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).

Red States Heart Taxes

I'm not saying Republicans should stop complaining about taxes, but let's be real for a minute. The fact of the matter is that blue states subsidize red states. See data below (from a 2004 Tax Foundation report).

States Receiving Most in Federal Spending Per Dollar of Federal Taxes Paid:
1. D.C. ($6.17)
2. North Dakota ($2.03)
3. New Mexico ($1.89)
4. Mississippi ($1.84)
5. Alaska ($1.82)
6. West Virginia ($1.74)
7. Montana ($1.64)
8. Alabama ($1.61)
9. South Dakota ($1.59)
10. Arkansas ($1.53)

States Receiving Least in Federal Spending Per Dollar of Federal Taxes Paid:
1. New Jersey ($0.62)
2. Connecticut ($0.64)
3. New Hampshire ($0.68)
4. Nevada ($0.73)
5. Illinois ($0.77)
6. Minnesota ($0.77)
7. Colorado ($0.79)
8. Massachusetts ($0.79)
9. California ($0.81)
10. New York ($0.81)

The Greatest Nation?

"The United States is the most creative, innovative, entrepreneurial and generous country on Earth."
http://www.cnn.com/2009/POLITICS/04/16/shapiro.entrepreneurs/index.html

A couple of points. First, people always say stuff like this. But is it really true? I'm not so sure. We're more creative than the Japanese? We're more generous than Nordic countries? I don't know.

Second, articles like this irritate me. I don't love the bailouts, or all elements of the stimulus package. But to pull the whole "bankrupting America for future generations" argument is silly (not only because it wasn't Obama who allowed the debt to spiral out of control. He's inherited a mess. See image below).

Debt is not the worst thing ever. Sure, it's high now, but it has been higher (over 100% of GDP in the 1940's - see image). And the best way to pay off debt is to stimulate the economy to raise future revenues. I just don't see what this guy is advocating for. "Letting markets handle it" is just not a concrete solution.

Allowing "bad companies to fail" is also not as simple as this guy seems to think. Our entire system is at risk of collapse; some of the companies at risk are the driving force of our economy, and letting them fail could easily have cascading effects. Output would fall, tax revenues would fall, and that big fat debt would still be big and fat.

Finally, I still do not understand why everyone has a phobia of government spending. Anyone who has taken basic economics knows that in the face of externalities, public goods, and collective security, the government is - practically speaking - the only one who can step up and provide. That is, it is sometimes efficient for the government to spend (so, for example, on infrastructure... who else is going to do it? No one has a private incentive to repair a highway or build a high-speed rail network).

So we might have to pay higher taxes in the future. Honestly, big deal. Look at the tax rates in other countries... compared to them, our rates seem on the low side - or at least average. SEE GRAPH HERE

It's a great privilege to live in the US - still one of the world's most vibrant nations. But with that privilege comes a responsibility to support our government for the good of all of our fellow citizens. And maybe that means that we have to pay slightly higher taxes. I think Joe Biden was right when he said paying taxes is patriotic. It was just stunning that he was criticized for saying it.

I paid a lot of taxes in the last week - and I felt great about it. I just can't imagine ever bemoaning my tax burden. And I really can't understand the uber-wealthy bemoaning theirs. With the level of poverty that exists, both in the US and worldwide, I think it is immensely selfish for the super-rich to complain about the "burden" they feel. Sure, giving up money isn't awesome. But in my opinion, the wealthy are damn lucky to have the money to give up.

Hopelessly incoherent rant over.