Tax, theory and practice

Should income taxes be progressive? There's some debate in today's comment section. To me, the moral answer is obvious: yes. Warren Buffet sacrifices a lot less by losing 30% of his income than some regular schmoe loses when he gives up 15%.

But optimal tax theory makes that more complicated. Taxes on the wealthy have especially high deadweight loss. Warren Buffet might not stop working if you ratcheted his tax rate up to 60%, but a goodly number of highly paid consultants, lawyers, small business owners and so forth would, and though it's common to portray them as leeches on society, in fact, they make a lot of stuff run a lot more smoothly.

The wealthy also have more latitude about when and how to take their earnings, because they aren't living paycheck to paycheck. That means that they will spend a lot of time and energy avoiding taxes. Do not natter about closing the loopholes. Above the complexity level of "Me Urgh! You give Urgh all your acorns!" there is no such thing as a loophole free tax. And come to think of it, I bet Urgh didn't get all the acorns, either.

If high taxes on the wealthy have very high efficiency costs, you can well end up with a smaller economic pie that doesn't actually make the poor much better off. That's why optimal tax theories tend to favor a relatively flat tax, with progressive distribution.

To me, the research suggests a relatively low level of taxation, but one that is steeply and continuously progressive to, say, a ceiling of perhaps 40% (combined federal, state and local), and goes negative for some income level. In other words, everyone should face pretty much the same marginal rate on an extra dollar of income--the poor, as well as the rich, should have to decide whether they want higher taxes and more government spending, or more cash and less spending. And all middle class subsidies should be abolished.

Note that the political odds of anything close to optimal taxation are about the same as the odds of my throwing the winning pass in next year's Superbowl.

Comments

I agree with you, but reality is not so far away already.

We aren't very far from this already- the tax schedule is somewhat bumpy, and the phaseouts sometimes create odd incentives, but we have a negative tax rate up to a fairly decent (above poverty line) income level, thanks to the EITC. Further, the tax schedule is already pretty steep, with 10/15% scaling up to 35% federal, which I think is either at or above your optimal federal rate. Even with deductions, you're not paying less than 28% with the AMT, and 28% plus state and local in high tax areas is usually at or above 40%.

As for loopholes, I agree and have long-since given up considering the possibility of meaningful improvement in the code. The rich will always, always, find a way.

Posted by Drew | October 22, 2007 4:53 PM

Thanks for this. It frustrates me, too--all these claims about helping people in need and in poverty, all this destruction of opportunity for same people.

But it could be worse.

Posted by caveat bettor | October 22, 2007 4:55 PM

I'm sure you have a pretty good arm Megan, but you'd have to deal with a lot of blitzing, and being thrown on the ground and then fallen on...

on first blush I'm not seeing a MORAL reason to tax people who make a lot of money MORE than those that don't. That begs presuppositions like taxation is about providing government sevices that are needed by the community at large. Like a rich person doesn't use a quantitatively different amount of those services.

When did taxation become about wealth redistribution? What IS the moral imperative of said redistribution? When did it become moral to steal from one person and give it to someone else?

Real tax codes are obviously complex... but what idea are we proceeding from? Currently the top 1% pay 50% to 75% [depending on number slice and dice]of taxes. The Bottom 50% geneally get full refunds. The top % already pay a lot. I already DON'T think that's fair. Why are we punishing them for doing well? What happened to "I do the job, and then I get paid."?

Why should THAT idea be any different if you are digging ditches, versus being Warren Buffet?

Now if Warren wants to share, or give his money away, more pewer to him, but what is the moral of TAKING it?

Posted by D | October 22, 2007 5:00 PM

Megan

The initial flaw in what you said is that your argument opens on the premise that progressive taxation is morally virtuous. However if we base all our economic policy decisions on this "brief appeal to emotion," as I believe you once said, we resign to the rubric that the wealthy must feel the sting of the whip upon their back, if for no better reason than under other plans, they wouldn't. A better reason might be that a higher percentage of the upper class's income would ultimately result in more revenue than a lower one, but I see the same argument that it is simply mandated for the sake of giving them a good "what for". And granted, even with a progressive tax, they'll all still be rolling in it, the central point remains that if these decisions are dictated by ideals of moral equity, rather than sound financial goals, we've begun slipping subconsciously back into collectivism.

Posted by Peter | October 22, 2007 5:02 PM

I actually question whether some of these high paid lawyers and finance people actually help anything run "more smoothly." Litigation is largely a zero-sum game, and if all our litigators were suddenly half as smart and talented I don't think that would decrease our wealth much, if at all. For finance the story is more complicated, but a lot of what goes on there is zero-sum as well.

Posted by ed | October 22, 2007 5:03 PM

In my comments, I was mainly trying to argue for the idea that progressive taxation is good (and yes, good in the moral sense).

Beyond that, I'm not going to claim expertise, certainly not to the level of talking specific numbers. If we can get to the point where the conversation begins with the assumption that progressive taxation is good, I'm happy.

(and in real-world politics, this translates to favoring going back to pre-Bush tax rates and against the Bush - and apparently all his would-be GOP successors -- impulse to cut, cut, cut and spend, spend, spend).

Posted by Peter Bautista | October 22, 2007 5:07 PM

My apologies for being dim, but how do you get a
progressive system where everybody has the same
marginal rate? That seems mathematically impossible.

Posted by David | October 22, 2007 5:21 PM

I don't understand how "optimal taxation" levels can be arrived at without some input that accounts for what's going on in the world.

If all the oaks that shelter the cave entrances were felled by the Great Mastodon Stampede, then it seems to me I might ideally have to render a few more of my acorns to Urgh than otherwise.

Similarly, in a world where our desired state faces threats that government is best-suited to counter, I'd expect to spend more of my money on government. In a less world that's less hostile in that way, I'd expect my government bill to recede. It would be really weird if instead there was some optimal tithe that would lead to a perfect balance no matter what else was happening.

Posted by southpaw | October 22, 2007 5:24 PM

[H]ow do you get a
progressive system where everybody has the same
marginal rate? That seems mathematically impossible.

This is a common misconception. You don't need increasing marginal rates to have a progressive tax system. Progressive taxation results from any system having one tax rate and a standard deduction or personal exemptions. For example, assume two taxpayers, one makes $10,000 and the other makes $20,000. Assume the tax system provides a $5,000 personal exemption and a 10% flat tax rate. The first taxpayer would pay a tax of $500 [10% x ($10,000 - $5,000)], or 5% of total income ($500/$5,000). The second taxpayer would pay a tax of $1,500 [10% x ($20,000 - $5,000)], or 7.5% of total income. The tax system is "progressive" because the tax paid, as a percentage of income, increases with income.

Increasing marginal rates only increases the amount of progresivity. Increasing marginal rates are not required for progrssivity.

Posted by David Walser | October 22, 2007 5:44 PM

D says:
When did it become moral to steal from one person and give it to someone else?

Oh, about the time slavery was first developed. It's now been refined into something called capitalism, where your time & labor is "stolen" by your employer, who may or may not allow you to keep enough to support yourself with, depending, I suppose, on how "moral" he or she feels.

What happened to "I do the job, and then I get paid."?

There you have me. We might note, however, that Warren Buffet had the opportunity to become an investor, and then the luck (no matter how much work he may have devoted to researching his investments) to have been successful. The ditch digger has never had the opportunity to become an investor.

I'd rather that a democratic government, allegedly responsive to the will of the people (though there's a lot of work to be done in that regard) take my money & use it, rather than have an individual or stockholder keep my money from me & spend it on politicians, in order to perpetuate the system that keeps the rich rich, & everyone else working for them at the lowest possible rate the rich can get away with paying.

Posted by M. Bouffant | October 22, 2007 5:53 PM

And all middle class subsidies should be abolished.

A dream indeed. You could get the highest bracket back to 90% before you'd be able to abolish the mortgage interest deduction.

The moral argument aside, I wonder where your 40% came from? I don't disagree, but why is this an 'optimal' number?

What about the quality of services government provides? Would the 'optimal' rate go up if the perceived quality of services were to increase?

There's no doubt the rate is lower in my homestate of Alabama (after factoring in the very low property taxes) but the quality of services in rural NY appears to be much higher and therefore I feel the tax rates (yes, they are a tad too high even outside of the city) aren't out of line with those in AL.

Posted by Michael W | October 22, 2007 5:54 PM

I don't understand how "optimal taxation" levels can be arrived at without some input that accounts for what's going on in the world.

I agree with that. I suspect Megan does, too. Tax rates should not be set in a vacuum. However, in addition to understanding how much revenue the government "needs" to raise, it's also important to understand how the tax law will influence economic decisions. To the extent tax law alters economic behavior, most economists (not nearly all) believe the tax system produces a sub-optimal outcome. (They may be willing to live with this outcome if it produces other results they value more, such as greater income equality.)

For example, if higher marginal rates causes enough decision makers to reduce their level of work, the result will be a smaller economy. Thus, the "optimal tax" rate is similar to the optimal maple syrup harvesting rate. If you extract too much sap, you kill the tree. Too high a marginal tax rate will produce lower tax revenues over time.

Posted by David Walser | October 22, 2007 5:57 PM

". In other words, everyone should face pretty much the same marginal rate on an extra dollar of income--the poor, as well as the rich, should have to decide whether they want higher taxes and more government spending, or more cash and less spending. And all middle class subsidies should be abolished."

I remember a reading about a study, where nearly everyone from 10K to 200K paid about 40% in taxes when you factor in all the taxes we pay (not just federal income tax). The elderly were the one exception, they had lower taxes across every income level. Besides, many of these rich make a lot of money from capital gains which is taxed at a lower rate than many people are. Lastly, their tax rates aren't that much higher anyways, since 35% is the maximum tax rate. They pay a majority of the taxes, because they make the majority of the money.

The mortgage interest rate deduction is essentially a transfer from paying tax on that money, to paying property taxes. Further, many people who can take advantage of this, don't have a lot of other deductions so only the amount that exceeds their standard deduction is a true tax deduction. It's not as big of a deduction as you are lead to believe.

Posted by JordanT | October 22, 2007 6:10 PM

capitalism, where your time & labor is "stolen" by your employer, who may or may not allow you to keep enough to support yourself

I think you mistyped there, it's spelled S-O-C-I-A-L-I-S-M and your employer is the government.

Remember it's "from each according to his ability" not desired occupation, but the one society determines you are best suited for ("To the mines!").

And in America, if you don't like what you're paid, you can quit and either hop on the dole get a new job. Hell, the two places I've lived the past few years can't find people to hire fast enough.

Posted by Skullberg | October 22, 2007 7:03 PM

"When did it become moral to steal from one person and give it to someone else?"

Oh, about the time slavery was first developed. It's now been refined into something called capitalism, where your time & labor is "stolen" by your employer, who may or may not allow you to keep enough to support yourself with, depending, I suppose, on how "moral" he or she feels.

Steal (v.tr.) -- To take (the property of another) without right or permission.

How is it that your employer is stealing your labor? Is an evil capitalist dragging you to your desk every day without your permission? Are you being drugged into submission before trading 40 hours a week for some pre-agreed-upon compensation? Is your boss somehow forcefully prohibiting you from terminating your employment? At any point while applying for a job, accepting that job, executing that job, and being compensated for said job, did you attempt to withhold your permission? No? Then in no way can you honestly or accurately claim that your labor has been stolen.

Oh dear. I wish that didn't need to be said.

Posted by Jared | October 22, 2007 8:28 PM

Here here Jared!

Infantilization of autonomous adults has always been one of the insidious cornerstones of modern liberalism.

Posted by Peter | October 22, 2007 8:52 PM

I agree that taxes should be "progressive"!

Everyone pays $10k each (300 million people /$3 trillon budget)-

"Progressives" can pay more if they wish... :o)

Posted by fletch | October 22, 2007 8:55 PM

the research suggests a relatively low level of taxation

you're getting a LOT of mileage out of the word "relatively". California is a high-tax state; Alabama is not. Given the relatively free flows of labor across state boundaries, you'd think that Alabama would be doing better. It's not.

Given your prediliction for thought experiments, try this one on for size:

If you want to open a high-tech medical devices research facility, do you go to (a) Orange County California or (b) Montgomery Alabama?

In California you face major restrictions on development, high taxes and traffic. You also find one of the most vibrant communities for med tech research, a capable labor force at all levels of sophistication and an existing customer base.

Californians tax themselves pretty stiffly because they (more or less) understand that running a top 10 worldwide economy requires an ongoing investment in schools, roads, water, wastewater, stormwater, trash removal, hospitals, cops, firefighters etc.

People bring good jobs here because they know that they can make more money here. In fact, we do such a good job of it we ship large amounts of money out of state via federal taxes that don't come back.

"Relatively low levels of taxation" needs a lot more explanation.

Posted by Francis | October 22, 2007 9:47 PM

Why assume an income tax at all? (I know it's what we have, and we're not likely to see radical reform soon, but this is a discussion, not a bill before the House.) We could tax land value instead. High income rates may discourage productive work, but taxing land does not discourage the production of land. It's also a progressive tax -- how many poor people do you know who draw millions of dollars from the rents on their vast estates, supplemented by their oil and mineral royalties, while they live in poverty in their tumbledown shacks among their acres of lawns and flower gardens in a tony nighborhood where residential land is very expensive?

Posted by Nicholas D. Rosen | October 22, 2007 10:23 PM

Francis, I think you have that backwards. California (or at least some of its urban centers) is already a hub of medical research, finance and a highly educated workforce. Network effects tend to perpetuate these sorts of concentrations, and it doesn't hurt that the weather is gorgeous. The state can therefore maintain a higher level of taxes and regulation than Alabama without losing too much business to a state that is mostly underdeveloped swampland with a history of corrupt governance.

In as much as higher taxes have an effect on business location, it's generally negative. California just has a great number of positive attributes that help to outweigh this.

Anecdote for anecdote, Michigan said similar things about the automotive industry 40 years ago. These days, the fastest growing state for auto manufacture is Kentucky.

Posted by heedless | October 22, 2007 11:55 PM

One point about progressive taxation I don't see often made is that it counteracts other forms of government intervention. For example, if the government decided to build and accredit more medical schools, the average wages of doctors would go down.

Of course there are many problems with progressive taxation too, as many people have already aptly pointed out.

@ Francis,
Good luck to California keeping that going!

Posted by benp | October 23, 2007 12:05 AM

heedless:

my point (such as it was) was that teasing out cause from effect is not necessarily obvious. The highly educated workforce continues to vote for, and pay for, one set of infrastructure bonds after another because they want the benefits that the bonds bring.

(cue Monty Python: All right, but apart from the sanitation, medicine, education, wine, public order, irrigation, roads, the fresh water system and public health, what have the Romans ever done for us?)

benp: Employers keep threatening to leave California. Some do; more come in or spring up from the ground.

Posted by Francis | October 23, 2007 1:12 AM

What about the Fair Tax? I keep looking at this, trying to come up with objections to it, but the more I think about it, it makes a lot of sense.

Posted by Juan | October 23, 2007 1:40 AM

I actually question whether some of these high paid lawyers and finance people actually help anything run "more smoothly." Litigation is largely a zero-sum game, and if all our litigators were suddenly half as smart and talented I don't think that would decrease our wealth much, if at all.

First, not all lawyers are litigators.

Second, ex post, litigation may be zero sum, but ex ante, the rule of law helps to create wealth, and litigation is part and parcel of the rule of law. If you couldn't sue, then people could breach contracts with impunity -- and if you could break contracts with impunity, then the economy would shut down. (Of course, since the economy is a repeat game rather than a one-time game, not all contracts would be breached without litigation -- but enough would to make the situation a mess.)

Posted by David Nieporent | October 23, 2007 5:09 AM

I would like to make a geeky argument for similar marginal tax rates for everyone.

I think that marginal utility is close to logarythmic. The reason I make this claim is that by and large people work fairly similar work weeks over fairly wide hourly earnings ranges, and the hedonic value of the Nth hour of leisure can be presumed to not vary much with with hourly income levels.

In other words, everyone who works 40 hours gets 128 hours of non-work per week, and has decided that a 2.5% increase in weekly wage wasn't worth sacraficing the 128th hour, but that the [larger] 2.56% increase he got for taking on the 40th hour from the 39 hour week was worth giving the [less valuable] 129th non-work hour.

Before you protest that 39 hour-a-week jobs are hard to find, I'll claim, "not really", and "to the extent they are, law and custom reflects what the marketplace wants."

Over a fairly wide income range, people gravitate to a fairly common work week, so taxing income at a certain percentage takes equal utility from everyone.

In other words, everyone who works about 40 hours per week shold face the same percentage tax rate, because by taxing the same percentage you are stealing about the same amount of non-work time from each taxpayer, and it's reasonable to assume that you're taking the same amount of non-work-time pleasure from each taxpayer to fund societies mutual needs. We can now proceed to decide what that level should be -- hard-core libertarians no doubt define it as "zero", but that bypasses this rather interesting academic exercise.

People making much more, and much less, than average in hourly terms have longer work weeks. These people should be taxed less, theoretically, on this argument. We do tax our low earners less. Taxing our high earners less would appear to be a good idea, but I doubt people want to go there.

-dk

Posted by Dick King | October 23, 2007 6:18 AM

One other point I should make is that we have an important piece of evidence that marginal tax rates in the 60-70% range choke off work effort.

In many US states, if you are a noncustodial parent, you owe child support. The support level is typically set as a percentage of income, typically 15-20% minus 15-20% of the custodial parent's income. Therefore, both the custodial and non-custodial parent face marginal tax rates of whatever the ordinary marginal tax rate is, plus that 15%.

There is a notion of imputed income in most jurisdictions. Succinctly, either parent can ask the court to decide what the other party would earn if they were to make a "reasonable" work effort. Child support is set, not on what the parents each actually earn, but what they should earn. There's a fair amount of case law on this issue. For example, your support level can't be set on a strenuous overtime schedule, even if you had been working that schedule before the child support order was set up.

We as a society wouldn't have to do this if we hadn't observed that many people slack off when they notice that they get to keep only 40 cents per dollar earned, because of the combined effect of the taxes they pay that look like taxes, plus the marginal child support dollar that they either pay or don't receive when they earn more.

Some people don't slack off. I attribute thst mostly to the fact that many people derive positive utility from their child support payments if they feel that the other parent is actually playing straight with them and the money actually does benefit the children, just as people still living with their children will earn money to feed them. Fathers living with their mothers and children do not reduce work effort just because they get to spend less on themselves on the margin when the baby is born; quite the opposite in the common case.

-dk

Posted by Dick King | October 23, 2007 6:32 AM

Who will lead their team to victory in the next Superbowl?

A. Peyton Manning (Indianapolis Colts)
B. Tom Brady (New England Patriots)
C. Megan McArdle (Washington Atlantics)

Posted by Colin Fraizer | October 23, 2007 8:55 AM

"To me, the moral answer is obvious: yes. Warren Buffet sacrifices a lot less by losing 30% of his income than some regular schmoe loses when he gives up 15%."

I don't understand how this is a sound moral argument. "I left you better off than the average joe" would justify many things that are immoral - stealing jewelry from a wealthy person, bulldozing their second home, spraying graffiti on their car, spitting on them, etc. In many ways, you are making a species of the "ends justify the means" argument, which is not normally considered a sound moral argument, and also, in the redistribution debate, the concentration on outcomes is the leftist approach so it would be difficult for you to avoid any further concessions.

I think that either a) there is no moral answer to the question, and it's just a Hobbesian battle, or b) if there is a moral answer, it can only be to have the same rate apply to every dollar of income, regardless of source or other dollars of income. In that case, each taxpayer pays an amount proportionate to the benefit he or she receives from society, to the extent that income = benefits.

Many people make the argument in support of a progressive tax system that the rich benefit more, so it's fair they should pay more. That argument justifies not just a progressive scheme, but also a flat rate, as I have just demonstrated. Standing alone, the principle of paying in proportion to one's benefits does not does not explain why a progressive scheme is more just than a flat rate. In fact, on its face, the progressive scheme requires the rich to pay more per dollar of benefit than less rich, and therefore violates the principle, of paying in direct proportion to benefits, that allegedly justifies it. The progressive argument confuses, IMO, the fair amount to be paid with the fair rate, akin, in calculus terms, to confusing a function with its first derivative.

Posted by Mt57 | October 23, 2007 1:35 PM

Dick King,

You would probably approve of French President Sarkozy's proposal to make overtime wages tax free.

Posted by Juan | October 23, 2007 2:55 PM

Francis,

I think you have some good points about California's wealth and it's general support of high taxes.

Having lived there until recently, I'm very skeptical about what the high taxes have gained California. Infrastructure is horribly underfunded: The major freeways (I-5, 99) North to South haven't been expanded since their inception and are 2 lane clogfests, commutes are exasperating, bridges are in dis-repair, the prisons overflowing, the electrical grid is faltering...etc etc. My energy costs near the coast were higher than when I lived in Colorado! Complaining about the state of schools seems to be a state-wide past-time. How is it that California is one of the highest taxed states, but has low public school funding?

However, it is a sunny place to live with exciting pasttimes, and we may very well move back there when we return from overseas. Such are the tradeoffs we make, but high taxes for overcrowded infrastructure is NOT one of its plusses. My $0.02

Larry DJ

Posted by Larry DJ | October 23, 2007 4:51 PM

Still, you must admit that California would never have been able to grab the computer business away from Massachusetts and New York if those other states had had a properly high level of taxation.

Posted by Paul Zrimsek | October 23, 2007 6:23 PM

What came first, California's high taxes or the technology industry? Were the geeks attracted to CA because of its high taxes when Silicon Valley was mainly orchards, or did the taxes go up after they got comfortable there?

Posted by Steve | October 24, 2007 2:42 AM

As i'm sure you're aware Megan, the tax schedules produced by optimal income taxation theory vary greatly depending on what distribution of skill are assumed to be within society and there is a lack of a consensus view on this matter in the literature. As i'm also sure you're aware, optimal tax theory is usually solely about economic efficiency, once a social welfare function is included the results vary substantially in accordance with that social welfare function, the choice of social welfare functions is, of course, a normative choice, but one must recognise that valuing the additional dollar of everyone equally is a normative choice like any other.

Posted by Sam | October 24, 2007 8:09 AM

Instead of a "progressive" income tax, how about either a flat tax (or even a national sales tax), but then you get rid of payroll taxes which impact the working poor much more than the weealthy. If you want to tilt things a little bit more against the upper middle class and the wealthy you could have the flat tax have a fairly large standard deduction.

Posted by Tim Fowler | October 26, 2007 3:03 PM

M- Bouffont - Re: "t's now been refined into something called capitalism, where your time & labor is "stolen" by your employer"

No stealing going on. You voluntarily work for your employer and than get paid for your efforts.

As for the government taking your money and using it being better than wealthy people taking it. - The wealthy are not taking it from you. They are giving you goods or services for it, or the companies they invest in are giving you goods or services for it. And you have a choice as to whether or not to buy their goods or services.

Re: "& spend it on politicians" - Special interests getting subsidies, targeted tax breaks, barriers to trade that benefit them, etc. is a problem, but the more government regulates and spends the bigger the problem becomes. The less government is involved in the economy, the less companies and rich individuals have an incentive, and the ability, to manipulate it to their advantage.

Posted by Tim Fowler | October 31, 2007 2:09 PM