Download THIS IS FAIR? ! A look at who’s

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Tax Truths
THIS IS
FAIR?
A look at who’s
actually paying
taxes and how the
tax code impacts
our economic
growth reveals
that dire change is
needed—but not
the kind of change
that’s being pushed
by the White House.
by Daniel J. Mitchell
34
Beginning as a simple
two-page form in 1913,
the internal revenue code
has morphed into a complex
nightmare that simultaneously
hinders compliance by honest people
and rewards cheating by Washington
insiders and other dishonest people.
But that is just the tip of the
iceberg. The tax code also
penalizes economic growth,
distorts taxpayer behavior,
undermines American
competitiveness, invites corruption
and promotes inefficiency.
There are three broad reasons
the tax code has become a national
disgrace:
Class warfare. Some politicians
seek to gain votes by pitting one group
against another, and soak-the-rich
taxes are a common manifestation of
this impulse. Lawmakers figure that
taxes imposed on a small slice of the
population—such as the top 10 percent
of earners—will be welcomed by the
envious and ignored by everyone else.
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Social engineering. The ability to
manipulate behavior through the tax
system gives politicians considerable
leverage, and they are not shy about
using that power to impose their
values. By tilting the playing field
(economists would say “by changing
relative prices”), lawmakers seek to
influence both the source of income
and the use of income.
Legal corruption. Many loopholes,
exclusions, deductions, credits,
exemptions and other preferences
are in the tax code solely because of
campaign contributions and other
forms of political support.
Ironically, these three factors often
work at cross purposes, and the results
can be quite perverse. Politicians
impose high tax rates and support
punitive double taxation of saving and
investment because they want to go
after the so-called rich. Yet the vast
majority of tax preferences benefit
upper-income taxpayers. Politicians
claim that social-engineering tax
breaks such as the itemized deductions
for home mortgage interest and
charitable contributions are for the
middle class, for instance, but the
overwhelming benefit flows to those
making more than $100,000 per year.
The special tax loopholes in the code,
needless to say, are almost entirely for
the benefit of wealthy (and politically
sophisticated) people and businesses.
(see Figure 1)
The best way to solve all the current
problems is to repeal the entire internal
revenue code and replace it with a
simple and fair system such as the flat
tax. If the 16th Amendment could be
repealed, another great option would
be a national sales tax plan such as the
Fair Tax. Unfortunately, rather than
move in the right direction, politicians
in Washington want to make the tax
code even worse. Obama has stated
that he wants the rich—however they
are defined—to pay higher income
tax rates. He also wants them to pay
higher payroll tax rates, and he wants
to increase the double taxation of their
dividends and capital gains. Last but
not least, he wants to also hit them
with a 45 percent death tax if they
create a nest egg for their children.
This radical agenda shows that the
36
In 1981, President Ronald Reagan signed the largest tax cut bill in U.S. history at his ranch near Santa
Barbara, Calif. Under Reagan, the top tax rate was cut from 70 percent to 28 percent. This cut led to
increased federal revenues.(AP/Charles Tasnadi)
administration is clearly taking a classwarfare approach to the tax code. But
this does not preclude other changes
that will make the internal revenue
code more convoluted. Obama has
a bunch of gimmicky tax proposals,
including the temporary payroll tax
credit that already was enacted as part
of the so-called stimulus. These nannystate proposals obviously increase the
level of social engineering in the tax
code. The president also has quickly
learned to play the corrupt game of
providing special loopholes to the
big-money crowd. The tax break in the
“stimulus” legislation for a Microsoft
billionaire would be a good example.
These are the add-insult-to-injury
aspects of Obama’s tax agenda. Social
engineering and special loopholes
undermine efficiency by luring people
into making decisions for tax purposes,
but the economic consequences of the
class-warfare provisions are far more
troubling. Persecuting so-called rich
people with oppressive tax rates may
be a good way to win elections, but it’s
not a good idea for the economy unless
you think America should be more
like France, with high unemployment
and lower living standards. Higher
tax rates—especially steeper tax rates
on investors and entrepreneurs—are
misguided.
HIGH TAX RATES ON THE RICH
REDUCE INCENTIVES FOR
PRODUCTIVE BEHAVIOR.
Ronald Reagan used to say that when
you tax something, you get less of it,
and when you subsidize something,
you get more of it. Politicians actually
understand this principle when it suits
their purposes. They routinely seek to
impose higher taxes on things such as
alcohol and tobacco, and they explicitly
argue that higher “sin” taxes are
necessary to discourage drinking and
smoking. Setting aside the question
of whether government should try
to control people’s private lives, the
politicians are right about the impact
of higher tax rates. Higher “sin” taxes
do reduce smoking and drinking.
(They also encourage smuggling and
other forms of criminal activity, but
that is a separate issue.)
Unfortunately, politicians
conveniently forget about economic
analysis when they decide they want
to tax productive behavior. And
just as high “sin” taxes discourage
drinking and smoking, high income
tax rates discourage work, saving,
investment and entrepreneurship.
Some proponents of class warfare
actually favor this result since they
think the economy is a fixed pie and
that ordinary people get less money
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Fig 1. Cumulative Total Deductions by Income Level (2006)
Total Cumulative Deductions (in Thousands)
1,400,000,000
1,200,000,000
1,000,000,000
800,000,000
600,000,000
400,000,000
200,000,000
Un
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Taxable Income
Source: IRS SOI Tax Stats
Fig 2. Growth in Living Standards
35,000
Inflation-Adjusted GDP Per Capita
30,000
25,000
20,000
15,000
10,000
5,000
1900
1903
1906
1909
1912
1915
1918
1921
1924
1927
1930
1933
1936
1939
1942
1945
1948
1951
1954
1957
1960
1963
1966
1969
1972
1975
1978
1981
1984
1987
1990
1993
1996
1999
2002
2005
0
Source: Historical Statistics for the World Economy
Year
Fig 3. Comparison of GDP Per Capita Across the United States, France, and Hong Kong
35,000
30,000
United States
France
Hong Kong
GDP Per Capita
25,000
20,000
15,000
10,000
5,000
198
0
198
1
198
2
198
3
198
4
198
5
198
6
198
7
198
8
198
9
199
0
199
1
199
2
199
3
199
4
199
5
199
6
199
7
199
8
199
9
20
00
20
01
20
02
20
03
20
04
20
05
20
06
0
Source: Historical Statistics for the World Economy
Year
when someone such as Bill Gates earns
a lot of money. This is a grotesquely
inaccurate assumption. The pictured
chart shows how living standards
in America, as represented by per
capita economic output, have grown
enormously over time. (see Figure 2)
The more knowledgeable classwarfare advocates admit that the
economy does expand, and they even
acknowledge that growth helps the less
fortunate, but they assert that high tax
rates do not make much of a difference
to the economy’s performance. There
is a wealth of evidence, though,
showing that tax rates are a key factor.
Tax rates are one of the reasons why
zero-income-tax states such as Texas,
Nevada, Tennessee and New Hampshire
generally grow faster than states with
harshly progressive tax systems such as
California, New Jersey and New York.
Likewise, low tax rates help explain
why jurisdictions such as Hong Kong
grow faster than the United States—and
differences in tax burdens also help
explain why both Hong Kong and the
United States grow faster than high-tax
nations such as France. (see Figure 3)
This does not mean that taxes are the
only important variable. Indeed, sound
money, rule of law and property rights
are probably even more important.
And trade policy, regulatory policy and
spending policy also can have a big
impact on economic performance. But
when researchers isolate the effect of
taxes, they find that high tax rates and
onerous tax burdens are associated with
slower growth. But it does not require
a Ph.D. to understand this relationship.
As Winston Churchill famously said,
“[F] or a nation to tax itself into
prosperity is like a man standing in a
bucket and trying to lift himself up by
the handle.”
HIGH TAX RATES ON THE RICH
WON’T RAISE MUCH REVENUE.
Many people think that politicians
like higher tax rates because that gives
them more money to spend, but that
may not be a reasonable assumption. It
is true, of course, that politicians like to
spend other people’s money. But it’s not
automatically true that higher tax rates
will lead to more tax revenue.
High tax rates discourage people
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38
Fig 4. Laffer Curve
Revenue Maximizing Point
Government Revenue
Growth Maximizing Point
1
5
9
13
17
21
25
29 33
37 41
45
49
53
57 61
65 69
73
77
81 85
89
93 97
Tax Rate (Percent)
Fig 5. 1980 and 1988 taxes paid on income over 200k
200k - 500k
500k - 1mil
1 mil +
200k - 500k
500k - 1mil
1 mil +
Returns
99,971
12,397
4,389
116,757
1980
Taxable Income
($Millions)
22,696.01
6,512.42
7,013.23
36,221.66
Income Tax Paid
($ Millions)
11,089.11
3,613.2
4,301.11
19,003.42
Returns
547,239
114,562
61,896
723,697
1988
Taxable Income
($Millions)
134,655.95
67,552.23
150,744.78
352,952.98
Income Tax Paid
($ Millions)
38,446.62
19,040.6
42,254.82
99,742.02
Fig 6. Living Standards far Above Western Europe
170
Per Capita Individual Consumption
150
130
110
Average living standard in the
industrialized word
90
70
50
Source: OECD
United States
EU-15
Fig 7. Tax Burden
60
50
Top 10%
Top 1%
40
30
20
10
0
197
9
198
0
198
1
198
2
198
3
198
4
198
5
198
6
198
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198
8
198
9
199
0
199
1
199
2
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199
9
20
00
20
01
20
02
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04
20
05
from working, saving and investing.
This means they earn less taxable
income. High tax rates also encourage
people to hide, shelter and under-report
their income, and this tax avoidance and
tax evasion also reduces taxable income.
And if taxable income falls enough, it
can completely offset the impact of the
higher tax rate, meaning less revenue.
This is what is known as the downwardsloping portion of the famous Laffer
Curve, where tax rates are so high that
tax cuts actually result in more revenue.
(see Figure 4)
A good example comes from the
1980s, when Ronald Reagan reduced
the top tax rate from 70 percent to 28
percent. Many leftists complained that
this would be a windfall for the rich
that would deprive the government of
revenue. Yet, just as “supply-siders”
predicted, the amount of income
reported by the rich jumped by a
huge amount between 1980 and 1988.
The increase in taxable income was
so immense that the amount of tax
collected at a 28 percent tax rate was
larger than the amount of tax collected
with a 70 percent tax rate. (see Figure 5)
The Reagan tax cuts are a special
case, though, because the tax rate used
to be at confiscatory levels. It is very
unlikely that lower tax rates today
would increase revenue (or that a tax
rate increase would lose revenue).
This is because we are probably on the
upward-sloping portion of the Laffer
Curve. But that does not mean it is a
good idea to raise tax rates. After all,
the goal should be for the tax rate to be
set at the growth-maximizing level, not
the revenue-maximizing level. So even
though Obama’s proposed tax hikes
probably would lead to more revenue,
at least in the short run, the economy
would suffer and taxable income would
fall. The IRS would collect a bit of
additional revenue because the effect
of the higher tax rate would more than
offset the impact of decreased taxable
income, but that would be a high price
to pay for the nation.
Of course, sometimes politicians
like higher tax rates solely for reasons
of spite. Obama said during the
campaign, for instance, that he wanted
to raise the capital gains tax rate even if
the government collected less money.
Percentage of Total Federal Taaxes
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Source: CBO Historical Effective Federal Tax Rates
Year
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HIGH TAX RATES ON THE RICH
WON’T HELP THE POOR —OR
ANY OTHER SEGMENTS OF THE
POPULATION.
The class-warfare crowd often argues
that higher tax rates are needed to
help the less fortunate, but they
rarely provide any evidence for this
assertion. Imposing punitive tax rates
may be an effective way of punishing
the rich (and making it more difficult
for other people to become rich),
but this means lost output for the
economy. Some honest class warfare
proponents admit the economy will be
less prosperous, but they assert that
slower growth is an acceptable price
to pay since the government will have
some additional money to spend to
help the poor. But this claim rests on a
couple of rather dubious assumptions.
First, as discussed above, higher tax
rates don’t necessarily mean more tax
revenue. Second, it assumes that bigger
government actually helps poor people.
But if that is true, why don’t
poor people in Europe—where
government is so much bigger—have
higher living standards than poor
people in America? Instead, the data
show that the poorest 10 percent of
Europeans and the poorest 10 percent
of Americans have comparable living
standards. For everyone else, including
the near-poor, lower middle class, and
above, America has a sizable advantage.
As the attached chart indicates, the
average per-capita consumption in
America is far higher than the same
measure of living standards in the
advanced nations of Europe. (see
Figure 6)
Fig 8. Americans Paying No Income Tax
35
Percentage of Non-Payers
30
25
20
10
196
2
196
4
196
6
196
8
197
0
197
2
197
4
197
6
197
8
198
0
198
2
198
4
198
6
198
8
199
0
199
2
199
4
199
6
199
8
20
00
20
02
20
04
195
0
195
2
195
4
195
6
195
8
196
0
0
Source: The Tax Foundation
Year
Fig 9. Median Income v Twice Median Income Marginal Federal Tax Levels
35
30
Marginal Income Tax Level (percent)
UPPER-INCOME TAXPAYERS
ALREADY PAY A HUGE SHARE OF
THE TAX BURDEN.
Advocates of higher tax rates should
be asked if there is a point where they
will be satisfied. Should the top tax rate
be increased from 35 percent to 39.6
percent, as Obama has proposed? Or
should it be 50 percent? How about 70
percent, which is where it was when
Reagan took office? And what share of
the tax burden should the rich pay? Is
it fair for the top 10 percent to shoulder
20 percent of the income tax burden? Is
40 percent the right amount? Would 60
percent be too much?
These questions are very relevant
since proponents of class warfare would
like voters to think that the so-called
rich are lightly taxed, but the IRS
data tell a different story. As the chart
illustrates, the top 1 percent pay about
25 percent of all federal taxes and more
than 35 percent of all federal income
taxes. The top 10 percent, meanwhile,
pay more than 50 percent of all federal
taxes and about 70 percent of all federal
income taxes. (The economic downturn,
especially in financial markets, is likely
to cause these numbers to fall when data
for 2007 and 2008 are released.) (see
Figure 7)
15
5
Median
Twice Median
25
20
15
10
5
195
5
195
7
195
9
196
1
196
3
196
5
196
7
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9
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1
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3
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199
9
20
01
20
03
20
05
20
07
0
Year
A HUGE SHARE OF LOWERINCOME AMERICANS PAY NO
INCOME TAX.
While upper-income taxpayers finance
an enormous share of government,
many Americans pay nothing—or
almost nothing. According to the Tax
Foundation, about one-third of all
taxpayers have no income tax liability.
The IRS, meanwhile, reports that the
bottom 40 percent of the population,
measured as a group, have a negative
income tax liability. This means that
what little tax they pay is more than
offset by the income redistribution (the
so-called earned income credit) they
receive through the tax system. (see
Figure 8)
This should be a big issue, but it gets
very little attention. As recently as the
late 1980s, fewer than 20 percent of
taxpayers escaped all federal income
tax. Now the number is 33 percent, and
President Obama has proposed policies
that will push the number of non-payers
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to more than 40 percent. One danger
of this approach is that people who
do not pay for government are more
likely to decide that bigger government
is a good thing. This something-fornothing mentality is probably among the
reasons why so many European nations
have become so uncompetitive. Once
a majority of the population figures
out how to mooch off government, it
becomes very difficult for politicians to
undo the damage.
HIGH TAX RATES ON THE RICH
LEAD TO HIGHER TAX RATES ON
THE REST OF US.
When the income tax was first imposed
in 1913, the top rate was only 7 percent
and it applied only to the top 0.5 percent
of the population. Today, the tax burden
on the rich is much higher, but so is
the tax burden on the rest of us. What
the politicians don’t want people to
understand is that there are not enough
rich people to finance big government.
So whenever they want to raise taxes on
regular people, they begin the process
by going after upper-income taxpayers.
Their theory is that ordinary taxpayers
can be tricked into accepting higher
taxes if their better-off neighbors are
getting hit even harder. Unfortunately,
the only winners in that game are the
politicians.
The chart on Page 33 shows how
this works. The tax rate on the average
household is strongly correlated with the
tax rate on households that have twice
as much income, which demonstrates
that regular people pay more when their
more successful neighbors pay more
(there also is a relationship between
the average tax rate and the official top
tax rate, but it is not quite as obvious
because of the interaction of tax rates,
tax loopholes and tax planning). (see
Figure 9 on Page 33)
The moral of the story is that upperincome taxpayers are the “canary in
the coal mine” for regular taxpayers.
When politicians play class warfare,
regular people inevitably are next on the
chopping block. •
THE TOWNHALL ON...
Taxes
“The tax cuts in the stimulus package will act
against the spending to thwart the economic effect.
Unless Congress passes tax increases, the country,
and possibly the world, will continue to slide into
a depression. Tax increases are necessary—no
alternative. Stimulus spending alone won’t salvage the
disaster.”
zoniedude
blogger, Daily Kos
“Our proposals are rooted in the belief
that fast-acting tax relief, rather than
slow-moving and wasteful government
spending, is the most effective way
to protect and create jobs and help
put our economy back on track. They
provide relief to those who need it most:
middle-class families, job seekers, small
businesses owners, the self-employed,
entrepreneurs, and homebuyers—all with
the goal of letting them keep more of
what they earn and helping our economy
create good-paying, long-lasting jobs.”
John Boehner
Townhall.com
“As a CPA, I cannot effectively advise
my clients what is coming for them in
the near future. I can only say, ‘Watch
your wallets; there is more going
to the government.’ So much for us
getting a stimulus.”
Bruce Bialosky
Townhall.com
Daniel J. Mitchell, an expert on tax
reform and supply-side tax policy, is a
senior fellow at the Cato Institute.
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