Personal Income Tax and Fairness

To get the more equal distribution of incomes 92% of Americans want, we must have higher taxes on high incomes.  But wouldn’t that kill economic growth?  Extensive recent economic research says not.

We have repeatedly cut the top rates on income since WW2, from 92% to 91% under President Eisenhower, then in steeper steps down to 35% for most of the past decade.  We said this would reward entrepreneurship, benefit everyone by creating more jobs, and boost economic growth.  We said growing the economy would result in enough additional tax revenue to pay for the cuts.  However, as this article notes: “The logic of the idea is hard to refute. It just doesn’t seem ever to have happened.”

As early as 1989 the data showed the recovery that began in 1983 and was believed to result from reductions in the personal income tax rate was caused mainly by expansionary monetary policy and to a lesser extent by growth in business investment after changes to corporate taxes in 1981.  Economic growth was much higher in the 1950s when personal income tax rates were much higher.

The paper I cited in Property Tax and Fairness that modeled the impact on economic growth of property, consumption and income taxes was based on annual data for 1971-2004, a relatively short period.  This much more comprehensive Review of Recent Academic Research indicates that cutting top individual income tax rates since WW2, more than twice as long a data series, had an insignificant impact on economic growth.   The data suggest we should in fact raise the top income tax rate closer to a revenue-maximizing 66.1% from today’s 39.6% rate.  

What does revenue-maximizing mean?  No revenue will be collected if the tax rate is 0% or 100%.  There is some percentage below which tax-payers keep enough of what they earn so they keep working to earn more, and above which they lose incentive.  The idea that cutting taxes would motivate growth was based on the assumption that the top rate was higher than the revenue-maximizing rate.  We now know it was, and still is, substantially lower.

The result cutting the top individual income tax rate did have was to greatly increase federal budget deficits and income inequality.  Income inequality grew because a low top rate motivates what economists call rent-seeking.  When high income folks can keep more of what they’re paid, they have a greater incentive to get higher wages.  A CEO has great influence to achieve that.  Lower level workers do not.  Because CEOs have the stronger bargaining position, they get a greater share of overall income.  That increases income inequality without increasing economic activity.

The recent sharp growth in income inequality is because a growing share of income is generated from capital, and capital gains are taxed at lower rates than “ordinary” income.  Long-term capital gains are currently taxed at a top marginal rate of 23.8% vs 39.6% for ordinary income.  The CBO says this cuts annual revenue by $161B, and is the most regressive of all tax breaks.  Fully 93% of the benefit goes to the top 20% of earners and two-thirds goes to the top 1%.

We have long, but not always, offered incentives for investing capital.  From 1934 to 1941, for example, 20%, 40%, 60%, and 70% of gains could be excluded on assets held for 1, 2, 5, and 10 years.  The recent history is detailed here, starting from 1988, the last time the tax code was significantly reformed.  The lower rate for long-term gains was briefly eliminated at that time, then set at 28% from 1991-1997, cut to 20% from 1997-2007 and cut again to 15% from 2007-2012.  Long term rates currently range from 15% to a top rate of 23.8%.

We encourage investment with lower tax rates because investment carries risk.  If I work at a job, I will get paid.  If I invest, I hope to get paid but I may not even get my investment back.  It does not make sense, however, that gains should be taxed at a lower rates to compensate for that risk because the size of potential gains already reflects their relative risk.  That’s why on average and over time the gains are higher with riskier small company stocks than stocks of well established large ones.

There is a “step-up in basis” rule that means someone who inherits property pays gains tax only on the difference between what it was worth when inherited and when sold.  The capital gain from when it was purchased to when it was inherited is not taxed.   There is no basis in fairness for exempting that capital gain which, according to the Congressional Research Service, is about half of all capital gains in the US.  There are other special cases, too, including lower rates on gains from collectibles, an exemption that benefits only the very wealthy.

Another special case is “carried interest” paid to investment managers.  Carried interest is their share of the investment profits.  It is taxed at capital gains rates even though the investment managers have nothing at risk because they contributed none of the investment.

As Ben Bernanke said in a recent speech“We have been taught that meritocratic institutions and societies are fair. … A meritocracy is a system in which the people who are the luckiest in their health and genetic endowment … [and] in so many other ways … reap the largest rewards.  The only way for a meritocracy to … be considered fair, is if those who are the luckiest in all of those respects also have the greatest responsibility to work hard, to contribute to the betterment of the world, and to share their luck with others.”  Reduced rates on capital gains mean those who are luckiest, and who in many cases do work hard, unfairly share less of the results of their good luck than those who are less lucky.

Perhaps, however, our unfair personal income tax system is redeemed by being effective?  I will explore the details in a separate post, but in brief, no.  Societies break down when wealth is distributed highly unequally.

So, our current income tax is both destructive and delivers results nine out of ten of Americans do not want.  Specific problems include:

  • Low top rates increase inequality
  • Lower rates on capital gains than “ordinary income” increase inequality
  • Exemptions for spending by wealthier citizens increase inequality
  • The “step-up in basis” rule increases inequality

In the next post in this series I will come to some conclusions about a better tax system.  I will not, for example, try to work out what should be our highest income tax rate nor what percentage of total revenue should come from income, consumption, property and estate taxes.  What I will do is figure out a tax structure that better fits what the majority want, subject to any gross mistakes in those wants.

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