Progressive Taxation

Echidne complains about conservatives who are sure that growing inequality is a good thing because technology is good (yes, it’s that non sequitur-y).

The comment thread on Echidne’s blog has turned to an argument about taxation, largely on account of one conservative who lies that the top 3% of taxpayers in the US pay 97% of taxes (in fact, the top 5% pay 54% of income taxes, and the top 50% pay 95-96%; obviously, payroll taxes blunt those figures even more).

It’s important to note two things about the US income tax system: first, it’s getting more progressive; and second, it’s already among the most progressive in the world. But, of course, there’s the huge elephant in the room that is payroll taxes, and state taxes tend to be far less progressive than federal taxes. Plus, one big reason why the rich pay more taxes is that they can afford to pay more, courtesy of the USA’s abnormally high level of inequality.

Warren Buffett once explained how when taking together all forms of taxation together, he and his receptionist both paid 30% of their income in taxes. I don’t know how much he pays his receptionist, but unless he pays her something in the neighborhood of $50-60k a year, she shouldn’t pay 30%.

First, it’s a travesty that people who barely make enough to eat and pay rent need to pay the government on top of everything. The amount of money people below poverty pay in taxes is negligible as a percentage of the IRS’s total tax collections, but is a fair chunk of these people’s income; hence there is no good reason not to set a threshold at or just above the poverty line below which no one has to pay taxes.

Even the taxes that people above poverty pay on their below-poverty income are fairly small. If everyone makes at least $13,200/year, the poverty level for a parent and a child, then at $1,300-1,600 per taxpayer, the total amount of money the US would lose from instituting that threshold would be about $150-180 billion a year, give or take (mostly take, since I’m ignoring the fact that below-poverty taxpayers pay less than that).

To make up for that loss, we can increase the middle brackets a bit, effectively making the middle and upper classes pay those $1,600 back. If the exemption is $13,200/year, then increasing the 15% bracket to 25% will make a taxpayer break even at $29,925, and pay about $140 more a year at $30,650 and above.

Wikipedia has very precise household income tables that make it relatively easy to calculate the loss in that case: the figure I got is $30 billion, but feel free to double-check.

But the real problem isn’t with income tax but with payroll tax. The US pretends to have a system in which you get what you paid into the system. The actual system has some redistribution, so unlike in Singapore people can retire at 65, but the pretense causes the country to cap payroll taxes for no good reason.

The American economy grew perfectly well in the 1990s, when the rich paid a 40% income tax and had to pay taxes on dividends and capital gains, and Canada’s GDP grows more quickly than the USA’s even though the total federal and provincial taxes are 46% in most provinces. Requiring the rich to pay full payroll taxes, at 15.3%, will increase marginal taxation to 50% only on the very rich; even someone making $400,000 a year will only pay 46% in total, up from 35% now. There’s nothing wrong with taxing the rich, despite what conservatives say when they call the poor lucky-duckies.

Exempting the first $13,200 again from taxation means a loss of another $100 billion, but eliminating the cap will recover that. The mean household income in the highest quintile, which more or less coincides with the group of people not paying marginal payroll taxes, is about $150,000 a year. So removing the $94,200 ceiling will result in added taxation on, on average, $55-60k of income for 18% of the population, reducing the loss to about $20 billion.

In the past, the IRS offered plenty of loopholes for rich people so that they didn’t have to pay marginal tax rates of 70% or 90%. Today there’s only one serious one, the exemption for dividends and capital gains, and that one’s intentional. Obviously, it will have to go; that alone will recover much more than the $50 billion lost to income tax exemptions on the poor.

Of course, eliminating bloated budget items will save much more. National health care will actually reduce government spending by about $100-200 billion, the current system is so inefficient; not invading random countries will enable cuts in the military budget of another $100-200 billion; cutting corporate welfare is good for another $100-200 billion. But then again, the deficit requires the US to institute these cuts without any reduction in tax collection.

Starting from the ground up, it’s possible to redesign the system entirely using Wikipedia’s data. The main advantage is that it’s possible to become even more progressive that way, with taxes on the rich in the 50-60% region and on the upper middle class in the 40% region (right now it tops at 37.7% at the FICA cap and slowly converges to 35% thereafter). It may be costly, but at least the people who will pay are those who can send their children to college without taking a second mortgage or committing tax fraud.


7 Responses to Progressive Taxation

  1. SLC says:

    Warren Buffets’ secretary would have to be making a lot more then $60,000/year to pay 30% of her income in taxes. I think that Mr. Levy is confusing the marginal rate which applies to income above a certain threshold to the total rate which is the amount of taxes paid divided by the total gross income. Although I don’t have a recent IRS tax rate schedule (thats what happens when one uses Turbotax or similer programs), but I believe that there are 5 thresholds at which the tax rate increments. Thus,

    1. for income up to tax threshold 1, you pay the lowest rate;
    2. for income between threshold 1 and threshold 2, you pay the second lowest rate;
    3. for income between threshold 2 and threshold 3, you pay the third lowest rate,
    4. for income between threshold 3 and threshold 4, you pay the fourth lowest rate;
    5. for income between threshold 4 and threshold 5, you pay the second highest rate;
    6. for income above threshold 5, you pay the highest rate.

    There is also income taken off the top relating to personal exemptions and standard or itemized deductions (resulting in net income). Items 1 – 6 above are for net income.

  2. Alon Levy says:

    No, I’m not confusing anything with anything. Warran Buffett’s receptionist pays 15.3% of her income in FICA, so to pay 30% of her income in federal taxes, she has to make enough to pay an income tax of 15.7%, which she will at $33,422/year.

  3. SLC says:

    Where did the figure 15.3% come from. Unless she is self-employed or an independent contractor, she pays 1/2 of the FICA, the employer pays the other half. Now Mr. Levy will argue that if the employer was not required to pay his/her 1/2 share, that money would revert to the employee. If you believe that, I have a nice bridge here in the D. C. area which I’ll sell you for only $100. Its a brand new bridge, just opened a month ago. However, Mr. Buffet, who is self-employed, has to pay the full FICA, which actually amounts to some 13%. On the other hand, the amount of income subject to FICA is capped so that Mr. Buffets full FICA

  4. SLC says:

    Accidently hit the wrong button. Scratch the comment about Buffet.

    I have just run a number of scenarios through Turbo Tax 2005 (obviously, Turbo Tax 2006 is not yet available). For an income of $120000, assuming standard deduction and 1 exemption, the income tax was $25811 which is 21.5% of gross income. The FICA was 7.75% (using 1/2 Mr. Levys 15.5% total FICA) of the first $96000, which I believe is the upper cap, which gives an FICA tax of $7440. Thus the total tax is $33251., which is 27.7% of the gross income, somewhat less then Mr. Levys’ 30% figure.

  5. SLC says:

    My figures for FICA and Medicare are slightly off. Medicare is not capped but on the other hand, the FICA cap for 2005 was $90000. I suspect that these two errors will just about cancel each other out!

  6. Alon Levy says:

    The upper cap is $94,200, and the tax is 7.65%.

    In fact, the tax is 15.3, not 7.65, but not because the employer could increase salaries otherwise. The employer still has to pay the 7.65%, which increases the cost of employing an American, and makes it less attractive than employing someone in a country where all taxation comes from the employee. It’s similar in effect to a corporate tax, but whereas a corporate tax is imposed on profit and encourages investment over paying dividends, an employer-paid social security tax is imposed on salaries and wages and encourages paying workers less.

    Actually, 15.3 isn’t precise, either. If you make $10,000 a year before taxes, then the cost to your employer is $10,765, and you get $9,235 after FICA, which works out to 14.2%.

  7. SLC says:

    By the way, speaking of the employers share of the FICA, this is usually ignored when people like Lawrence Kudlow go on cable TV and claim that individuals receive their full FICA contributions within 2.5 years of the start of collection. If the employers contribution is included, that increase the payback time to 5 years. The Kudlows of the world also ignore the fact that the Social Security trust fund is not hidden in a mattress but is invested in Treasury instruments that pay interest. If the interest earned is included in the payback, the payback time increases drametically. I have examined a number of scenarios with different rates of interest different employment times and different rates of wage escallation. The bottom line is that a multiplier of 2.5 on the payback time is very conservative. However, we’re not done yet! During the payback time, the remaining contributed funds are still earning interest. Again, depending on the payback rate, interest rates, etc., a further multiplier of 1.5 turns out to be very conservative. Thus, the payback time escallates to somewhere around 18 years, a far cry from the 2.5 years schmucks like Kudlow claim.

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