Bunilaw Tax Blog » Taking From the Rich

Taking From the Rich

Posted on September 14th, 2010 by bunilaw

Why discussions of tax rate progressivity sharply divide proponents of big and small government.

James Surowieki incites us to soak the rich
In an article in the August 16 issue of The New Yorker entitled, “Soak the Very Very Rich,” James Surowiecki says we should soak the very very rich, The two ‘very’s” suggest that even if we might feel bad about soaking people generally, we should feel ok, or even good, about soaking someone who is wealthy. Surowiecki explains that top income earners enjoyed much higher increases to their incomes than others between 2002 and 2007, and that therefore today very (very) high incomes should be subject to higher rates of income tax. Surowiecki says that as income levels become more disparate, higher incomes should be taxed at higher rates. He complains that our present rate structure doesn’t have enough brackets, that the tax rate difference between brackets is not big enough, and that, “at the moment, we have a system of tax brackets well suited to nineteenth-century New Zealand.”

His article opens with an illustration, reproduced below. As you can see, there is a smiling guy sitting on a large pile of money and a sad guy sitting on a smaller pile. Each is tossing a gold coin into a hat. This is supposed to illustrate the unfairness of our current system and why it needs reform.

Income vs. Wealth
Before discussing progressivity let’s make sure we distinguish between income and wealth, because an income tax taxes only income, not wealth. It might seem like the concepts are related, but they are not. Wealth is how much you own minus what you owe. A wealthy person may have little or no income. This has been true of many wealthy people during the recent depression in capital markets.

Unfortunately it’s hard to say what income is without using a technical definition, but roughly put, it’s how much you spend plus how much your wealth changed since the end of the last tax year. If you don’t understand that definition don’t worry about it. In grad school I had to stare at this concept for several hours before it actually made sense. Just keep in mind that a person with high income, even very high income, may have little or no wealth because he may spend everything he earns (or more) while owning little and owing a lot.

So let’s first clarify The New Yorker illustration by assuming that the piles do not represent the relative wealth of happy guy and sad guy– because sad guy may be wealthier. Instead the piles represent their current incomes. And let’s quantify it. It looks like happy guy’s pile might be about five times the size of sad guy’s, so let’s assume happy guy’s taxable income is five times as much as sad guy’s.

What’s progressivity?
Progressivity refers to the rate structure of an income tax. Under a progressive rate structure people with higher taxable income pay higher a percentage of their income toward tax. Under a flat rate people with higher incomes still pay more tax, but the tax they pay is the same percentage of their income as others pay. A regressive rate structure is the opposite of a progressive one: people with higher income pay a lower percentage of their income toward tax, even though they may still pay more tax.

Let’s illustrate with some simple examples. Let’s say there are two tax rates: a 20% rate for income up to 100, and a 30% rate for income over 100. Sad guy’s taxable income is 50. Happy guy’s is 150 (three times as much). Sad guy would pay 10 in tax (20% of 50). Happy guy would pay 35 (20% of 100 plus 30% of 50– three and one-half times what sad guy pays).

Under a flat tax, happy guy would pay three times what sad guy pays, regardless of the rate of tax.

Let’s take a regressive tax where the first 100 of income is taxed at 30%, and income over 100 is taxed at 20%. Sad guy would pay 15 (30% of 50). Happy guy would pay 40 (30% of 100 plus 20% of 50– 2.7 times what sad guy pays).

Compare this to a head tax, probably the simplest form of tax. Under a head tax sad guy and happy guy would always pay exactly the same tax, no matter what their relative incomes. You can see that a head tax is steeply regressive, at least in a world where we expect those with higher incomes to pay higher tax. In a world where tax operated on a retail model where everyone paid for roughly the same product, a head tax would be viewed as flat, because everyone would pay the same, in the same way that we all pay the same for bananas, electricity, and rides at Disneyland.

What’s wrong with this picture?
Let’s look again at the original New Yorker illustration that we’ve used without permission to see if we can understand why happy guy is happy and sad guy is sad. Each is tossing one coin into Uncle Sam’s hat. Again, if tax worked on a retail model with Uncle Sam, say, selling the same car to each guy, we wouldn’t be at all surprised that happy guy and sad guy are each paying the same. In fact, if we found out happy guy was paying, say, five to sad guy’s one for the same product we might even think it was unfair to happy guy. We might wonder why he wasn’t sad.

Most of us expect happy guy to pay more tax than sad guy, justifiably or not, just because they are paying income taxes and because happy guy has more income. We have this expectation even if sad guy is much wealthier than happy guy and regardless of whether we have progressive or flat rates. Remember, even under a flat tax, one where everyone pays at the same rate no matter what their taxable income, we will expect happy guy to pay five times as much as sad guy because he has five times the income. If we had a flat tax and were illustrating the unfairness of it and why it needs reform, the drawing would look like this.

Flat income tax

Why is sad guy still sad? It’s not because happy guy is taking on a much larger burden (five times as much), it’s because after the guys have paid their income taxes, happy guy still has a much larger pile. It’s not five times larger anymore, but it’s between four and five times larger, still much larger. Surowiecki’s point is that sad guy can’t be happy until income taxes cause happy guy’s pile to be reduced to something much closer to sad guy’s.

As Surowiecki correctly explains, we have a moderately progressive income tax, one where happy guy pays at only a slightly higher rate than sad guy. To illustrate the unfairness of our current tax rate structure and why it needs reform, The New Yorker drawing should have looked like this.

Progressive income tax

Big vs. small government
Both sides of the progressivity argument claim to have the better case, though the less heated tend to admit there can be no decisive winner. Supporters of progressive rates tend to argue that you can collect more tax this way, and opponents tend to say, so what? it’s not fair. Supporters of progressive rates tend to base their arguments in utilitarian morality that favors aggregate pleasure, while opponents tend to favor a more traditional morality that does not depend on pleasure. Supporters tend to have redistributive impulses, while opponents tend to oppose the idea that majorities can reallocate entitlements to money or property.

Beyond the swirl of rhetoric, the practical reality is that a progressive rate structure can probably collect more tax, and this is the unspoken motive on both sides of the debate. Those who favor progressivity tend to see it as a way to fund ambitious government projects. Their opponents disfavor progressivity for exactly that reason.

Surowiecki could have said: Our Government needs to spend lots of money to do lots of good governmental things. And it can only do that without creating deficits if it collects a lot more tax. And the only way to collect a lot more tax is to reverse the flattening trend of the past decades and increase progressivity.

He didn’t say that. Instead he pretended to make a scientific case for raiding a few high-income earners. His arguments remind me of a roommate’s who used my paper towels even though he had his own. I bought them in eight-packs. He bought one roll at a time. When I asked him why he was using my paper towels, he said, “Because you have a lot.” My roommate wasn’t clever enough to also mention 19th century New Zealand, (as in, If I don’t use your paper towels it will be like 19th century New Zealand around here), but the premise was the same. It’s easy and fashionable now to make a populist appeal to envy, but on reflection most people will admit that envy is not good, and not a sound basis for any kind of policy.

A more progressive tax like the one Surowiekici urges

By the way, I mentioned a head tax earlier. If we had a head tax and wanted to illustrate its unfairness and why it needs reform, we might do it like this.