Monday, September 19, 2011

Math



When I studied taxation at the University of Chicago Law School, back when it was even more of a bastion of conservative legal scholarship than it is today, students were not allowed to take the idea of a progressive income tax structure as a given. We were required to think through and discuss all of the possible rationales for taxing higher income brackets at a higher marginal rate, starting from the perspective that none of the arguments in favor of progressivity were easy or obvious to make. But one argument that I never heard, even at the University of Chicago Law School, was the argument that people who make large incomes should actually pay a lower marginal tax rate than people of moderate incomes. Even at Chicago, prevailing thought among conservatives would allow a poverty level of income to escape taxation altogether, thus introducing a modicum of progressivity to the tax system.

We accept that some payroll taxes should be regressive (right now they cap out at around $100,000) because they support a floor of Social Security payments that is of more benefit to people of moderate means. We also accept a lower tax rate for capital gains, for reasons that I admit I never understood very well. Sales taxes are also somewhat regressive, because lower and middle class people tend to spend a higher proportion of their income than people who can afford more savings and investments. But I don't know of any good arguments for making people with lower incomes pay a higher marginal income tax rate than people of higher incomes. If we allow that, we move away from the whole idea of an income tax: An income tax, by definition, taxes incomes. Therefore we should at least tax all of the income that a person makes at at least the same rate. I understand the flat tax idea, which would subject all income to a flat percentage rate--I don't agree with it, but at least I understand it--but not too many economists or politicians even want to try to make the argument for a regressive income tax.

That is the argument that President Obama is forcing the Republicans to defend right now.

It is an indefensible position, and the House Republicans would be wise to simply agree to pass the so-called Buffett rule, as plain old common sense. Otherwise they must explain why what's left of the middle class should be required to pay a larger share of their incomes in taxes than the wealthy. And claiming that any attempt to make the wealthy pay at least the same rate as the middle class would amount to class warfare is not going to cut it.

(If you're short on time start watching at around 13 minutes on this video; the "math" line comes around 16:30)

7 comments:

  1. Joe, the idea that "people with lower incomes pay a higher marginal tax rate than people of higher incomes" is simply untrue. I'll assume that you're parroting this in good faith, but the Obama administration knows it's a lie.

    Today, the Associated Press debunked this myth with the actual IRS statistics. The rich pay more - way more. Not just in dollars, but in percent of income.

    Economy 101 should also make it clear why you can't lump earned income tax with capital gains "income" tax, unless your actual goal is to discourage investment in America.

    Since Obama's plan isn't even vaguely accurate math, it is either class warfare or jaw-dropping ineptitude.

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  2. Thanks for the comment. The AP article has some good statistics, but it might be contributing to the confusion also. I'll admit I could also have contributed to the confusion, so I'll try to clarify. You are right that marginal tax rates on earned income are higher as income goes up. So it would not be true, strictly speaking, that a person with a higher income pays a lower rate on earned income than a person with a lower income. And as the article points out, on average the rich do pay more, both in dollars and as a percentage of income. But that is only on average, and there are exceptions, and those exceptions are what the so-called Buffett rule would fix.

    One exception is that capital gains rates are much lower than taxes on earned income, which I alluded to in my post. And another is that people who can take advantage of a lot of deductions and other provisions in the tax code can also pay a lower rate. I haven't seen the details of the proposal, but I am guessing it is similar to the alternative minimum tax, and so it would apply to those millionaires who are able to take advantage of capital gains rates and various deductions and loopholes, and would require them to pay an overall rate at least equal to the overall percentage that people of middle incomes pay.

    We could have a debate over whether it is appropriate for capital gains to be taxed at a lower rate in the first place, but like I said, I never fully understood all the reasons for the lower capital gains rate, so I'm probably not qualified to make those arguments. If it were up to me, I'd probably tax the income that people make by clipping coupons at the same rate as those who actually work for a living--I might even tax it at a higher rate--but that's just my opinion. You're right that we don't want to discourage investment, but surely we don't want to discourage work either, right?

    Anyway, my understanding is that this proposal would not get rid of the lower rate for capital gains altogether, but might create an exception for people whose income largely consists of capital gains. And so it would remedy at least the injustice that Warren Buffett is always talking about.

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  3. Joe, the reason capital gains rates are lower than those on earned income is because the government wants to (or formerly wanted to?) encourage people with significant sums of money to invest and energize the economy rather than taking their money out of circulation by keeping it in a vault. As you say, that's a debate we could have...but I think it would be fairly hard to argue that discouraging investment in business will benefit the economy.

    And I agree with you that we don't want tax policy to discourage work either, but if we take capital gains out of the equation, that's precisely what the progressive tax rates do to small business owners.

    You're right that nobody is talking seriously about eliminating capital gains tax rates for everyone, but is "fairness" really served when (in effect) new, progressive capital gains taxes are levied on only those the government wishes to punish (and are few enough in number to not represent a significant voting block)?

    Personally, I'd like to see a lot of the confusing tax loopholes and deductions eliminated just to cut through the fog. Republicans have indicated that they're open to this, and it would be nice to see a real bipartisan effort to both simplify the system and make it more fair for everyone.

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  4. It seems to me that whatever rate we decide to tax investment income, people will still always be looking for the highest rate of return they can find. Why would someone leave stacks of money in a vault where it would earn no interest, when they could buy stocks or bonds or real estate that would produce some income for them? It seems to me that people would rather invest their money no matter what the rate of taxes are on the investment income, because that would still be better for them than leaving their money in a vault where the rate of return is zero (actually less than zero when you factor in inflation).

    I thought that one rationale for a low rate of taxes on capital gains was that we want to encourage people to REALIZE their gains, in other words to cash out of one investment in order to find a better investment elsewhere. If the rate of tax on capital gains is too high, then people have an incentive to hold onto stocks or bonds or real estate or whatever for a long time just so they can defer paying the tax on their gains.

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  5. My understanding is that if you invest in capital assests then you will pay a capital gains tax if they appreciate in value and are sold. However, you are limited in what you can deduct if they lose value. You can only deduct $3000 a year from later profits. So your question about why wouldn't people with liquidity invest no matter the % of capital gains tax might be answered by saying the gamble becomes too high. The downside is too high and the upside too low.

    On the Math issue, lets review Obama's own math concerning the new stimulus or jobs bill:

    He wants to spend $450 billion to create (by his own estimation) 1.9 million jobs. That is more than $235,000 per job. Although that is better than the 2 million per gren job created the by the first stimulus it is still far too high.

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  6. I'm not sure you're right about the limits on the deductibility of capital losses, but I get your point about risk. After I wrote that comment, I thought that I probably should have added that risk is another justification for lower rates on capital gains. Inflation is a third justification for reducing the tax rate on capital gains, I believe. And there may be others. I get all that, but I would probably still tax capital gains at the same rate as ordinary income, if it were up to me. But fortunately for investors everywhere, it's not up to me.

    On the math of the stimulus plans, I think it's a little misleading to talk about the money spent purely in terms of dollars spent per job created. Because remember we also get a lot of roads and bridges and schools and stuff for that money. And on the tax cut part, we also put a lot of money in people's pockets. And if people use that money to buy new TVs made in Japan or China, we might not create too many jobs with it, but we all still get to keep our TVs. So there is value there apart from the jobs created.

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  7. Just a quick note that KP is correct- while there is no ceiling on how much you'll pay if you sell stocks at a profit (other than the percentage cap), your losses are limited to $3000 a year. So a potential investor may well be choosing between keeping his money in a vault with 0% interest and 0% risk, versus investing and (if Obama got his way) losing up to 38% of any gains in taxes, while realistically facing risk of a 50% loss or more.

    Regarding the notion that "if people use (stimulus) money to buy new TV's made in Japan or China, we might not create too many jobs with it, but we all still get to keep our TVs," is it really a good use of taxpayer money to buy TVs for people while simultaneously enriching foreign economies? Put another way, if Mr. Obama's "American Jobs Act" doesn't create jobs, then why rationalize other "value" to justify it?

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