Raise Taxes on the Poor?

The negotiations over raising the U.S. debt limit have centered around tax policy—and in this realm, both Republicans and Democrats have proven themselves to be failed negotiators, not because they do not know how to bargain, but because neither side knows what it should bargain for. In my last column, I criticized the Republicans for their "no new taxes" pledge. In this column, I shall direct my fire toward President Barack Obama and the Democrats for their equally rigid stance on taxation questions. As is well known, the president has also drawn his line in the sand; he has insisted that the new revenues needed to close the deficit must be obtained from either raising taxes on affluent individuals or raising corporate taxes. The vulnerable and needy are to be kept free from their share of the tax burden.

Illustration by Barbara Kelley

Democratic leaders think this is a matter of basic tax fairness. Nancy Pelosi has said that Democratic lawmakers "will not make working families and the middle class sacrifice without also calling on everyone to contribute their fair share." Indeed, it seems that the president and the Democrats are determined to insure that the now 50 percent or so of Americans who do not pay income tax are able to maintain this privileged status, even as some of them (along with some richer Americans) will be forced to bear—largely in the future of course—some reduction in the benefits that they receive, especially from the big three programs: Social Security, Medicare, and Medicaid.

The implicit assumption behind this Democratic rhetoric is that the current distribution of benefits and burdens sets an appropriate "baseline" against which to test the justice of any future tax reform. Given the current recession, the president and key Democrats have concluded that the right course of action is to steepen the level of progressivity in the income tax. When combined with other taxes, this stratagem could easily bring marginal tax rates for wealthy Americans—especially those making over one million dollars—over the 50 percent mark, and perhaps as high as 70 percent, according to Michael Boskin.

Distressingly, neither the president nor the Democrats offer any rigorous account of the optimal level of tax progressivity. Rather, the president seems to think that no matter how high the current marginal tax rates, the correct social policy is to move them upward. As such, he cannot explain why the top marginal tax rate for the rich should not approach 100 percent as they accumulate more and more wealth. After all, why not push the limits if efforts to redistribute wealth do not at some point impede its creation?

A progressive tax is far harder to administer than a flat tax is.

My view is the polar opposite of Obama’s. I believe, now more than ever, that the optimal level of progressivity in the system is zero, so that today’s marginal adjustments in taxes should increase taxes on those on the bottom half of the income distribution. To explain why, let us start with the premise that the defenders of any progressive tax have to give some principled account of the optimal degree of tax progressivity. They have to identify which of the infinite number of progressive tax schedules they embrace, and then explain why it is best.

In my view, the defenders of a progressive tax cannot select an ideal rate of progressivity for the system as a whole. The dilemma here runs as follows. A progressive tax is far harder to administer than any flat tax. A flat tax, in its most rigorous form, taxes everything from the first to the last dollar at the same rate. That rate is chosen politically, and should be set to bring revenues and expenditures into balance, so as to avoid the current situation where close to 40 percent of current expenditures are financed by debt.

Under a progressive system, the amount of a tax owed depends both on the person who earns the income and the year in which that income is received. Given the taxing difference between high and low brackets, high net-worth taxpayers have strong incentives to shift their taxable income to their low income relatives, artificial tax entities, into low income periods, or all three.

Any government that is determined to enforce its progressive system has to close these legal loopholes, which means the creation of complex rules to deal with partnerships, trusts, and corporations, all vehicles that allow money earned by one individual to appear on the tax forms filed by others. But, these various devices are so critical to the effective operation of the economy that it is impossible to ban their use or to decree that their incomes be taxed at the highest marginal rate.

It’s easy to vote for increases in government spending when those costs are borne by other individuals.

Unfortunately, all the money that is spent in creative tax planning (which gets an added fillip from the efforts to minimize exposure to gift and estate taxes) is tax deductible, reducing yet again government revenues by sparking high-powered schemes that would never see the light of day in a world without taxes, or, more importantly, in a world of flat taxation.

These administrative expenses present the defenders of progressive taxes with a problem. If one has a system of modest progressivity, which helps avoid adverse incentive effects, it is hardly worth the effort to spend tens of billions of dollars in administrative fees to raise some extra tax dollars from top earners. But by the same token, steeper progressivity, of the sort that the Democrats want, will only intensify socially wasteful efforts to avoid high tax brackets. In addition, high tax rates will quickly translate into fewer new business ventures that could yield more jobs and better products to consumers in the United States and abroad.

Such adverse effects will hit hard those people at the bottom of the income distribution, for less investment in new businesses will drive down wages at all levels of the income spectrum. During the past several years, wages have stagnated for people up and down the income ladder.

Here is another way to think about the issue: would workers rather have a salary of $3,000 per month, with no federal taxes, or would they rather have a salary of $3,500 per month, with a 10 percent federal tax and the prospect for higher wages through economic growth in the future? In other words, a slow economy imposes implicit taxes on untaxed individuals.

A slow economy imposes implicit taxes on untaxed individuals.

The situation is even bleaker once we consider another unfortunate feature of the current system. A large number of Americans are incentivized to either support or tolerate tax increases on the rich. Why? It is a lot easier to vote for increases in government spending when all the additional costs are borne by other individuals.

Human nature what it is, most ordinary citizens will be tempted by government largesse, despite the potential losses from hamstringing the economy with higher taxes. It is for that reason that whenever there is a revenue shortfall, political forces now clamor to "tax the rich." In the end, this is a plea for steeper progressivity, which in turn cuts deeper into long-term economic growth.

The willingness to call for tax increases is dulled, however, when rates are flat. Then, the proponents of tax increases know for certain that they will have to foot their part of the bill for each new program.

A sound flat tax policy will benefit people on all portions of the income spectrum. Unfortunately, Democrats think that progressive taxation has desirable redistributive effects with few adverse economic effects. But today’s profound fiscal malaise should offer them a wake-up call: their views on taxation hurt the constituency that they most want to help. If Democrats could learn that income redistribution has real limitations as a social strategy, and if Republicans could work hard to make sensible reforms to tax policy, then we would be well on our way to a sound budget deal. Until then, the road to true reform remains rocky even if the United States manages to avoid default this time around.