Deficit Plans Cut Marginal Tax Rates, But Raise Average Rates, for High Earners
Liberal critics of the deficit reduction and tax reform plans that surfaced over the past couple of weeks have been blasting them for the sin of cutting tax rates for the rich at the same time they’d slash spending for the rest of us. I understand why the left would object to cuts in government benefits and services, but their complaints about the tax cuts are way off base.
Here is Nobel Prize winning economist Paul Krugman writing in The New York Times about the plan offered by Erskine Bowles and Alan Simpson, the co-chairs of President Obama’s fiscal commission: “So how, exactly, did a deficit-cutting commission become a commission whose first priority is cutting tax rates, with deficit reduction literally at the bottom of the list?”
First, you need to know the code. Krugman is talking about marginal tax rates—the rate you pay on the last dollar of income you earn. And it is true that both Bowles and Simpson and a second deficit panel chaired by Alice Rivlin and Pete Domenici would cut marginal tax rates for the rich (and, as many critics never quite mention, for most everyone else as well).
But both plans raise average tax rates for high-earners, and by quite a bit.
Nearly every economist believes that, all else equal, low marginal rates are better than high rates. That’s because while all taxes throw some sand in the economic gears, low rates throw in somewhat less and thus are more economically efficient. With low rates, people are more likely to make decisions based on economic fundamentals. When rates are high, they make choices just to save taxes and can make some really stupid decisions.
But Krugman is not making an efficiency argument. I suspect he knows better. He is making a fairness argument. But if you want to talk fairness, it is pointless to look at marginal rates. Instead, you want to look at average tax rates. In other words, what share of their total income do people pay in taxes and how does that compare to what others pay?
And if you ask that question, you get a completely different answer than the left claims. The Tax Policy Center calculated average effective federal tax rates– including individual and corporate income taxes, payroll taxes and estate taxes– for both plans. It turns out that under both Bowles-Simpson and Rivlin-Domenici, average rates go up—and not down—for high earners (and for nearly everyone else, for that matter. They are deficit reduction plans, after all).
Take Bowles-Simpson. While it proposes several reform alternatives, TPC looked the one that eliminates all deductions, exclusions, and exemptions except for the earned income credit and the child credit. Measured against current policy (that is, assuming the Bush-era tax cuts continue), the average rate under this plan would rise from 21.7 percent to 23.9 percent. To focus on the high-earners that so trouble the left, those in the top 20 percent would face an increase in their average rate from 26.1 percent to 28.5 percent.
The highest earning 0.1 percent of households would see their average rate rise from 32.9 percent to 38.1 percent. Thus, while their marginal rate would fall from 35 percent to 24 percent, their average rate would go way up. Those very top earners, btw, would pay about $500,000 more in taxes under Bowles-Simpson once the plan is fully effective in 2015.
Rivlin-Domenci does even better if progressivity is your thing. TPC found average tax rates would go up for every income group, except the lowest 20 percent. Those in the top 20 percent of earners would pay an average rate of 31.6 percent, compared to 26.4 percent under current policy. The top one percent would pay an average rate of 35.8 percent, compared to 29.9 percent under the Bush-era tax cuts, and the top 0.1 percent would pay 40 percent, up from 32.6 percent. Once the Rivlin-Domenici plan is fully effective, TPC estimates this group would pay, on average, $730,000 more in taxes than they would have in 2018 if the Bush tax cuts had been extended.
Some of the reasons why high earners would pay more under both plans: Capital gains and dividends would be taxed as ordinary income and capital gains would be taxed at death. This would be a big deal since investment income is a very large share of what high-earners make. In addition, these same households would also lose the benefit of many other deductions, credits and exclusions that both plans would curtail. Thus, they’d be paying more tax on, for instance, employer-sponsored health insurance, pension contributions, and mortgage payments.
The story is somewhat different if you prefer to compare these plans to tax law in the Clinton years. But even if you do that, the very highest earners still pay a higher effective tax rate under either of the reform plans. It is true, however, that many in the upper middle-class would pay slightly lower effective rates under Bowles-Simpson than if the Bush tax cuts had been allowed to expire.
We can certainly argue about whether either of these plans is progressive enough. And they could be easily adjusted to raise taxes more at the top or less at the bottom, if that is your taste. But to imply that they are a huge tax cut for the rich is plain wrong.
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[...] their fair share.). The TaxVox blog, run by the left of center Urban and Brookings Institution’s, highlighted this back in November of last year. Take Bowles-Simpson. While it proposes several reform alternatives, TPC looked the one that [...]
[...] Mr Ryan’s staff simply instructed the CBO to assume revenues remain at 19% of GDP. “There were no specifications of particular revenue provisions that would generate that path”, it says. This can be risky. When the CBO analysed Mr Ryan’s Roadmap for America’s Future, it accepted Mr Ryan’s instructions that revenues would rise to 19% of GDP. When the Tax Policy Center analysed the specifics of the Roadmap, it concluded that tax revenue would fall below 17% of GDP. It also concluded that its benefits would accrue overwhelmingly to the most affluent 20% of American families, mostly because Mr Ryan exempted capital gains and dividends from taxation. By contrast, the Bowles-Simpson plan does not, and thus its tax proposal is mildly progressive. [...]
[...] though, like most things, mainly for the rich – while reducing exceptions, a move that would lower marginal rates but raise effective ones, thereby raising revenue overall. I am opposed to lowering marginal income rates since current rates without loopholes would raise [...]
You assume that the market for wages is free – it is not – hence some redistribution is appropriate in a capitalist system. Indeed, the key feature of capitalism is that the owners of the firm retain some of the value generated by employees rather than distributing it through wages. In a free market, the entire net productivity of workers would go to them in wages and benefits and none would be received by business owners as profit.
The 1986 Tax Reform was followed by a rate increase in the very next administration, then a larger increase in the administration after that. This history demonstrates that the erasure of tax benefits is permanent, but the rate reductions are temporary.
Tax reform is a foolish bargain for those who desire low tax rates. It is a good idea for those who want to raise more revenue with minimal economic damage. In the present circumstance, most reasonable people are in the latter category. However let's not pretend that history will not repeat itself as the pressure for revenue increases.
Another aspect I do not see discussed is the psychological effect of low income tax rates = easy money = nothing good.
We have become a culture of money. Low individual tax liabilities incentivize making money, I would argue, at the expense of making added value products/services to solve real problems for real people. Which of course is the fundamental basis of capitalism, as contrasted to the Crony Capitalism prevalent in US culture today.
For the wealthy, money is easier and easier to make with capital and complexity of financial instruments and tax law (as well as general legislation). The focus of individuals' efforts is towards making money primarily; making anything else is a necessary ancillary nuisance.
Amongst the wealthy owners and managers, this leads to such effects as lower and lower product/service quality, reliability, longevity, and “social responsibility.” Instead of “the customer is always right,” the consumer has become a necessary nuisance to be exploited.
Historically low personal tax liabilities resulting in historic wealth accumulation and inequity can be dis-incentivized with higher individual tax payments. THIS IS THE ONLY WAY to re-focus people psychologically towards providing true value added products and services…not just the cheapest in greatest volume at highest margin consumables. Our young people have no concept of the product reliability we boomers enjoyed in our youth.
IT IS THE ONLY WAY to reverse The Race to the Bottom. At the moment, the US can still be amongst the winners of a Race to the Top; but we are currently winning the Race to the Bottom.
WRT the Republican/”Conservative” argument that lower taxes is economically stimulative and growth positive, you need only be a fool not to see the effect of the lowest tax rates and greatest wealth accumulation of the past 90 years culminating in the Fall of 2008 with its resulting Fall-Out for the bottom 98%.
In addition to creating a more equitable tax structure amongst income/wealth groups, one aspect of tax law that does not receive the attention it deserves is the “social engineering” effect inherent in US tax code.
To this end I applaud efforts to eliminate by phase-out deductions, credits, etc. that effectively lower the cost of certain products and services. Obvious examples include the mortgage and home equity deductions; ethanol credits, depletion allowances, even fossil fuel expense deductibility, to name a few of probably thousands.
The effect of such is to create artificially low prices for targeted products and services. This makes the concept of “free markets” a myth and a sham; stifling and suppressing true innovation by creating a highly “un-level and distorted playing field.”
It is the primary means of maintaining a Status Quo that has become clearly un-sustainable.
“If our government stops subsidizing losers, it would not need to pick 'winners.'”
Oh, and a Happy Thanksgiving to everyone at TPC, Brookings and Urban! Here's hoping you are closed on Friday too so that I can enjoy my holiday without checking TaxVox.
Realistically, of course, many tax benefits aren't going anywhere. Bruce Bartlett has an excellent piece in Tax Notes on this.
I do agree with you on taxing capital gains and dividends as normal income. Even if the marginal rates were unchanged – making that shift and allowing the inheritance tax cuts to expire would do a world of good. Raising or eliminating the income cap would also mostly save Social Security (while crediting the employer contribution equally as an average would enhance its progressivity even more).
I still maintain, of course, that targeting help to wher it is needed is better policy for recovery than using fiscal policy to do so. People whose mortgages are not under water don't really need tax relief, which won't help those whose mortgages are underwater. Making mortgage modifications mandatory if the securities backing the loan are held by the government (Freddie, Fannie and the Fed) would end the recession quickly. I am not sure anything else will, with the exeption of hefty inflation.