Personal Finance

Tax Code Not Aligned With Basic Principles

Bruce Bartlett|The New York Times

It is clear that the rising inequality of wealth and income and how the wealthy should be taxed will be major issues in the political campaign.

Mike Kemp  | Getty Images

All the Republican candidates are committed to at least preventing any increase in taxes on those with large incomes. President Obama is pressing the so-called Buffett Rule that would require those making $1 million a year or more to have an effective federal tax rate (taxes divided by income) of at least 30 percent, while raising the top statutory tax rate for those with incomes over $250,000 to 39.6 percent from 35 percent.

One problem that undoubtedly will arise is how to generalize about any particular income class’s tax burden. As I pointed out last week, tax burdens depend a lot on how one defines “income.” In particular, the tax law makes a sharp distinction between income earned through wages and salaries, sometimes called “earned” income, on the one hand, and income from capital, or “unearned” income.

Wage income is very heavily taxed because both the income tax and payroll tax apply to it. The lower one’s income is, the more likely that it consists solely of wages. Therefore, the heavy taxation of labor necessarily hits hard those with low and middle incomes.

By contrast, income from capital is lightly taxed. Unrealized capital gains are untaxed, realized gains are taxed at a maximum rate of just 15 percent, and gains held until death are never taxed. Moreover, wealthy hedge fund managers are permitted to treat their managerial fees as if they are capital gains, something that is called “carried interest.” Dividends on corporate stock are also taxed at a maximum rate of 15 percent.

The wealthier one is, the less his or her income is derived from labor. According to the Tax Policy Center, households in the middle three quintiles get about 70 percent of their total income from wages and salaries. Those in the top quintile get 55 percent of their income from labor.

For those in the top 1 percent of the income distribution, only about 30 percent of their income comes from labor and for those in the top tenth of 1 percent, just 20 percent of their income comes from labor.

By contrast, those with low and middle incomes derive very little of it from capital. The bottom 80 percent of households get less than 4 percent of their income from capital. For those in the top quintile, however, 16 percent of their income comes from capital. And among the top 1 percent it is 35 percent.

But looking at the data this way understates how low taxes on capital benefit the wealthy, because if one looks only at capital income, virtually all of it goes to them. Those in the top quintile get 86 percent of all the capital income in the United States — $960 billion out of $1.1 trillion in total capital income. Most of that went to the top 1 percent, which received $633 billion — 57 percent of the total. And the top 0.1 percent got two-thirds of that.

The point is that a tax system that lightly taxes capital and heavily taxes labor is necessarily going to benefit the wealthy. As this chart illustrates, federal tax rates on the wealthy have been falling since 1978, when Congress cut the maximum capital gains rate to 28 percent from 35 percent.

The average federal (income plus Federal Insurance Contributions Act) tax rates for a sample of 2005 taxpayers after adjusting for growth in the National Average Wage Index. We rationalize this mainly on the grounds that increasing the stock of capital is good for everyone. For example, it will raise productivity, which in the long run will raise wages for all workers.

The empirical question of whether sharply lower taxes on capital, and hence the wealthy, has actually raised saving, investment and productivity is one I will revisit. Suffice it to say that since 2003, when the current tax rates on capital gains and dividends were instituted, the economy offers little, if any, evidence on this score. (Before 2003, capital gains were taxed at a maximum rate of 20 percent and dividends were taxed like wages and salaries.)

The point I want to make here is that differential tax rates on different forms of income mean that tax burdens will vary not only between income classes but within them as well. The latest Economic Report of the President has an interesting table that illustrates this point.

For the wealthy, we can see, effective tax rates vary between 12 percent for those at the lower end of the top quintile and 29 percent for those at the upper end. Among the top 1 percent, effective rates vary between 9 percent and 35 percent.

Those paying the highest effective rates are, no doubt, those such as doctors and lawyers with large incomes consisting mostly of salaries.

Thus we see that the bottom tenth of those in the top 1 percent pay well less in federal taxes as a share of their income than at least 25 percent of those in the bottom income quintile. And 25 percent of those in the top 1 percent pay less than substantial numbers of households in the upper three quintiles.

I couldn’t find the raw data underlying that in the table, but the Census Bureau put the floor for households in the second quintile at $20,000 in 2010. For the third quintile, the floor was $38,043; for the fourth $61,735; for the fifth $100,065, and for the top 5 percent $180,810.

We can see, then, that the tax system in the United States violates the fundamental principles of income taxation. Those are “vertical equity,” which says that those with upper incomes should pay a higher effective tax rate than those with modest incomes — as far back as Adam Smith, ability to pay has always been a core principle of taxation — and “horizontal equity,” which says that those with roughly the same income ought to pay roughly the same taxes.