When Your Taxes Go Up

With it looking increasingly likely that we will "go over the fiscal cliff" at least temporarily (once everyone's tax rates have already gone up, a whole different set of factors may come into play and make Congress want to reduce some people's taxes back down again) it's not a bad time to think about what effect we feel when our taxes go up. The obvious answer is "pain". As Megan McArdle points out, the best way to quantify this is not how much your taxes go up, but rather how much your take home income goes down:

[W]hen we're talking about policy, we tend to look at tax increases as a fraction of total taxable income, or as a fraction of the current tax rate. To see what I mean, think about two cases: one where the tax rate is going from 5% to 10%, and one where it is going from 50% to 55%.

If you look at this as a percentage of total income, these two tax increases are the same.

If you look at it as a percentage of the tax rate, then the first increase is much larger: it is doubling your taxes! While the second increase is only upping them by 10%.

But in terms of behavior, the percentage increase in the rate, or the percentage decrease in total income, is much less important than a third figure: the percentage decrease in your after-tax dollar. Most people think less about their nominal annual salary than about how much they bring home in each paycheck. And if you look at it this way, the second tax increase is much, much larger than the first.

Taking your tax rate from 5% to 10% decreases your after tax income by 5.26%. But by the time your tax rate is 50%, you're only keeping half of your income. So increasing the tax rate by 5% decreases your after-tax income by 10%: you used to take home 50 cents out of every dollar, but now you only take home 45 cents.

If you were surprised that Gerard Depardieu decided to leave France rather than pay the new 70% top rate, think of it this way: the rate increase was only 30%, but it was going to cut his income in half. Yes, that would still leave him with more money than you and I live on. But people don't think this way: if the government came and took half your after-tax income away, that would still leave you with more money than a middle-class family in Bangalore lives on, and you would still be hopping mad, not to mention panicking about how the mortgage was going to get paid.

The Clever Economics Behind Romney's Tax Plan

One of the things which the candidates sparred over repeatedly in the debates was Romney's tax plan, on which Obama has repeatedly charged "the math doesn't work".

Romney's plan, as it has been presented, is to reduce tax rates by 20%. Thus, for example, the top rate would go down from the current 35% to 28%. Deductions and credits would then be reduced such that while the middle class would experience a net tax decrease, those at the top would continue to pay the same amount in taxes as they do now. Romney suggested how this might be done in the first debate:

[W]hat are the various ways we could bring down deductions, for instance? One way, for instance, would be to have a single number. Make up a number, $25,000, $50,000. Anybody can have deductions up to that amount. And then that number disappears for high-income people. That's one way one could do it.

The idea here would be that for a family making, say 60k/yr that currently takes a total of $15k in deductions, the deductions would remain untouched while their rate would go down, resulting in lower net taxes. For a family making $400k/yr that currently takes $70k in deductions, their deductions would be capped at $25k but their tax rate would be lower, so they would pay about the same as they do now.

Democrats seem to want to suggest that some sort of secret poison pill would be slipped into the plan such that either the middle class would get a tax increase (while the rich would get a tax break) or such that the deficit would go up because fewer tax revenues would be collected. What this tends to miss is that the president does not get to unilaterally pass a tax plan. He has to ask Congress to pass one along the lines of what he would like. I think it's highly unlikely that Congress will pass anything that is a net tax increase on the middle class (or, indeed, anyone) if it's dominated by the GOP, as seems likely, especially if the election has gone well enough for the GOP to put Rommney in the White House. That Congress would pass a plan that increases the deficit is more likely (goodness knows they've done it before) but the president himself isn't exactly standing on a good record in that regard either so that argument seems something of a wash.

The thing about this tax plan which is actually interesting, and which isn't being discussed (probably because it takes more than one minute of shouting to convey) is how it's designed to increase the amount of income available to be taxed, and in a way much more clever than the somewhat stale "tax people less and they will make more money" argument. This supply side argument is true, and we've seen examples of it working in history, but although tax cuts do tend to result in pre-tax incomes going up as people seek to increase the income that they make more of, the effect is pretty mild when the existing tax rates aren't absolutely confiscatory. Thus, you might actually see total tax revenues go up cutting the top marginal rate 20% from 80% to 64%, because if 80% of your incremental earnings are being taken away you have little incentive to find ways to increase your earnings. You're better off finding ways to enjoy leisure with the earnings you already have. However, cutting the top rate 20% from 35% to 28%, it's a lot less clear that people would increase their incomes enough more to actually lift total tax revenues.

In a good post over at EconLog the other day, David Henderson digs into the different incentives that wage earners experience when their tax rates are cut:

When the government cuts a marginal tax rate, and that's all it does, that cut has two effects in opposite directions: a substitution effect and an income effect.

The substitution effect is to make leisure more expensive. If you're facing a 35% marginal tax rate (MTR), for example, and the rate is cut by 20% to 28%, your "price" of leisure rises by (72 - 65)/65, or 10.8%. When the price of a normal good rises (and leisure is a normal good), you buy less of it. So people work harder.

The income effect is to make you buy more leisure. The cut in marginal tax rates increases your real income and therefore you demand more leisure. That is, you work less.

Empirically, the substitution effect tends to outweigh the income effect slightly for men and strongly for married women. This means that cuts in MTRs alone will tend to increase income somewhat for men and a fair amount for married women. That was the effect of Reagan's cuts in MTRs in the early 1980s.

Now, I'm certainly not one to say that the government has a need to maximize the amount of total tax revenues it takes in. Maximizing the size of government is not an end unto itself, and it can actually cause all sorts of problems. So in the abstract, one might argue that if lowering marginal tax rates were to cause incomes to go up, we should simply do that and find a way for the government to get by with a little less. However, the fact is, right now the government is spending far, far more than it takes in. Even the most aggressive responsible budget cutters (emphasis on responsible here -- there are some silly plans out there that claim they can cut spending by huge percentages right off) need tax revenues to remain fairly stable in order to get the budget balanced.

Well, it turns out that by cutting marginal tax rates but also cutting deductions so that the who balance out, you can have the substitution effect that Henderson describes without having the income effect. The rate cuts and deduction cuts are perfectly balanced, so your income is exactly the same as it was before. You don't "feel richer", and so you don't have the incentive to rest on your laurels and enjoy your newfound wealth. However, the substitution effect does come into play. If you have the opportunity to make more, less of that incremental income will be taken away in the form of taxes, and you'll get to keep more of it. The reward for making more is higher, and so (all other things being equal) people will tend to do it more.

And, of course, if this does result in incremental total income for citizens, that incremental income will be taxed (at the new lower rates) and result in incremental tax revenue which can be used to close the deficit. Thus, a tax reform that was essentially revenue neutral (people pay the same taxes each year) but which decreased marginal tax rates and deductions would have the same stimulative effect on incomes that a tax cut would have, but wouldn't present the deficit risk of significantly decreasing tax revenues and counting on economic growth to make up for that gap.

The plan really is quite clever, which makes it a shame that no one is willing to talk about it except in tiresome soundbites.

Tax Dishonesty

I've been listening to music via Pandora a lot recently (while writing) and the result is that although I've been hearing more than my usual share of political ads. (Since I don't watch television or listen to commercial radio, I'm normally exempt from these despite living in Ohio.)

One thing that particularly struck me is the rampant dishonesty in regards to tax policy that's going around, in part due to the both party's bad habit of making tax breaks look more affordable by enacting them only for short terms, thus necessitating frequent renewal.

The first bone of contention is the "Bush tax cuts". These tax cuts, which affected taxpayers all across the income spectrum, are estimated to have a "cost" of $3.3 Trillion over ten years (this "cost" is the combination of foregone theoretical tax revenues and the cost of servicing the debt resulting from federal spending not going down by a similar $3.3 Trillion.) Democrats like to refer to the "Bush tax cuts" as "tax cuts for the rich" and to quote the full "cost" of $3.3 Trillion as being the cost of those cuts. What this ignores is that two thirds of that $3.3T actually went to what President Obama refers to as the middle class (families making less than $250,000 per year.) So while it's true that the "Bush tax cuts" had a "cost" of "over three trillion dollars", the attacks against this ignore the fact that two thirds of that total is "tax cuts for the middle class" which Democrats support.

Just to make it even more confusing, Democrats like to call extending the Bush tax cuts "massive tax cuts for the rich", despite the fact it is simply an extension of tax rates which have already been in place for some time. Republicans, on the other hand, like to refer the potential expiration of the tax cuts as a "massive tax increase." This is accurate, to the extent that people would indeed experience their taxes going up, but it ignores the inconvenient fact that Republicans wrote the tax cut in such a way as to expire (in order to avoid having to make hard budget decisions to 'pay for' the tax cut.)

As if one set of expiring tax cuts that everyone talks about in different ways were not confusing enough, there's also the Obama payroll tax cut: a cut of 2% in the payroll tax that pays for Social Security. This was never meant to be a permanent tax cut, but rather a short term economic stimulus. Social Security has financial problems to begin with, it doesn't help to make a significant cut in its funding. (And that's ignoring the fiction that the money you put into Social Security is the money you're get out again.)

However, even though both parties have signaled that they're essentially willing to let the temporary payroll tax cut expire at the end of this year (though both parties hope to see this done as part of a broader overhaul of taxes suited to their own priorities) that hasn't stopped some commentators and advertisers from characterizing Republican support for letting the cut expire as "a tax increase on the middle class".

So Who Did Build That?

Every so often a politician makes a statement which so well represents the partisan divide that the political chattering class settles down to mocking or defending the statement for a week or two. Such a case, it seems, is Obama's "you didn't build that" speech last Friday. Speaking to supporters in Virginia, Obama said:

There are a lot of wealthy, successful Americans who agree with me — because they want to give something back. They know they didn’t — look, if you’ve been successful, you didn’t get there on your own. You didn’t get there on your own. I’m always struck by people who think, well, it must be because I was just so smart. There are a lot of smart people out there. It must be because I worked harder than everybody else. Let me tell you something — there are a whole bunch of hardworking people out there.

If you were successful, somebody along the line gave you some help. There was a great teacher somewhere in your life. Somebody helped to create this unbelievable American system that we have that allowed you to thrive. Somebody invested in roads and bridges. If you’ve got a business — you didn’t build that. Somebody else made that happen. The Internet didn’t get invented on its own. Government research created the Internet so that all the companies could make money off the Internet.

My primary reaction to this is literary and intellectual snobbery. The pass to which political rhetoric has come in this really pretty sad. Compare Obama's whimpers of populism with the master, William Jennings Bryan:

Mr. Carlisle said in 1878 that this was a struggle between "the idle holders of idle capital" and "the struggling masses, who produce the wealth and pay the taxes of the country;" and, my friends, the question we are to decide is: Upon which side will the Democratic party fight; upon the side of "the idle holders of idle capital" or upon the side of "the struggling masses?" That is the question which the party must answer first, and then it must be answered by each individual hereafter. The sympathies of the Democratic party, as shown by the platform, are on the side of the struggling masses who have ever been the foundation of the Democratic party. There are two ideas of government. There are those who believe that, if you will only legislate to make the well-to-do prosperous, their prosperity will leak through on those below. The Democratic idea, however, has been that if you legislate to make the masses prosperous, their prosperity will find its way up through every class which rests upon them.

You come to us and tell us that the great cities are in favor of the gold standard; we reply that the great cities rest upon our broad and fertile prairies. Burn down your cities and leave our farms, and your cities will spring up again as if by magic; but destroy our farms and the grass will grow in the streets of every city in the country.

Bryan may have been wrong on a lot of things, but dang could he speak.

But aside from its poor prose, the surprising thing about Obama's speech is its poor thinking. Yes, it's certainly true that no one does anything "on his own" in that we are all live within society. And of course, successful businesses exist within the context of a civil society in which laws exist and are enforced, infrastructure is maintained, etc. It is entirely just, for that reason, that we pay taxes to maintain that law enforcement and that infrastructure, and that we charge taxes proportionally to people's earnings, so that those who make the most pay the most. Contrary to Obama's implication, no one is disputing this. Even the most radical of "flat tax" proposals would still result in the rich paying far more than the poor. The only truly regressive tax we pay in the US is the social security tax, to which Obama, Mitt Romney, Bill Gates and I all pay exactly the same tax bill every year.

However the claim "If you’ve got a business — you didn’t build that. Somebody else made that happen." doesn't merely suggest the obvious and inane point that "hey, we all exist in society", but rather that there's nothing particularly special about those who build huge businesses or otherwise become huge successes. "Let me tell you something," Obama offers, with his typical, hectoring, I'm-much-smarter-than-you tone, "There are a lot of smart people out there.... [T]here are a whole bunch of hardworking people out there."

But here's the thing: We all have roads and laws and the internet and teachers available to us. Bill Gates and Michael Dell aren't billionaires because they had roads and teachers and I didn't. They're billionaires because through some combination of vision, hard work, drive and luck they built companies that provide millions of people with things they want enough to pay for. I grew up with the same legal system, the same public infrastructure, and the same educational opportunities as them, and I didn't build a huge, successful company. I work a good job and earn a nice paycheck by providing services that my employer is willing to pay for, and as a result I pay my mortgage and buy things that we want. And I pay taxes -- though far less taxes then billionaire entrepreneurs (as is just, since they make more money.) However, despite having the same government provided services and infrastructure available to me as billionaire entrepreneurs (and smaller entrepreneurs), I haven't built a successful company that provides other people with jobs and many more with valuable goods or services. As such, the difference between my fortune and that of Michael Dell or Bill Gates is not due to the government providing them with infrastructure, it's due to them and their actions. They really did build it.

This doesn't mean that taxation is theft or that those who are highly successful shouldn't pay an equitable share of the cost of maintaining the civil infrastructure and services we all benefit from, but it does mean that the "you didn't build that" line of argument that the president is attempting isn't just bad rhetoric, it's just plain wrong.

The Oft-Repeated Lie About Warren Buffet's Secretary's Tax Rate

For last night's State of the Union Address, President Obama invited Warren Buffet's secretary, Debbie Bosanek, to sit in the First Lady's box during the speech and specifically promised in that speech to support tax changes in order to mend the injustice Buffet claims occurs allowing him to pay the lowest tax rate of anyone in his office, including his secretary. This line of attack is doubtless partly designed to pave the way millionaire Barrack Obama to make populist attacks on multi-millionaire Mitt Romney during the upcoming presidential campaign. Romney is, after all, very, very rich, and his income comes primarily from investments.

David Leonhardt at the NY Times asks both right-leaning economist Greg Mankiw and the left leaning Center on Budget and Policy Priorities to comment on this alleged tax injustice. Mankiw makes a fairly reasonable case that the reason capital gains are lower is that investment income is based on corporate profits and corporate profits have already been taxed. Companies would have more profits to pass on to investors (either as dividends or in the form of being worth more) if they didn't pay corporate taxes, and so the tax on investment income is set lower to avoid this "double taxation". Chuck Marr of the Center on Budget and Policy Priorities must know the facts aren't on his side, because instead of answering the question he provides a canned response about income inequality and how tax rates are lower than in the '70s. The column is worth a read.

However, there's another issue here which I think is worth pointing out. Progressives writing on this issue usually act as if billionaire investors such as Warren Buffet are all paying right around 15% (the capital gains rate) in taxes -- Buffet claims that he pays 17.4% -- and that "middle class Americans" are paying the top marginal income tax rate of 35%. However, that top marginal income tax rate only applies to taxable income (for 2011) in excess of $379,150 a year of which "middle class" families by any reasonable definition have exactly none. If you think in terms of gross income, a lot of middle class families probably fall in the 25% bracket, which is applied to married couples with a combined income of $69,000 – $139,350. Many others fall in the 15% bracket, which is applied to married couples with a combined income of $17,000 – $69,000.

Even that, however, is not the whole story. That tax rate is applied to your adjusted taxable income. If you have kids, a mortgage, medical expenses, 401k contributions, student loans, etc., your taxable income can be significantly lower than your gross income, plus you may qualify for tax credits which apply directly against your tax liability.

So, to take one concrete example, although our total household income falls neatly in the middle of that 25% bracket range, by the time we took all deductions and tax credits into account last year I ended up paying actual taxes equal to 5% of my gross income. This is pretty typical. According to Congressional Budget Office numbers, the average effective income tax rate for all American households was 8.7% in 2005. Those in the bottom 40% of households got more money back then they paid (they had negative effective income tax rates) and those in the top 10% paid an effective income tax rate of 15.9% and those in the top 1% paid 19.7%. Even if you look at total federal taxes (including both the highly regressive payroll taxes that fund Social Security and Medicare and the corporate income taxes which tend to his only the more wealthy), the total federal effective tax rate is progressive all the way up the income stack, with the bottom 20% paying 4.3% and the top 1% paying 31.4%

I don't doubt that Warren Buffet pays tax lawyers a lot of money to make sure that he doesn't pay more taxes than he has to, and as a result he may well manage to pay a lower effective tax rate as a member of the top 0.000001% than a member of the top 0.01% would, but to claim that he is paying a lower total effective federal tax rate than members of the middle class is, to put it bluntly: a lie.

Why Doesn't Warren Buffet Pay Extra Taxes?

A friend once complained to me that, "All you ever seem to write about is money and sex." I'm not sure this is entirely the case, but they are certainly topics which I can write about very quickly. So while I'm still working on some travel writing about my sojourn in San Francisco last week (at a conference put on by one of the vendors I work with) I thought I'd throw up a quick post on this WSJ editorial which caught my eye, because it makes a seemingly valid point about wealthy people who call for higher taxes on the rich.

I wish I had a dollar for every time a wealthy liberal has declared he thinks he should pay more taxes. That list includes Warren Buffett, George Soros, Bill Gates Sr., Mark Zuckerberg and even Barack Obama, who now says that not only should rich people like him pay more taxes, they want to pay more. "I believe that most wealthy Americans would agree with me," he said of his tax-hike plan. "They want to give back to the country that's done so much for them."
...
So why don't they? There is a special fund at the Treasury Department for taxpayers who want to make "gift contributions to reduce debt held by the public." But very few do. Last year that fund and others like it raised a grand total of $300 million. That's a decimal place on Mr. Zuckerberg's net worth and pays for less than two hours worth of federal borrowing.

I understand the basic satisfaction of saying, "Look, mister, if you really want to pay more taxes, no one is stopping you," but I don't think that it's actually a very good argument. The reason why people like Bill Gates and Warren Buffet advocate for higher taxes but don't voluntarily pay higher taxes than the law requires is pretty obvious: If the US raised the top marginal income tax rate and the capital gains rate in order to try to collect more money from people like Buffet and Gates, this would affect all people in that tax bracket. (If the current tax brackets were used, that would man any married couple making more than $379,000/yr.) This would mean that while high tax advocates such as Warren Buffet would pay more taxes, their relative wealth compared to the other wealthy would remain the same. Thus, Buffet's ability to buy or control things via his wealth would not diminish relative to the other wealthy.

On the other hand, if Buffet decided to simply write an extra check to the Feds each year for $10 million, the result would be that his relative income (and thus buying and influencing power) would fall somewhat relative to other members of is class. Now, as someone who makes a number of high profile donations, Buffet is clearly willing to give money away, but when he makes a direct donation to a non-profit he has a pretty good say in how that money will be used. If he simply writes a check to the Feds, he has very little. As someone who supports higher taxes, he's clearly okay with handing more money over to the Feds -- but I think it's pretty rational that he's not willing to do so in a way that reduces his economic power, and doesn't do all that much to stem the budget problems.

So really, I don't see there as being much hypocrisy in the unwillingness of rich high tax advocates to voluntarily pay extra. Though at the same time, it's important to understand there's no virtue in their claim that "they'd be willing to pay more". They are, clearly, willing to pay more (thus the advocacy) but only if they can do so in a way which doesn't reduce their standing versus other rich people (and the rest of the country).

Do The Wealthy Pay Their Share?

Having linked last week to some discussion on whether the US is really becoming "Of the 1%, by the 1%, for the 1%", I was struck by this chart, which I saw a link to this morning, over at Carpe Diem, showing top marginal income tax rates versus percentage of income tax paid by the top 1% of earners since 1980.

However, I thought it would be a lot more interesting if the chart showed the percentage of total income earned by the top 1%, and also showed the total federal tax liability (including Social Security and Medicare) rather than the just the income tax. Luckily, all this information is available easily on line. (Percent of taxes paid. Percent of total income. Historical tax tables.)

Here's the chart I produced with that data:

The blue line is the share of total federal tax liability paid by the top 1% of households by income. It doubled between 1980 and 2007 from 14% to 28%.

The green line is the share of total adjusted gross income earned by the top 1% of households. It increased by 2.7x from 1980 to 2007, from 8% to 23%.

Whether this means the wealthy are paying "their share" or not probably depends a lot on one's point of view. On the one hand, the share of income earned by the very wealthy has increased more than their share of total tax liability. On the other hand, their share of total tax liability remains greater than their share of income. Personally, I would tend to think that this represents the right balance, but there are sure to be those who think this means the wealthy are not paying enough (their income grew faster), and others who think it means they are paying too much (their share of tax liability is greater than their share of income.

Perhaps another way to look at the extent to which our tax system is adjusting for growing inequality is to look at the share of total federal tax liability for the bottom quintiles (A quintile is a 20% range, so the bottom three quintiles of income distribution are 0-20%, 20-40%, 40-60%) versus the share of total adjusted gross income earned by the bottom 50% of households. (I don't have this by quintile in the above sources, but I think the bottom 50% should compare moderately well if we look at all three bottom quintiles, representing, in sum, the bottom 60% of earners.)

The result is as follows:

The share of adjusted gross income earned by the bottom 50% of households went down by about a third from 1980 to 2007, from 18% to 12%.

During that same period, the percentage of total federal tax liability (including Social Security and Medicare) went down by over half for the bottom quintile, from 2% to 0.8%; by a third for the second quintile, from 7% to 4.4%; and by nearly a third for the third quintile, from 13.3% to 9.2%.

Finally, it's perhaps worth noting that the main "drag" on the progressiveness of the US tax system at this point are is the pair of "universal" programs (Social Security and Medicare) which tax all income up to ~110k at the same rate and then provide all citizens (rich and poor) with benefits. If those programs were made to work more like a welfare program and less like a fixed benefit pension, the solvency of these programs would no longer be in question and the tax burden on the poor and middle class would be lighter.

Rewinding Taxes to the Good Old Days

For decades, progressives tended to accuse conservatives of wanting to bring back the '50s, but in recent years the shoe is on the other foot, with some prominent progressives saying they yearn for the good old days when unions were strong, manufacturing was the core of the economy, and the top marginal tax rate was over 90%. I wanted to see what the real tax situation was for people in a number of different income situations, so I decided to pull the historical tax tables and do the math.

Luckily, the Tax Foundation publishes the income tax tables for every year from 2010 back to 1913. I decided to compare 2010 and 1955. Here are the 2010 tax tables:

I then got the 1955 tax tables and adjusted the income brackets to 2010 dollars using this inflation calculator. (For those interested, the inflation factor from 1955 to 2010 is 713%) The result is as follows:

Next, I wanted to see what this would actually mean for people at various family incomes. Keep in mind, I'm not looking at deductions or tax credits here; I'm just looking at the basic rate calculation. This obviously is not a full real world picture, but I think it at least gives us a view of what the basic message of the tax rates was at these two points in history.

As you can see, everyone paid more in taxes in 1955 than they do now. However, the degree to which they paid more then is interesting. Someone making 40k in 2010 dollars would have paid 1.6 times as much in 1955. Someone who made 80k, only 1.4 times as much. Someone making 120k would have only paid 1.3 times as much. It's not until we get to the astronomically wealthy fellow, earning 1.2 million 2010 dollars per year, that he pays a higher multiple, 1.9 times as much in 1955 as he would in 2010. (Also note that the famed 91% marginal income tax rate doesn't kick in until you're making more than 3.2 million dollars per year in 2010 dollars. You'd have to be well into the richest 0.1% to feel it.)

So while the rich pay less in taxes in 2010 than in 1950, the middle and working classes pay much less as well. And overall, we have a significantly more progressive tax code now than we did then.

Divided Thoughts over the Tax Deal

I find myself with oddly divided feelings about this whole tax deal making its way through congress.  On the one hand, while extending the tax cuts which we're already experiencing seems prudent, especially in a recession, piling additional tax cuts on top of those (especially the across the board 2% reduction in social security withholding) seems seriously unwise when our deficit is already the size that it is.

On the other hand, I could certainly use the extra $150+ per month in take-home income.  As I look at moving bills and such, I keep thinking, "Well, if this passes my paychecks will go up soon."

We routinely scorn politicians for being easily bought, but I'm feeling rather hungry for my pot of lentils myself about now.