The Rich, Their Taxes and Economic Growth

Over the last couple of weeks, the House and Senate have each enacted a different version of legislation to extend the Bush tax cuts beyond their December 31 expiration.  The most likely way forward in this highly charged political season is that nothing more will happen until after the November 6 election, and then a lame-duck Congress will pass something so taxes won't rise on everyone on January 1.

It's hard to talk about this without sounding political, but the issue is too important to be left, as they say, to the politicians.  Here are two thoughts from this pragmatic -- and free-market-biased -- economist.

High Income Earners Do Pay Most of the Total Tax

First, it is said that it's only fair that the rich should pay more.  The question is, though, "more" than what?  Many in upper income brackets have investment income that is taxed at lower rates than wage income, so sometimes, as in the publicized example of Warren Buffet, CEO of Berkshire Hathaway, and his secretary, he apparently pays a marginal rate of about 18% on his income while the rate she faces on her regular salary is, perhaps, 31%.  It is seen as a scandal that she must pay a higher marginal rate than he does.  We don't know what his total income or his total taxes run to, or hers either.  But what we do know from IRS and Congressional Budget Office data is that, in actuality, the upper income brackets really do pay a disproportionately large share of income taxes overall and they pay a markedly higher effective rate on their income than people in the middle, contrary to what media headlines often assert.

We've made this point before here, but in this season, it seems important to say it again, and perhaps more concretely.

This table shows shares of income, average tax rates and shares of total income tax at four rankings of income.  The numbers come from a recent report by the Congressional Budget Office, a non-partisan advisory body of the Congress.  Their calculations encompass a broad definition of income that includes workers' fringe benefits as well as wages and investment income.[1]  The top 1% of taxpayers received 15.6% of this income overall during 2002-2009, a modestly larger proportion than during the 1990s, which we refer to here as the "Clinton Era".  The Bush tax cuts indeed cut the effective tax rate for the high-end, to 20.6% from the Clinton Era's 24.2%.

"Everyone Else" Loses Some Income Share, but Pays Basically No Income Tax

The tax rate cut is not the only fact evident in the table.  We do see the widening income distribution that concerns many people these days.  The movement here is not dramatic, but it appears one-sided, with the top 1% and the top 20% getting larger portions of total income in the Bush Era than in the Clinton Era, while the next tier down has a basically unchanged share and the bottom 60% – a crowd we dub "Everyone Else" – sees some erosion.  Indeed, data back to 1979 show that Everyone Else's share was as large as 33% then, compared to the 27.5% in the recent 2000s.  That some people are unhappy about this trend is understandable.

However, the table also shows that tax rates were reduced for everyone, not just the high-end, and the Everyone Else bracket has actually received money back from the income tax system during these recent years.

It is also evident in the table that high-end taxpayers pay huge shares of the income taxes:  the top 1% pay almost 38% of total income taxes and the top 20% of taxpayers pay 87% of the total.  These are both increases over the Clinton Era, which were 33% and 79%, for the top 1% and 20%, respectively.  This is what makes us ask the question, what is a fair share for the high-end "rich" to pay?

There's lots more one could say on relative tax rates and burdens, and we refer you to the Congressional Budget Office report itself[1] and an interpretation of it published just yesterday in the Wall Street Journal[2].

Tax Progressivity Hampers Economic Growth

At the same time, the question of fairness has lots of facets and there's one more we'd talk some on here now.  In the short-run with the economy so fragile, there's concern over raising anyone's taxes, but on the face of it, it seems less onerous to hit the high-end who should be able to afford to pay more.  That may be true on the surface, but it doesn't take much to get to the incentive effects.  How do taxpayers feel when the government lays more burden on them or presumes on their capacity to fund public needs by increasing the progressivity of the tax system?  They might well pull back or slacken off if gains they make are only seen as a source for public funding.

We've thought this view was generally indicative of specific political leanings opposed to income redistribution.  But we lately encountered some research from a quite objective source showing that more progressive tax structures are associated with less economic progress.  Taxing higher income earners more can in fact lead to slower growth.  The work is not new; it's from late 2008, by Jens Arnold, an economist for the Organization for Economic Cooperation and Development, the OECD, in Paris.  The OECD is multinational, with 34 member countries, hardly politically conservative and seeks to promote policies that "will improve the economic and social well-being of people around the world."  Mr. Arnold's particular analysis "Do Tax Structures Affect Aggregate Economic Growth?"[3] involves the relationship of tax progressivity and per capita GDP growth in 21 countries across 35 years.  With the group of countries and the very long time frame, the study is not limited to one political party or government and is not impacted by specific business cycle forces.

Arnold's statistical regression analysis finds that flatter tax schedules are associated with more economic growth than progressive ones.  He attributes this to the discouragement of risk-taking inherent in progressive tax structures.  This has been one of our arguments, that if business owners or financial investors take risks and are successful, the first party to be rewarded is not the risk-taker, that is, the investor or entrepreneur, but the government, and by a predetermined formulaic amount.  Arnold's work shows further that the form of taxation most detrimental to growth is the corporate income tax, where the government takes directly from successful business operations.

Clearly, taxes serve important purposes in funding government activity.  But the capacity of governments to conduct their activities can, ironically, be harmed by over-reliance on the "rich" of the society.  Spreading and balancing the tax burden across the spectrum of taxpayers is important in promoting and maintaining the vibrancy of the economy.  That, in turn, gives citizens who are less rich greater opportunities to better their own condition.

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[1]Congressional Budget Office, "The Distribution of Household Income and Federal Taxes, 2008 and 2009".  Washington, D.C.:   July 2012.  See "Supplemental Material" on the CBO website for time series data and other information: http://www.cbo.gov/publication/43373 .

[2]David Wessel. "The Numbers Inside a Hot-Button Issue. Amid the Debate About Whether and How to Reform the Tax Code, a Look at How the Picture Has Changed.  The Wall Street Journal. August 6, 2012, page A4 or website http://online.wsj.com/article/SB10000872396390444246904577571042249868040.html .  Accessed August 7, 2012.

[3] Jens Arnold.  "Do Tax Structures Affect Aggregate Economic Growth? Empirical Evidence from a Panel of OECD Countries." Organization for Economic Cooperation and Development: Economics Department Working Papers No. 643, 14 October 2008.  http://www.oecd-ilibrary.org/economics/do-tax-structures-affect-aggregate-economic-growth_236001777843.    Accessed August 7, 2012 .  This paper was cited in Edward Conard.  Unintended Consequences:

Why Everything You've Been told About the Economy Is Wrong.  New York: Portfolio/Penguin.  Page 84.