Some Observation about Middle-Class Taxes
As conservatives think about how to deal with the aftermath of the seemingly-likely Republican Armageddon in November, there appears to be a lot of cognitive dissonance on taxes. Some (e.g., me) argue that a focus on marginal income tax rates has somewhat run out of political steam, both because we have been successful in reducing marginal rates so dramatically over the past 30 years, and because the economy has changed so much. Others (e.g., also me) argue that a pro-growth, low-tax agenda is central to a conservative movement that can command majority support and serve the best interests of the nation.
To an extent, these groups are talking past each other because so many conservatives casually conflate taxes with the federal income tax. This may have useful in 1978, but deeply misrepresents the world of 2008. Thinking about total tax burden (including all federal, state and local taxes) can lead to some different conclusions.
Many pro-growth, low-tax conservatives observe that an increasingly large share of total income tax is being paid by a smaller and smaller fraction of the population. It is striking that the top 20% of households by income pay about 2/3 of all federal income taxes, and most of this is paid by the top 1% of earners. This raises the eternal fear that the populace is voting to expropriate wealth through legal means.
Now, one driver of this is that increases in wage inequality since about 1980 mean that the highest-income households make a ton of money these days. Here is the effective federal income tax rate by income quintile:
Highest income quintile: 12%
Second-highest income quintile: 7%
Middle income quintile: 5%
Second-lowest income quintile: 3%
Lowest income quintile: 1%
This picture is somewhat less dramatic, though the federal income tax certainly remains highly progressive. Of course, the top marginal rate is an important as a driver of incentives for wealth creation. Most people would accept a somewhat less progressive tax schedule, even though it would lead them to pay more taxes this year, if they believed that it would drive enough incremental economic growth by incenting more work and risk-taking that their after-tax income in future years would be much higher because the nation as a whole would become wealthier. One of the central achievements of the conservative movement was to make this case successfully to the American electorate. This was quite convincing in the world of 70% marginal income tax rates that obtained in 1980. How much benefit further reductions in the current top marginal tax rate of 35% would create for the nation as a whole is a lot less clear.
But there are lots of other taxes that people pay. In fact, the federal income tax represents only a little more than ¼ of total tax receipts. The federal income tax rate is highly progressive, but the total tax rate (including all federal, state and local taxes) is much less so. According to the Tax Foundation, here is the effective total tax rate in the U.S. by income quintile:
Highest income quintile: 35%
Second-highest income quintile: 31%
Middle-income quintile: 28%
Second-lowest income quintile: 23%
Lowest income quintile: 13%
What can be so eye-opening about this is how flat the rate distribution is from the second-lowest income quintile all the way up to the highest income quintile. In extremely round numbers, a household right around the middle might make $50,000 per year, have a tax burden of $14,000 and therefore has $36,000 left to spend. An upper-income family might make $150,000, have a tax burden of $55,000 and have $95,000 left to spend. You can see why somebody sitting in the middle might not be so sympathetic to the argument that America’s key tax priority is to lower the taxes on the guy making $150,000 per year.
Where do all of these not-so-progressive taxes that are hitting those in the middle come from? According to the Tax Foundation, here was the distribution of total tax burden for the middle income quintile of households in 2004:
Payroll taxes: 32%
Federal income tax: 18%
Property tax: 12%
General sales tax: 10%
All other: 28%
Total: 100%
By far the biggest tax burden (and especially federal tax burden) for the typical household in the U.S. is the payroll tax. Only for the top income quintile is income tax larger than payroll tax. So, tax credits against the payroll tax seem like they would be a logical part of what it means to cut taxes (and especially federal taxes) for the middle class. The proposal to provide a child tax credit against payroll taxes strikes me a reasonable way to do this. It is “social engineering” in the strictest sense, but like the mortgage tax credit against income taxes designed for an earlier era, it seems like a minor compromise with principle to serve the ends of providing middle-class tax relief and encouraging fairly broad-based behavior that is in the interests of society (i.e., raising kids), rather than being some truly special interest tax break.
It will be important to balance many competing objectives as we think about the best tax policy for America. We need to use taxes to grow the pie, not just to divide up the pie. Holding the line on a return to much higher marginal income tax rates will be hard enough. Unfortunately, international competition is likely to become much more severe over the next several decades, and increasing economic efficiency will be a required to maintain American growth and the resulting standard of living. So, growing, not just maintaining, the incentives for work, risk and entrepreneurship need to remain central to the conservative project. As somebody who has been an entrepreneur for some time, it’s not clear to me that further reducing the top marginal income tax rate is nearly as important for encouraging this as is the capital gains tax rate plus tax simplification more generally. An advantage of focusing on capital gains is that it encourages an ever-broader slice of the electorate to become entrepreneurs, who tend to be natural conservatives, or at least become so as they manage a business. The information revolution, in ways we don’t yet fully understand, appears to be lowering efficient firm size. Focusing on gains to entrepreneurship as opposed to salary is one part of getting in front of the wave of a changing economy. One of the advantages of being out of power is that it becomes easier to champion reform proposals that hurt incumbents but help the country. Legislators like an excessively-complicated tax code because it allows them to sell tax breaks in return for campaign contributions. It is shocking how much deadweight cost this creates, and what a deterrent this is to small entrepreneurs, for whom tax compliance it is not just a cost of doing business, but a barrier to entry.
Being for lower taxes ought to be a core part of what it means to be a conservative for the conceivable future. As food-for-thought, it might be more useful to do this by (i) going after the total tax burden, for example through a child tax credit against payroll taxes, (ii) placing more relative emphasis on reducing marginal rates for capital gains than income, and (iii) tax simplification.
( cross-posted at The Corner )
Jim: I think there’s more bang for the buck in terms of dead-loss reduction by eliminating the corporate income tax rather than by eliminating the capital gains tax. And eliminating the payroll tax would both make the code much more progressive, encourage productive employment, and remove a big incentive for hiring people off the books.
Meanwhile, we’ve got a huge savings deficit and our tax code is skewed towards taxing productive activity rather than consumption. We even encourage consumption in real estate via the mortgage deduction.
So, my big-bang tax reform:
Eliminate the payroll tax
Eliminate the corporate income tax
Eliminate the mortgage deduction
Replace lost revenue via a value-added tax
— Noah Millman · May 22, 08:22 PM · #
Jim, Great post. But I kind of don’t get this…
“The proposal to provide a child tax credit against payroll taxes strikes me a reasonable way to do this. It is “social engineering” in the strictest sense, but like the mortgage tax credit against income taxes designed for an earlier era, it seems like a minor compromise with principle to serve the ends of providing middle-class tax relief and encouraging fairly broad-based behavior that is in the interests of society (i.e., raising kids), rather than being some truly special interest tax break.”
What’s the point of the tax credit? If the aim is to reduce middle class taxes, Why not just cut the middle-class income tax rate? Maybe its good politics to design the tax code to punish childless middle-class renters, but an across-the-board cut seems at least as good, no?
And if the payroll tax is such a huge hit, why not plump for converting half of it into personally-owned retirement accounts?
— Will Wilkinson · May 22, 08:59 PM · #
Noah:
I certainly agree that there is nothing to love about the corporate income tax, and will not defend it. The key point I was trying to make about the cap gains vs. income tax comparison is that “encourage risk-taking, entreprenuership and extreme work hours” doesn’t always imply lower top marginal income tax rates. I was also consciously trying to identify incremental improvements, rather than a big bang.
The practical issue I have always seen raised by tax experts about the VAT is that it is too easy to raise it with minimum public resistance and awareness because so much of it is “below the waterline”. I have no independent view about the validity of that argument and/or its empirical support, but would love to see something on it if you have a pointer.
— Jim Manzi · May 22, 09:02 PM · #
Jim: I’ve heard that objection as well. I don’t think it’s a black and white thing. On the one hand, the VAT is built into prices, so it’s somewhat of an invisible tax. On the other hand, consumers are pretty aware of prices, and I should imagine that political hay could be made by a challenger about higher prices if an incumbent voted to raise the tax and then high prices became a concern.
But everything has tradeoffs. The VAT is a relatively cheap tax to administer and has fewer compliance problems than a sales tax. So the dead loss associated with it is lower than for any other tax scheme. These are the happy sides of the same coin, the unhappy side of which is that it’s easier for politicians to raise without the citizenry noticing.
Moreover, I’m proposing eliminating a tax – the payroll tax – that’s also something of a stealth tax (employees never see the employer contribution, so they are misled as to the size of the tax taken out), and regressive, and a drag on economic activity to boot. So I think it’s a good trade.
The optimal tax from the perspective of encouraging productivity and progressivity is probably a wealth tax. But any wealth tax would entail substsantial compliance costs, and would create powerful incentives for cheating, pitting the government against the citizenry. It would be substantially worse than the income tax in that regard. And, hence, probably not worth it.
— Noah Millman · May 22, 09:53 PM · #
Will:
Thanks.
What’s the point of the tax credit? If the aim is to reduce middle class taxes, Why not just cut the middle-class income tax rate? Maybe its good politics to design the tax code to punish childless middle-class renters, but an across-the-board cut seems at least as good, no?
There is a technical answer to the easy part of this. You would burn through all the income tax payments for lots of people in the lower middle class pretty quickly, and unless you go to a negative income tax at the same time that you have people with payroll tax deductions from their paycheck, you have to start digging into the payroll tax payment. As to the harder part of this, that is, why privilege families with kids over households without them, there are two theoretically-awful, but I believe practical reasons for it.
1. Coalitional politics. I think that a key strategic objective for conservatives is to re-establish the alliance between social conservatives and economic libertarians. This is one reason I keep banging on about subsidiarity. I think that a package of tax reforms that offers huge rewards for successful risk-taking ought not only to provide middle-class tax relief, but do it in a way that skews to social conservatives.
2. Social engineering. I think that providing tax support for raising kids is not a bad way (though not an “I’m emperor of the world” way) to go about doing this.
And if the payroll tax is such a huge hit, why not plump for converting half of it into personally-owned retirement accounts?
I couldn’t agree more. I wrote an article for National Review recently that argues for vouchers / individual accounts / whatever you want to call them as a unifying framework for a range of social services from schools to medical care to retirement accounts. I see them as a kind of halfway point between direct government provision of services and a negative income tax.
— Jim Manzi · May 22, 10:22 PM · #
>pro-growth, low-tax agenda
It’s really time to acknowledge that these two things don’t correlate, and stop stating, as an unchallenged truism, that they do.
Because they don’t. It’s a myth.
If they did correlate, the US, with a far lower tax burden than Europe, should have seen extraordinally greater growth over the decades—especially since the Reagan revolution.
But it simply hasn’t happened. We’ve run the test, and the results are in.
Change in real GDP per capita (PPP), difference between EU and US
US growth percentage minus EU15 growth percentage (positive numbers=US ahead)
Starting years at left, ending years, top. Gray is >29 years. Outline is >19 years.
You’ll notice that this table directly addresses the timing and lag concerns that Jim Manzi (justifiably) points out in Bartels’ dem/pub analysis (and that few economic studies of this subject address.)
US taxes are about 28% of GDP. EU15 averages 40%, and ranges from 30-50%.
If lower taxes created prosperity, we would be seeing a huge difference. And we’re seeing, essentially…none.
It’s time to put that myth to bed.
— Steve Roth · May 26, 05:32 PM · #