hence payed less in taxes. Thus, the state government suddenly had much lower revenues than they had been used to. I don't have a source for this assertion at hand, so I await confirmation or rebuttal from someone who knows the score (Walt?).

I'll be curious to see similar files for 2002 and forward, to see what impact the tax cuts had on these percentages. Of course, Bush has obviously sacrificed the point about avoiding not financing government spending with debt.

Comments

California's problems?

I think that's partly right and partly wrong.

The big problem in California's finances--and particularly city & county (read Library, Parks, etc.) finances--is, was, and continues to be Prop. 13, sold as a "save old folks' homes" measure but, in reality, a "cut taxes on commercial real estate" measure, since commercial real estate almost never actually changes hands legally and, thus, never gets reassessed and taxed at market levels. (Homes do get sold and have the 1% tax rate applied to market value. Commercial buildings rarely get sold, and get the lion's share of the Prop.13 tax break as time goes on.)

There's also a little factor of California having by far the largest tax outflow (negative tax/spending balance) to the Federal government--I think something like $60 billion last time I read about it, and it's probably grown.

Yes, the drop in personal incomes over the last couple of years did hurt. No question there. (California's income tax isn't all that progressive, though: You hit the maximum level at a fairly moderate household income for California. I think it was an overall drop in tax, not particularly a drop from the wealthiest. But I don't have figures to back that up.

I'm not assailing your general logic. I agree that there's a limit to how progressive a tax system can be without being self-defeating. On the other hand, one way to have more than 50% of taxes being paid by the lower-earning 96% of people might be to have a little less disparity between wages at the top and bottom. But although I find anything more than a 20:1 ratio between lowest annual wage and highest hired-hand wage appalling, I'm not in any way suggesting that government should do anything to prevent it...the harm from such actions would far outweigh any benefit.

Re:California's problems?

Thanks for the informative reply. In your mind, what explains the net tax outflow from California? How does the size of the outflow compare to Ca.'s GDP?

It would be interesting to see a map of the U.S. in red and blue, not for political parties, but for states by net tax out- or inflow.

I didn't understand the part about the "20:1 ratio between lowest annual wage and highest hired-hand wage". Would hired hand mean a day-laborer? I just didn't pick up on your gist there.

Re:California's problems?

I think the net tax outflow is primarily explained by the nature of Congressional politics: California has one-eighth of the nation's population (and a little more than one-eighth of the nation's GDP), one-fiftieth of the nation's Senators, and less than one-eighth of the nation's Congressfolk.

The best source of "balance" information, unfortunately only through 1999, is the Taubman Center's annual "The Federal Budget and the States" publication. The series was begun by Sen. Moynihan based on his belief that New York was getting shafted. He was right--but, of course, California gets shafted worse than New York. (In total terms, with New Jersey and Michigan also hit hard. In Per Capita terms, Connecticut, New Jersey, and New Hampshire get hit the hardest.)

The surplus states are interesting. In dollars, it's Virginia by a landslide: Basically, California contributes over $20 billion to Virginia's economy. In per cap terms, look to Montana, New Mexico, Alaska, Arkansas, Arizona...

Percentage of CA's GDP? Not huge: CA's 1999 GDP was $1.171 trillion, with a federal tax outflow of $23 billion ($700 per capita). (OK, I admit, I'd heard much larger numbers, like $50 billion. I was wrong.) So that's about 2% of GDP. (CA GDP last year was $1.4 trillion, making us the fifth largest economy in the world--the state economy continues to grow, just less rapidly than before.)

But percentage of CA's budget deficit? Considerably more than 100%, over time. After all, the state budget about to be signed is only $78 billion (5.6% of CA's GDP, for those curious as to what "high tax" really means).

The Taubman Center reports referenced above do indeed have maps of the U.S. in inflow/outflow terms, mostly per capita.

As to the off-the-cuff remark about 20:1, I was thinking of "hired hands" as any full-time employees (or FTE equivalent wages for part-timers), and "hired hands" explicitly excludes founder/owners, entertainers, creators, and the like. Bill Gates and Larry Ellison should make as much as they want and their shareholders will put up with: They created the companies. But "hired hands" like Ken Lay and the PG&E executives getting fat bonus checks for landing the company in bankruptcy...well, that bothers me, although I would absolutely not suggest legislation to prevent it.

Actually, around here, day laborers mostly get $10 an hour (at least skilled day laborers working for contractors do, according to the paper). I'd argue that $200 an hour, $400K a year should be enough money for any hired employee to live on. But I was really talking about corporate hired hands: Thus, if the lowest-paid assembly-line worker or secretary or janitor gets $25K, then $500K should be the highest salary (including guaranteed bonuses and subsidized stock purchases) for anyone who's an employee, not a founder/owner.
Just a bit of utopian thinking, not a serious proposal. I would not, repeat not, suggest increasing marginal tax rates to confiscate excess earnings.

Re:California's problems?

Very informative response. I appreciate your taking the time to write it.

I see now what you mean about "hired hands" like Ken Lay, who earn extravagant bonuses despite mismanagement. I agree. It is difficult nowadays to stake out a nuanced position on this kind of thing. I can imagine a poorly-run company that has hired more people than it can use. If something isn't done to set the company in order, it will go bankrupt and all who work there will lose their jobs (not to mention the losses likely born by the creditors, who may in turn be forced to cut jobs as well). In such a circumstance, a leader (hired hand or owner/founder) who cuts the number of workers in the right way is doing a good thing. I am contrasting this example with those who simply downsize because they know that the sound of that word will please stockholders, regardless of the real consequences. One should be able to affirm the former without affirming (or being accused of affirming) the latter.

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