Can We Afford to Raise Taxes On High Incomes? Can We Afford Not To?


Another tax related post.  It appears that taxes, in particular, taxes on the top income bracket will be a major topic of debate propaganda for the next year and  a half until the next presidential election.  Part of the reason is because the tax deal done last December (2010) between Republicans and Obama last December (2010) perpetuated the Bush-era tax cuts until Dec. 31, 2012, just after the election.  Another reason is because the Republicans in Congress, led by Congressman Paul Ryan have passed a proposed budget that will cut the top individual federal marginal income tax rate to 25%, ten points below the even the Bush-era 35%!  (source: Reuters)

The Republicans and Tea Partiers basically offer three arguments for cutting the top tax rates on high-income folks. None of the arguments hold up under examination.  First, they argue that the U.S. is too heavily taxed already. So, let’s compare the U.S. to other countries in the graph at the right from CBPP.  The U.S. is in fact, a relatively low tax country compared with other developed, industrialized nations.  (although to be fair, we should note that the other countries on the graph pay for healthcare for all their citizens and most of it comes from the government budgets).

So let’s move onto the second argument.  Republicans like to argue that cutting taxes for the top end, for the rich and high income brackets will create jobs.  They repeatedly call these high-end income folks the “job creators”.  Apparently out of some pique, these people refuse to “create jobs” for us lesser people whenever their tax rates exceed some number around 35%.  Unfortunately, this concept has been tried before and found wanting.  Simply put, there’s no empirical support for the idea that cutting tax rates primarily on the top end bracket will create jobs.  See here and here for more details. George Bush and the Republican Congress cut taxes and tax rates in 2001. At the end of the decade, in December 2010, the net increase in jobs (employment) in the U.S. was zero. That’s right. Not a single net new job.  No more people were employed in Dec 2010 than were employed before the tax cuts.  As I’ve discussed before, this doesn’t mean that Keynesian theory that cutting total taxes collected on from the nation has been disproven. Rather it means that how the taxes are cut matters.  Tax cuts only work to stimulate the economy and create jobs when they create new spending.  Tax cuts on the top brackets don’t create new spending, though.  They create a boom market in fixed luxury assets such as mansions in the Hamptons, Vail, or outside the country.  Tax cuts on the top brackets help fuel investments in off-shore funds and overseas entities, but they don’t really drive much spending here at home, at least not the kind of spending that drives good jobs and middle-class incomes.  Let us not make a mistake, while the Bush-era tax cuts included some minor cuts for lower income brackets, the overwhelming benefit accrued to the top bracket, as shown below (again from CBPP).  For more details and to see the real empirical record of tax rates vs job creation/economic growth, see Presimetrics, a site and book well worth the read.

Now let’s consider the third argument often provided as to why we need to cut tax rates for the top bracket.  Strange as it may sound, but the argument is offered that it’s the fair thing to do.  I know when you look at comparable average tax rates by income bracket like I did here and here, that it seems like the tax code is already quite fair to people earning a million dollars or more.  Yet their argument goes that it’s the richest people who pay for most of the government’s total taxes paid.  They cite the fact that the top income bracket people pay the majority of all tax dollars collected by the government.  That’s true.  But they neglect to say that it’s because the top bracket gets the dominant share of income in the U.S, not because the tax rate is too high.  Indeed, the top bracket payers are the only ones who have really benefitted in the last 30 years and seen their incomes grow substantially.  See the accompanying CBPP chart to see how the top 1% has seen it’s income rise 281% since 1979 (as it’s tax rates have been on a long down-hill slide), while the lower 80% barely grew 25% income.  The reality is that the top bracket pays the majority of tax dollars because they get the majority of the nation’s income.  Yes, the income distribution numbers are that out of whack.  The top 1% of households by income get a whopping 17.9% of all national income.  That’s just the top 1%!  Their share was only 7.5% 30 years ago.  (source: CBPP)So, actually the fair thing would be for the top bracket to pay a little more since they’ve benefitted the most from the current tax regime.

During the 30 year time frame that the top bracket has been raking in a larger and larger share of the national income while seeing their income tax rates decline, the lower brackets, the ones with incomes below $100,000 have seen their payroll tax rates double to build a giant Social Security trust fund.

Overall, I think we can afford to raise tax rates on the high income tax bracket.  In fact, if anything, there are good reasons to raise tax rates on the high end. First, since our government persists in it’s belief that it must borrow to finance a deficit (an unnecessary self-imposed constraint) and since many politicians, including those Republicans, think it’s a good thing to reduce the deficit (opinion I do not share), then we should.  As I observed with the post on the do-nothing plan, letting the Bush-era tax cuts expire and letting the existing law take force in January 2013 to raise the top tax bracket to 39%, which it was during the Clinton low unemployment years is a good plan. Let’s see what happens when if we allow the Bush tax cuts to expire and let the top rate go back to the 90’s era 39% vs. keeping the present 35% rate.  Again, CBPP obliges.

A strong argument can be made that the top bracket benefits disproportionately from the work of the government.  It’s not the poorest households that have investments in the middle east and around the world that are protected by the U.S. global military presence. It’s the richest. Time to pay the bill.

Taxes and Unshared Sacrifice

It’s tax time so it’s appropriate to look at the fairness of the tax code.  One of the greatest beneficiaries of the Bush-era tax cuts were hedge fund managers.  Hedge fund managers are people on Wall Street who manage other people’s money, not primarily their own.  In return, they get paid fees for managing the money. The more money they make for clients/investors, they more they get paid.  Sounds like wages or income to me, and I suspect to you, too.  But not to Congress.  In 2001, they redefined things. The compensation these hedge fund managers is only taxed at less than half the rates other people pay for income.  This is despite these incomes being at astronomical levels.  Wonkroom puts things in perspective with a nice little graph.

CEO pay pales in comparison to that of hedge fund managers:

Last year was very lucrative for some of the biggest and best-performing hedge funds’ chiefs. Wealth was so concentrated that a mere 25 people pocketed a total of $22.07 billion, according to this year’s annual ranking by AR Magazine, which tracks the hedge fund industry. At $50,000 a year, it would take the salaries of 441,400 Americans to match that sum.

Making matters worse, hedge fund managers benefit from preferential tax treatment that middle-income Americans don’t. Due to what’s known as the carried-interest loophole, the income that hedge fund managers receive if their funds make money is treated as capital gains — rather than ordinary income — and gets taxed at the capital gains rate of 15 percent. Even though the pay is performance-based compensation (just like any other performance-based bonus made by any other worker), hedge fund managers receive a tax break on that income.

This results in hedge fund managers paying less in taxes on this income than middle-class workers, who are subject to a 25 percent top marginal tax rate:

Congress has debated closing this particular loophole over and over, but has never actually followed through. At a time when vital and popular programs are being placed on the altar of deficit reduction, removing this tax break for some of the richest people in the country seems prudent.

To be fair, the graph compares only the marginal tax rate each taxpayer faces.  The marginal tax rate is the tax rate on the next dollar of income earned after you’ve reached that level.  It is not the average tax rate paid. Average rate paid would be total taxes paid divided by income.  But, even if we went by average tax rates, these hedge fund managers pay a lesser tax rate than ordinary middle class or poor individuals.  Further, since this income is not considered by Congress to be wages or labor income, they don’t pay Social Security taxes on the additional income.  

BTW, there’s another way to look at the graph.  The firefighter, the teacher, the police officer, and the doctor all perform valuable services that improve the quality of our lives.  All four may occasionally screw up, but the damage done is isolated (although granted if it’s your home that burns or your body that’s hurt, you may feel differently).  Hedge fund managers, however, have been a key part of the Wall Street environment that sought more and more risky investments and complex financial schemes in the last decade.  The kind of stuff that blew up and created the Great Global Financial Crisis. 

Micro Theory vs Reality: Baseball Edition

From James Kwak at Baseline Scenario:

“No, No. It’s Already Priced In. ” That was undoubtedly the response of theoretical law and economics devotees to the premature retirement of Kansas City Royals pitcher Gil Meche a few weeks ago, which we discussed in one of my classes last week. Meche signed a five-year, $55 million, guaranteed contract before the 2007 season, which would have paid him $12 million in 2011 simply for showing up, despite a broken-down shoulder that made him an ineffective pitcher. Yet Meche decided to retire, giving up the $12 million. Meche said this:

“Once I started to realize I wasn’t earning my money, I felt bad. I was making a crazy amount of money for not even pitching. Honestly, I didn’t feel like I deserved it. I didn’t want to have those feelings again.”

One of the topics of the class was non-economic preferences, particularly preferences for fairness, which have been a staple of psychology and behavioral economics over the past decade. Classical theory says that Meche should have kept the $12 million for two reasons. The obvious reason is that $12 million is more than zero, and almost certainly more than the disutility of having to show up to work for another eight months. (Although maybe his marginal utility of money is very low at this point, after four years of his big contract.)

The slightly less obvious reason, which is drilled into law students’ heads in the first semester, is that the risk of career-debilitating injury is already priced into the contract. On this theory, parties are free to bargain for whatever contract terms they wish. In Major League Baseball, the standard for free agent contracts is that they are guaranteed, meaning that they cannot be terminated due to injury (and, I believe, only for cause, where cause includes things like going to jail or getting injured in specifically prohibited activities like dirt-bike racing). So, the argument goes, baseball players chose to bargain for contract guarantees, and in return they are getting less of something else that they want — presumably less money. Put another way, the risk of injury is already priced into the contract. If a player goes through his contract without injury, and remains productive, the team is not going to pay him more money simply because of that. (The player will get more money eventually, either by renegotiating partway through or by getting a bigger contract at the end of the current one, but presumably that’s priced in as well.)

This all may be right. More importantly, it provides a powerful justification for taking the money. It’s hard to stand up and say, “I’m taking the $12 million because it’s in my contract, and I want it, and it’s legally mine.” It’s a lot easier to say, “Teams and players are free to contract however they want, and I accepted less money each year because I got a guarantee, so the $12 million is not only legally but morally mine — it’s just like the payout on an insurance contract, where the reductions in my salary each year were the premiums and the $12 million is the payout.”

So maybe Meche should have taken the money. But at the same time, theoretical law and economics doesn’t dictate our societal norms, at least not yet. As he said, “It’s just me getting back to a point in my life where I’m comfortable. Making that amount of money from a team that’s already given me over $40 million for my life and for my kids, it just wasn’t the right thing to do.” It sounds like he just decided he was happier without the $12 million than he would have been with it.