Enforcing Our Progressive System In taxation, as in many things, the way the system is supposed to work is not the same as the way it does work. We are supposed to have a progressive tax system, in which people who earn more income pay tax at higher rates than those who earn less income. In practice, many high income people pay much less than you would think, which means that the working middle class pays too much.
The idea behind the progressive tax system is that the burden of providing government services should be distributed based upon both the ability to pay and the relative financial benefit that people receive from being able to do business in the stable environment that our government supports. The ability-to-pay concept is an economic efficiency notion: If the government needs $1,000 and can take it either from a person who earns $20,000 per year or from a person who earns $200,000 per year, the population is better off if the government takes the $1,000 from the person who earns $200,000 because she will (on average) suffer less pain from the loss. In other words, society is better off overall if the government collects relatively more from higher-income individuals than from lower-income individuals. Relative social benefit is a fairness notion. If you took two babies born in a poor nation, such as Chad, and auctioned off the right for one of them to grow up in America, the child who was destined to become Bill Gates would presumably be willing to pay more than the child who was destined to become a Wal-Mart cashier. The latter child certainly is still much better off in America than in Chad, on average, but the child destined to become Bill Gates would be better off to the tune of $30 billion. The progressive tax system runs that auction retroactively, effectively saying, “Bill, this country has been very, very good to you, so we’re going to ask you to give a little extra in return.” This concept does not mean that talented, hard-working people should be prevented from earning and keeping a lot of money. It just means that efficiency and fairness both dictate that those wealthiest individuals should pay a relatively larger share of the cost of running our society – the society in which they have prospered and have been able to use their talents. Parts of our tax system are not progressive at all. All workers pay 7.65% in employment taxes on their wage income – double that amount if you take the view (as most economists do) that the employer’s share is passed through to the employee as lower wages. However, 6.2% out of that 7.65% does not apply to wages above $97,500. As a result, people earning more than $97,500 in salary actually pay employment taxes at a relatively lower rate than people who earn less than that amount. And people who receive their income from sources other than wages do not suffer any employment tax on that income. Similarly, sales taxes are not progressive. Given that everyone in a particular town generally pays sales tax at the same rate and that people with very high incomes generally do not ever spend all of their money, higher-income individuals may pay relatively less sales tax. Because of this effect, a family earning $40,000 a year will spend about 10% of its income on state and local taxes (state income, sales, property, gasoline excise, etc.), while a family earning over $100,000 a year pays a little over 7%. Families earning more than that pay a progressively smaller percentage. But the progressive income tax part of the system operates, for the most part, in the way that you would expect. In 2005, looking at adjusted gross income (income before personal exemptions and itemized deductions), families earning $20,000 paid federal income tax at an average effective rate of 5%, families earning $40,000 paid it at an 8% rate, families earning $100,000 paid 13%, and those earning $200,000 paid 20%. But at that point, the progressivity curve starts to flatten out. The rate of tax on families who earned over $500,000 in 2005 hit 24%, a relatively small increase over the $200,000 group, and the rate of tax dropped to 23.5% on those earning over $5,000,000 and to 21% on those earning over $10,000,000. Why are top rates so low? In large part, it is due to the special low rates that apply to capital gains and dividends. Families earning less than $50,000 a year derived about 1% of their income from those sources in 2003 (and another 11% of their average income from pensions and IRAs, for which these favorable rates provide no extra benefit), while families earning over $1,000,000 obtained 35% of their income from those sources. Recently we’ve learned how the “carried interests” trick allows wealthy hedge fund managers to pay tax on their income at only a 15% rate– a far lower rate than what their secretaries pay. That’s just the latest in a long line of devices by which people manage to pay less tax than you might think. So, a family earning $40,000 a year pays, on average, 7.65% (or 15.3%, depending on how you look at it) employment tax, 8% federal income tax, and maybe 10% state and local tax when they spend their money, for a total of about 25.65% (or 33.3%, if you take the view that an employer passes its portion of employment taxes on to its employees). A family earning $4,000,000 a year, or 100 times as much, pays employment tax of about 0.62%, state and local tax of perhaps 6%, and federal income tax of 24%, for a total of some 30.62%. That may or may not be progressive at all, depending again on how one views the employer portion of the employment taxes. At best, it’s certainly not very progressive. The Shared Economic Growth proposal would get rid of the special favorable rates for capital gains and dividends, shutting down a string of schemes such as Wouldn't that be more appropriate?
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