Making Taxes Fair, and Good for the Economy

  • There is considerable debate – but arguably somewhat less understanding – about what constitutes a “fair” tax system.
  • There is no simple numerical rule that defines fairness.  It is, instead, a collective political judgment.
  • There are arguably reasonable conditions for making a sound collective judgment – but they are not met in the real world.
  • If the nation can agree on opportunity as an objective, we are left with a choice:  Will we direct our resources to reward the few spectacular successes, as an incentive to others; or will we instead use those resources to limit the tax burden on many ongoing businesses, to facilitate effort?  This blog argues for the latter, on both economic and fairness grounds.

With recent changes in tax rates as part of the year-end “fiscal cliff” deal have come renewed discussion of the most fundamental question of tax policy:  What is “fair?”

A frequent form of this question is a lament that “the 1 percent of taxpayers with the highest incomes pay 22.3 percent of the taxes” (typically using the figures published for some time now by the Congressional Budget Office (CBO); the number I quote here is from their latest estimate, using 2009 data, available here).  A possible subtext, never articulated, is that because 22.3 percent is greater than 1 percent the tax system is excessively progressive.  To interpret that subtext we need a conceptual marker.  If the top 1 percent of taxpayers paid 1 percent of the taxes (and the same for every other 1 percent ranked by income), then we would have the numerical equivalent of a head tax – both Warren Buffett and the proverbial elderly widow in the walk-up cold-water flat would write a check (if the widow had a checking account) to the Treasury for the same number of dollars.  That probably would not strike too many people as a “fair” tax system.

Sometimes the lament is a bit more sophisticated.  With a one-layer-deeper dive into the data, it can be worded as “the 1 percent of taxpayers with the highest incomes earn 13.4 percent of the income, but pay 22.3 percent of the taxes.”  Again, the unstated subtext can be read that 22.3 percent of the taxes, being greater than 13.4 percent of the income, is too high.  But the implied standard that those with 13.4 percent of the income should pay 13.4 percent of the taxes is the numerical equivalent of a single-rate income tax with no exemption or deduction.  Both Warren Buffett and the proverbial elderly widow would pay the same 13.4 percent of their income in taxes – and not the marginal rate (on their last dollar of income), but the average rate (the percentage of all of their income that they actually paid).  Most Americans probably would question whether that was a fair outcome, either.

(Footnote:  The numbers quoted above are for total federal taxes paid – income taxes, payroll taxes, excise taxes, and everything else.  This yields a different perspective than looking at income taxes alone.  The differences between the two are debated with an almost religious fervor, and are a topic for another, very long, day.  Also note that the sum of those different taxes is more a patchwork quilt than a “system.”  But we must persevere, because that is the tax “system” with which we must live.)

So if the 1 percent of Americans with the highest incomes earn 13.4 percent of the total income in the country, how much of the taxes should they pay?  Probably more than 13.4 percent; but how much more?  In truth, there is no simple numerical answer – as the very basic review of the tag lines above suggested.  This question can be answered only by the American people themselves, through the political process.

But that answer is only part of the answer.  How should the American people approach this question?  Clearly, there is plenty of ignorance around.  The concept of marginal tax rates came up three paragraphs ago.  Economists consider marginal income tax rates to be a fundamental determinant of taxpayer economic behavior.  But one can only wonder how many Americans know what a marginal tax rate is, and how it works.  (I have run into numerous intelligent and otherwise-informed people over the years who fear that they might earn one dollar too many, which would push them “into a higher tax bracket” and cost them hundreds or even thousands of dollars.)  And of those who do understand what a marginal tax rate is, I wonder how many know what their own marginal tax rate actually is.  For this last group as a percentage of the total population, I’m betting single digits.

But even putting such concerns aside, how should we even think about the question?  The approach that always made the most sense to me, for what it is worth, is that of John Rawls in his book, A Theory Of Justice.  Flattening an entire philosophy book into one sentence (an economist, after all, can squeeze the entire economy into one equation), people should make choices about such issues as though on the other side of a “veil of ignorance.”  In other words:  What income tax system would you want if you did not know what your income would be?  Presumably, people would choose a system that would give them some relief if their incomes were low, and would pay for that with taxes that would be somewhat higher – by an amount that they would be willing to pay – if their incomes were high.  There is no question that the extremes of popular opinions of fair taxation differ widely in this country.  But polling suggests that there is a sound consensus in the middle range of opinion, with concerns about both the standing of the less-successful and the opportunity to succeed.

In our democracy, the tax system that we get is the tax system that our elected representatives create.  If that tax system were created according to Rawls’ vision of what justice is, many probably would be happy to accept it.  Is that the tax system we have?  Does the political system match Rawls’ vision?  Quite possibly not, for at least two families of reasons.

One broad family of issues is the workings of our political and policymaking systems.  CED has been concerned about the arguably excessive role of money in politics for some time.  The legislative process is manipulable to prevent action and thus perpetuate outdated decisions (through abuse of the Senate filibuster and prohibitions of consideration of amendments in the House), and also to add without review programs that would not pass a cost-benefit test (through abuse of conference committees).  Entitlement programs and tax expenditures are almost totally immune from oversight and review.  Citizen participation, including both the expression of their views and the acquisition of information on which these views are based, falls far short of the ideal.  In other words, the outcome of the process does not reflect the views of the citizenry to anything like the ideal degree.

But in addition, Rawls’ “veil of ignorance” is not opaque.  Today’s voters and legislators know with certainty their current situations, and with considerable confidence their future situations, and even those of their children.  Outcomes in the United States are not random; evidence indicates that economic mobility is reduced relative to the past, and is lower than in many other countries (see here and here.)

Mobility is restricted at both ends of the economic scale.  The working breadwinner of a family needs to protect his or her children from risk by purchasing life insurance.  However, a family head who supports his or her children solely through the return on already accumulated wealth faces no such risk; the wealth will be there regardless.  Likewise, those who already have accumulated wealth for their children are not blinded by a “veil of ignorance” when making judgments about public policy, and arguably have the greatest wherewithal to express their preferences through the political and policymaking systems.  Some would argue that those who might be at the other end of the economic spectrum and without ambition to leave it would have strong incentives to vote for highly progressive taxation and generous public benefit programs, although those at the low end of the income scale (especially the non-elderly) are the least likely to vote (see here and here,) and have the least resources to use to attempt to influence the political process.

Whatever one’s own political views, it is apparent that many of today’s voters render an impartial judgment on taxation (and other policy issues) only to the extent that they choose to do so, not because of an impermeable veil.  With life outcomes far from a random draw, many people – especially at the income and wealth extremes – know with some certainty where they stand, and where they will sit.  Thus, the ongoing tax debate – including the debate over tax reform that may be beginning – is not purely about an impartial, disinterested vision.

Adverse assessments of the progressivity of total federal taxes rest not only on the most recent data (as reported by the CBO), but also on the trend over time.  So, for example, CBO reports that the share of total taxes paid by the highest 1 percent of the population ranked by income increased from 14.2 percent in 1979 to 22.3 percent in 2009.  (See the following table.)  But over that same period, those taxpayers’ shares of total pre-tax income increased from 8.9 percent to 13.4 percent; and their shares of all income after taxes increased from 7.4 percent to 11.5 percent.  So income before taxes has become more concentrated, and the tax system has not fully undone that process in the outcomes after taxes.

Top 1 Percent

Share of Total Federal Tax Liability
(Percent)

Share of Before Tax Income
(Percent)

Share of After Tax Income
(Percent)

1979

14.2

8.9

7.4

1980

13.3

8.8

7.6

1981

12.1

8.9

7.9

1982

12.2

9.4

8.6

1983

13.4

10.1

9.3

1984

13.9

10.5

9.7

1985

14.2

11.2

10.4

1986

16.3

13.7

13.0

1987

15.6

11.0

9.7

1988

17.6

13.1

11.8

1989

16.3

12.2

11.1

1990

15.7

11.9

10.8

1991

15.1

11.0

9.9

1992

17.0

12.0

10.6

1993

18.0

11.6

9.8

1994

18.5

11.7

9.7

1995

19.4

12.2

10.1

1996

21.1

13.4

11.2

1997

21.9

14.5

12.3

1998

22.5

15.3

13.3

1999

23.7

16.3

14.1

2000

24.9

17.4

15.2

2001

22.0

14.4

12.3

2002

20.6

13.1

11.1

2003

21.7

13.8

11.9

2004

23.9

15.6

13.6

2005

26.3

17.4

15.2

2006

26.8

18.1

15.9

2007

26.7

18.7

16.7

2008

25.0

16.0

14.1

2009

22.3

13.4

11.5

Incidentally, just as there is no simple numerical rule of thumb to say what distribution of the tax burden is fair, so is there no clear indicator of how a fair tax system should alter such changes in pre-tax incomes.  Nor is there any definitive answer to whether, and if so how, the tax system should change if the distribution of income changes.  Suppose that we have a tax system today that we believe is fair with respect to persons with multi-million-dollar incomes.  If tomorrow more persons have multi-million-dollar incomes, does it necessarily follow that this tax system no longer would be fair, and would need to be changed?  It is far from clear that it would.

Nor is it clear that changes to the tax system that reduce taxes on those with high incomes in year one would lead to a less equal distribution of before-tax income in year two.  Such changes would be most unlikely to reduce or hold back the earnings of moderate-income persons.  They would increase the amounts of wealth which upper-income persons would carry into year two and on which they would earn interest and dividends, but that would be a slow-moving process that would not much affect pre-tax incomes in the immediately following years.

But there is reason for concern about the increased concentration of U.S. incomes, to the extent that it has resulted from a lagging of lower- and middle-range incomes, rather than simply an increase in the number of persons achieving great success.  And although there has been much conspicuous success in the United States, it is also clear that typical incomes have grown much more slowly than the nation would like.

Why be concerned?  Progress for even the least successful yields a broader and deeper consumer base.  That in turn yields stronger prospects tomorrow for everyone, including today’s more successful.  Less need means less demand for remedial public benefits and services.  Some economists argue that the frustration of slow growth of the incomes of typical households, coupled with increased inequality, has stimulated over-consumption, over-borrowing, and consequent rising personal debt and bankruptcies.  And even for the most well-off, the aesthetics of a more-unequal society are less attractive.  Sixty years ago, writers on the case for progressive taxation memorably described inequality in society as “unlovely.”  Opportunity is good.  Inequality is not.  Given that the door to achieve success is open for those with skill and perseverance, who would want those who for whatever reason achieve less success to be worse off – thereby to increase “good” inequality?

So why do we have increased inequality in pre-tax incomes, if not because of the state of the tax system?  And what does that say about the tax system we should have?

Various commentators have offered explanations for the growth of inequality.  One is technology – the notion that innovations disproportionately replace lower-skilled labor while earning greater rewards for the well-off owners of that technology.  Anecdotes to this effect are readily available for hire.  Recent press stories have declared that the robots are coming, they will take over much of what in the past was human employment, and there never will be a job recovery from the “Great Recession.” A branch office of this argument has been recent press observing that many college graduates today hold jobs that on their face should not require a post-secondary education.

Having heard these laments repeatedly over my professional career and even before, I have observed that such concerns mostly coincide with economic recessions.  There certainly were such stories in the early 1990s “jobless recovery.” They were followed by arresting stories such as this one that showed the lengths to which employers had to go – and were willing to go – to find potential employees with far less than post-secondary credentials in the hot economy and the tight labor market of the later 1990s.

Technology has been replacing low-value human work since the first harness connected a horse to a cart, and it will continue to do so.  At the same time, given the right conditions – including macroeconomic management – ingenuity and consumer demand will find ways to employ human judgment to create value in the marketplace.  Our challenge is to maintain the right conditions.

Does technology today drive inequality in some new ways?  Certainly – including facilitating a “winner-take-all” economy (a term coined in a book by Robert H. Frank and Philip J. Cook).  How many people will beg off of paying a modest fee to hear the local tenor sing, and instead stay home, pop a CD or DVD in a high-quality sound system, and listen to Pavarotti – and possibly watch him from a closer-than-orchestra-seat vantage point on a wide-screen TV?  (And Pavarotti is even dead.)  How many others will stay home and watch the Yankees on cable, rather than going to the local park to see the home-town Double-A minor league team?  The result of these innovations has been spectacular returns to the few headliners who can capitalize on mass-distribution opportunities (including Pavarotti’s heirs), with probably less attention and income than was available in the past for somewhat-lesser (perhaps merely lesser-known) performers.  A plug for one of my all-time heroes, Arthur Ashe:  He took a lot of heat, including facing lawsuits, to require that star pro tennis players show up for local tournaments and run the risk of being beaten by younger up-and-comers – who thereby would have the chance to establish careers or at least earn incomes, by sharing in the gate which would be larger because of the presence of the superstars.

There also is evidence that technological advance renders obsolete some skills, and leaves even further behind persons with limited skills in the first place.  Society as a whole wins, but some members of society lose.  This “skills gap,” too, widens income inequality.  (And we should note that inequality in cash wages, as opposed to either total income or total compensation, has been swelled by rapid increases in the cost of employer contributions for health insurance – which can wipe out the routine annual raise of a comparatively low-wage worker.)

Another explanation offered for growing inequality has been globalization.  Here, too, there are anecdotes galore.  U.S. firms are earning growing shares of their profit overseas.  But this is not so much because they are producing overseas for shipment to the United States; it is, rather, that they are producing and selling overseas.  There are many reasons why any firm would like to produce in the country of its market; it maximizes contact with and understanding of the customer, and minimizes currency risk and transportation costs, among other things.  U.S. production would be greater if U.S. demand were greater, going back to the issue of the weak U.S. economy as a limiting factor for incomes of typical families.  But given current realities, this means that owners and managers of major U.S. firms can earn considerable incomes through foreign, rather than domestic, production and employment.  This increases inequality within the United States.  (There is recent concern about firms engaging in sophisticated international tax avoidance and minimization, moving income from the United States to other countries in search of lower tax rates. However, such tax avoidance arises not from moving production and employment, but rather from moving the location of intellectual property and from accounting manipulation.  It is a totally different issue from globalization per se.)

This effect of globalization is definitely adverse; but again, what is the alternative?  If our nation refuses to allow U.S.-based firms to produce overseas, do we expect foreign governments to allow their native firms – think Honda, Toyota, Hyundai, Mercedes – to produce here?  Or can we expect that those U.S.-based firms will retain their U.S. bases for long?  Considering technology and globalization together, we might ask other nations to accept U.S. hegemony over the world economy in perpetuity, hold station on technology and innovation, and agree not to play too hard in the future – so that we can relax and maintain employment here without competitive pressure.  Other nations are not likely to agree.  If we take that attitude, U.S. producers will fall progressively farther behind world standards, and will lose their shares of both overseas and U.S. markets.  This would be the surest way to have the United States join the ranks of England, Rome, Greece, and Egypt as former world powers.

What should we do instead?  One no-brainer is to improve our education system.  There is plenty of evidence that we are doing a lousy job of preparing the rank and file of the future U.S. workforce.  Some argue that we have lost our global lead in educational attainment, though others question the measurement details of that comparison.  Without quibbling, it seems clear that we are losing part of our advantage, even if not all of it.  Better-prepared workers will innovate and create new business opportunities and the jobs that go with them.  In addition, smart regulation that does not unduly delay formation of new businesses is key.

But back to Topic A:  What does all this mean for the tax system?  Per John Rawls, a fair system would be so perceived by the consensus of Americans on the outside of the “veil of ignorance.”  And in looking for consensus, however views might differ on the treatment of the income extremes, just about anyone without foreknowledge would want the opportunity to succeed.  And here is a potential tie to concerns about technology and globalization.

If our national economy is to succeed, with employment opportunities for all who want them, entrepreneurs will need to innovate and retain America’s collective ownership of as much of the technological frontier as possible.  There are two very different conceptions of what that implies for fair tax policy.  One notion is to hold out the brass ring as an incentive – to offer a low tax rate on capital gains (especially, but also on dividends), so that the very few who achieve spectacular returns from marketable investments can keep the largest possible fraction of the extreme resulting wealth.  This approach appeals intensely to those who can see through the “veil of ignorance,” and who know that their pre-tax incomes will be among the highest.  Those individuals are the most likely to use their wealth to steer the political system to favor the very highest achievement.

There are two downsides to this approach.  One is the strong temptation for those who already have accumulated considerable wealth through predominant positions in the marketplace to seek legislation and regulation that would protect them from competition and new entrants into their lines of business.  Designing the tax system to provide the greatest rewards for the few most successful as an incentive to others maximizes the wherewithal for those who are successful to buy political protection from subsequent economic competition.  If the most successful can head off new competitors in the political arena, the economy will suffer from hardening of the arteries of innovation, and other nations will surpass us.  There is no rule that would dictate that extreme wealth would be so used.  But assuming the contrary would rely on business winners to take the far-sighted, even altruistic perspective of Arthur Ashe, voluntarily exposing their commanding market positions to hungry young competitors.  We might not want to count on that.

The second risk of imposing the lowest possible tax rates on extreme success comes from a kind of law of conservation of matter.  Whatever your preferred size of government, there is a lower bound.  Federal spending cannot be cut to zero.  Once we have a tax system that collects the minimum required level of revenue, a dollar of tax revenue forgone from the most successful as an incentive must be collected from someone else.  Realistically, a dollar of taxes reduced on the capital gains of an upper-income person will be replaced by an additional dollar of taxes imposed on the ordinary income of another upper-income person.  That is how the political system works, as tax-burden-distribution tables determine the perception of the fairness of tax-law changes.  But most of the returns to new and growing businesses are taxed as ordinary income, not as capital gains.  Entrepreneurs who run their businesses and earn a living from them receive a salary.  Many businesses are in the end not marketable, or are held in a family and never sold.  If those entrepreneurs and innovators are taxed more heavily year after year to provide an incentive that in the end rewards disproportionately the very few who achieve colossal wealth anyway, what have we accomplished?

In sum, a fundamental question for fair tax policy and tax reform will be whether we send incentives and rewards to those who are struggling to make it, or instead to those who already have it made.  In the interests of opportunity, innovation and employment, our nation’s resources should not be held out like a lottery ticket with a one-in-a-million chance of a huge reward.  That is not what opportunity is really about.  It will not drive innovation.  And it will not achieve tax fairness.

1 comment
  1. Dave Schutz said:

    I’m mostly with you on Rawls, but my idea of what I would pick from behind the veil is the reward/tax level which would encourage the most productive lives. Yes! a kid doesn’t starve if his bricklayer father gets a career ending injury. Even a layabout should have a decent, though not lush, life. More attention should be paid than is now to structuring the incentives to reward sustained diligent effort, for everyone.

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