Taxation and Fairness: Flat and Progressive Taxation, and America's Lucky Rich

There is much debate over the role of taxation in American society. On the one hand, many conservatives argue tax rates are too high, and stifle economic growth. However, liberals (when they are not too scared to say it) tend to feel that tax rates are too low, especially on the country's most wealthy.

One general distinction that is important to understand is that between progressive and flat income taxation. Thinking about these two theoretical tax structures enables us to better understand the fairness of tax systems.

A progressive tax puts a higher income tax rate, as a percent, on wealthier individuals. This can apply both on the margin and on average. That is, under a truly progressive scheme a wealthier person can be expected to pay more tax on an additional dollar of income than a poor person, as well as a higher average tax rate than a poorer person.

A flat tax, on the other hand, would charge all individuals in society the same tax rate - say, 17% of income (as Steve Forbes once suggested in the 1990's). Usually, this rate would only kick in on income above a certain cutoff, which would in theory spare the poorest from bearing too much of the national tax burden. Russia and many other Former Soviet Union countries currently have flat tax systems.

In my mind, the progressive tax (which is what we have - at least in theory - in the US) is quite significantly fairer than a flat tax. First, taxing 17% of the income of a poorer person puts quite a bit more burden on that person than does taxing 17% of the income of a billionaire. This is true even with a generous individual deduction - for a middle class family, with income safely in excess of the deduction, the burden from a flat tax would be far greater than for the wealthiest people in society.

This concept of tax fairness across incomes, in terms of tax burden, is often referred to as vertical equity, and I find it extremely compelling. By raising the taxes on billionaires by just a few percentage points, we can bring millions of Americans out of poverty through tax cuts. And I think this is an entirely reasonable tradeoff.

Why? Because the simple fact is that where and to whom you are born plays a major role in determining your future income. So a brilliantly smart person born in a project in LA is likely to earn much less in their lifetime than a equally brilliant person born in Cambridge, MA. This is, in a basic sense, unfair.

People who are wealthy love to think that they achieved their success because they are inherently better and smarter than people with lower incomes, but that is not the whole story - they are also extremely lucky, and in the case of most people with wealth, extremely privileged in terms of the wealth they were born into. Progressive taxation corrects for this fundamental inequity by redistributing wealth to a portion of the population that is statistically less likely to be blessed with the extreme good fortune that so many of us fortunate individuals take for granted. So on the fairness count, I'm afraid the flat tax cannot compare to the progressive tax - the debate should be (and in serious policy circles, is) not about whether we should have a progressive tax or not, but on how progressive it ought to be.

Indeed, I would argue that the US does not have a truly progressive tax system, because the wealthiest Americans can quite easily exploit loopholes and oversights in the tax code. For example, the country's wealthiest people don't have the country's highest salaries - the top earners derive much of their income from capital gains, which are taxed at only 15% in the US, while taking advantage of low-ish corporate tax rates when possible. So, many of the wealthiest people in the US don't have extremely high reported salaries in their tax returns, since much of their money comes not through income but through capital gains. Amazingly, the IRS reports that only 220 of the top 400 highest taxpayers are in the top marginal tax bracket, and that for the top 400 taxpayers, 81.3% of income comes from capital gains and only 6.5% comes from salaries!

What does this mean? Well, in a nutshell, the top 400 taxpayers in the US are paying an average tax rate of only 16.6%, comfortably below estimates of average tax rates in the country as a whole. Taken together with fundamentally regressive taxes like the social security tax, the US has a far less progressive tax system than it lets on... and it's probably regressive to some degree. Personally, I think this is shocking, and its time for change.

Of course, this doesn't even touch thorny issues like offshore sheltering of money, companies like Amazon bullying states into allowing them to not charge customers a sales tax, state taxes in general and a whole myriad of other issues... No doubt about it, taxes are complicated, but its the wealthiest Americans who are exploiting the system the best, and as a result turning what should (in my view) be a progressive tax system into one that more closely resembles an unfair, flat tax system (or even a regressive one).