The Problem with "Tax The Rich": It Won't Work   (May 28, 2010)

Many observers conclude our fiscal problems could be solved if only we "taxed the rich." There are structural reasons why this won't solve our fiscal profligacy.

Calls to increase taxes on the rich are highly popular with people who are not rich. This is understandable; those of us who do pay income taxes naturally feel we already pay enough and some wealthier person could cough up a few more bucks without undue sacrifice.

And of course those who pay no Federal income tax at all--about half the populace--are also in favor of unnamed "rich people" paying more, though since they have no "skin in the game" because they pay no Federal income taxes, their views are somewhat detached from the entire debate.

As I took great pains to document in Tyranny of the Majority, Corporate Welfare and Complicity (April 9, 2010), the bottom 60% of U.S. households pay essentially no Federal income taxes while the top earners pay most of the taxes already:

After including earned-income tax credits, the bottom 60% of households paid less than 1% of all Federal income taxes, and the households between 60% and 80% paid 13%.

The top 20% paid 68.7% of all Federal taxes: Income taxes, Social Security and Medicare, excise and corporate taxes. The top 10% of households paid fully 72.7% of all Federal income tax, the top 5% paid 60.7%, and the top 1% paid 38.8%.

Here are the source documents:

Historical Effective Federal Tax Rates, 1979 - 20065.

Nearly half of US households escape fed income tax .

A number of commentators have noted that the incomes of the super-wealthy (which I define as the top 1% who own most of the productive assets of the nation) have risen even more than their taxes. They also note that the Social Security tax of 7.65% (employee and employer each pay 7.65%) is regressive, as those making $500,000 a year only pay tax on the first $108,000 of income: 47% Of American Families Pay No Income Tax! Really?

So we have to be careful not to say that half of all wage earners don't pay any tax whatsoever. On the other hand, as I documented in Will Delinquencies Trigger a New American Revolution? (April 7, 2008), we also have to absorb the reality that the higher-income citizenry pay the vast majority of Federal taxes:

The top-earning 25 percent of taxpayers (AGI over $62,068) earned 67.5 percent of the nation's income, but they paid more than four out of every five dollars collected by the federal income tax (86 percent). The top 1 percent of taxpayers (AGI over $364,657) earned approximately 21.2 percent of the nation's income yet paid 39.4 percent of all federal income taxes. That means the top 1 percent of tax returns paid about the same amount of federal individual income taxes as the bottom 95 percent of tax returns.

Here is the source document: Summary of Latest Federal Individual Income Tax Data.

My conclusion is this: by heavily taxing earned income, the system extracts the highest taxes from the most productive citizens, leaving the less-productive with essentially no income taxes and the super-wealthy with the huge tax break offered to capital gains and other unearned income.

To the consternation of the unearned income crowd and their politico flak-catchers, it seems baked in that the 15% long-term capital gain tax rate will rise to 20%. Given that the nominal tax rate on significant amounts of earned income is about 40%, that represents a 50% "discount" on what wage earners have to pay.

As I noted in Tyranny of the Majority, Corporate Welfare and Complicity (April 9, 2010):

In essence, this is a vote-buying scheme by the Status Quo: the top 1% control the policies of the State in alliance with the State's own Elites, and together they buy the complicity of the bottom 60% to passively accept their dominance.

In other words, the bottom 60% are recipients of Central State largesse and the top 1% who "own" the political and thus the taxation process limit their taxes by favoring unearned income (what they collect from sales of securities, stock options, rents, etc.). Thus the productive quintile (top wage earners) pay the highest tax rates and most of the taxes.

It's a partnership of "Tyranny of the Majority" and "Outsized Influence of Elites." If the political status quo alienates the majority by making them pay more taxes, they risk losing power in the next election. If they alienate the top 1% who fund their multi-million-dollar campaigns, then they will also lose power. So they heap the tax burden on those "rich" who are actually earning their money rather than clipping coupons.

There are deep structural problems with any scheme to "tax the rich." One is that it appears to be impossible to collect more than about 20% of all income as Central State taxes:

The Revenue Limits of Tax and Spend: taxes never rise above 20% of GDP. While this is an academic study, the explanation for this is commonsensical:

1. High wage earners tend to be smart people, and they are adept at "gaming the system" to lower their taxes.

2. At some point, high wage earners are incentivized to opt out of higher tax rates by voluntarily reducing their taxable earnings and/or moving their income offshore to nations with lower effective rates such as Switzerland.

3. The super-wealthy simply "buy" tax credits or loopholes via millions of dollars in campaign contributions.

If you set a higher tax rate at, say, $249,000 per household, smart people will make sure their taxable income is $248,900. Many of these high wage earners either control their workload or own small businesses, and thus it is well within their powers to simply pay themselves less, work less or simply sell off their assets/business and retire.

I know a number of readers of this blog who fit this description. At some point, usually when you're paying 50% or more in total income taxes, business license fees, property taxes and a host of junk fees, then it's not worth it to work so hard. Rich people (the self-made variety, not the inheritors of wealth) also tend to be thrifty, so bailing out is often a plausible alternative to grinding away at keeping the business afloat.

The super-wealthy buy loopholes and tax credits as a regular "cost of business." Hence the generous "depletion allowances" for owners of oil wells, and the immense tax breaks offered by family trusts, which enable the sheltering of millions of dollars for relatively modest legal fees.

The other structural problem is the Federal deficits are now so large that they exceed even the most extractive tax schemes. Many observers have noted that Federal corporate tax collections have declined for decades. What they fail to note is that this how this tracks the globalization of U.S. corporate earnings.

You only have to pay taxes on income in one country, so if you have a choice (and global corporations and the truly wealthy always do), then why declare income in a high-corporate tax nation like the U.S.? It makes no sense.

We can rant and rave all we want about evil corporations who don't pay enough Federal taxes, but in the globalized economy where many U.S. firms make most of their sales and profits overseas, high corporate tax rates simply drives income overseas. If we want to collect more corporate taxes, then we should set them below equivalent rates in China, Japan, the EU, Switzerland, etc.

You cannot control the flow of capital and earnings in the current global economy, and every attempt to tighten the screws on capital and earnings will simply drive more of it overseas.

Even on a local-government level, the politicos who raise taxes and junk fees in breathless anticipation of higher revenues find that revenues fall when taxes are raised.

But let's say we managed to collect the vast majority of Corporate America's earnings: let's say we collected a cool $1 trillion. Unfortunately, the Federal deficit is now structurally set at $1.5 trillion a year. That's how much the Central State has to borrow just to maintain the status quo. So we would still be "short" a half-trillion dollars.

The same can be said of doubling the tax rate on the top 25% who pay almost 90% of the Federal taxes. That would raise another $900 million. Oops, we're still $600 billion short.

The truth is that raising taxes will never be able to reduce the gaping Federal deficit. That is a pipe dream. As I noted in Tyranny of the Majority, Corporate Welfare and Complicity (April 9, 2010):

Meanwhile, the slow poison of gargantuan deficits is eating away the soul of the nation. The Federal government gets $900 billion in individual income taxes and borrows $1.56 trillion each year. That is a rather stark number: the government borrows almost double what it collects in individual income taxes.

The "deal" is obvious: the costs of borrowing that $1.5 trillion are hidden from both the bottom 60% who are recipients of government funds and also from the top 1%, who believe that socializing risks and bailouts and privatizing profits is the ideal system of governance.

The people paying most of the taxes will opt out when taxes get too oppressive, and the super-wealthy will just buy more loopholes and credits or move their earnings overseas. We cannot collect more than 20% of the nation's earnings in Federal tax. Thus the only fiscal solution is to spend no more than 20% of the nation's income at the Federal level.

Borrowing $1.5 trillion a year is a "solution" only until the dollar loses its value or the interest payments overwhelm revenues. There is no other endgame to borrowing 11-12% of GDP every year just to maintain the status quo.

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