Wednesday, February 1, 2012

Fairness in taxes, part I

 Like it or not, we have a graduated not level federal income tax. This means, roughly speaking, that the tax ones income is not a fixed percentage of the entire income, but is, rather, a changing percentage on various segments of  that income, with the percentage increasing as the segments  have higher and higher endpoints. The number of segments and the percentages used have varied over the history of the federal income tax. This history began during the Civil War with the first  -- and, even then, graduated -- income tax. This was declared unconstitutional in 1895 and so disappeared until the the 16th amendment legalizing it was passed in 1913; since then the federal personal (and corporate) income tax has been with us, and always in graduated form.

Why has the tax been graduated and not flat -- say 15% of ones entire income? Taking fixed percentages -- or applying proportionality --  is a rather primitive mathematical response to computation of quantities that change. It's basically saying that if the value of the quantity at input level A is P, and at input level B is Q, then the value for input halfway between  A and B -- i.e. at  (A+B)/2 -- should be halfway between P and Q, or (P+Q)/2. This is fine for computing say interest on  bank deposits of varying sizes, but it doesn't work for lots of things; for example, the light intensity 2 meters from a bulb is not half the intensity 1 meter from that bulb. The value of a college education is not proportional to the number of years spent in college or the dollars in tuition paid. While the force of Earth's gravity one an object is proportionate to the mass, it is not proportionate to the distance of the mass from the Earth.

In the areas of economics and morality the  assumption of strict proportionality is particularly questionable -- especially in the matter of taxation. A simple example shows that a strict flat tax is unfair. Suppose that a person needs $8000 a year simply to live -- to purchase adequate shelter and adequate food. If you tax a person who is making exactly that amount of money at a 10% rate, that person will die (you have to make nearly $9000 to survive that kind of tax). So, clearly, you have to adjust your tax structure to be fair on even this basic level.

A slightly more sophisticated approach is to exclude from taxation the amount it takes to survive, and tax the remainder at a fixed level. This is the modified flat tax. In the above example, this would levy a tax of 10% only on that part of a person's income above $8000. More generous plans would tax income only above say twice that -- i.e. above $16,000.

How fair are these plans? Well, that depends on what you mean by fair. Perhaps in the dim dark past, when mere survival was the basic goal, this would be OK. But there are many things in life, especially in modern countries, that we consider important besides food and shelter. Almost everyone these days would include among them medical care, education to varying degrees, a reasonable amount of vacation or leisure time, spiritual and cultural enrichment etc. As you can see, the situation becomes rather complicated, and determining values and cutoffs for these kind of expenditures is not at all easy.

There is also a challenge of another type to proportional taxation. What is a fair income anyway? Is ones success completely independent of the success or failure of others? If not, then one has to assess how ones income depends on ones "societal worth" or even on ones work or effort. If I make lots of money by oppressing others, how does that count? Should I make up for it by contributing more to the social effort through taxes? What if I consume more than my (proportional) share of natural resources such as clean air and water? If I work 80 hours per week instead of 40, should I be entitled to twice as much? Conversely, what if I make 200 times the average national wage, how much socially useful work should I have done?

 These are not easy questions. There are simple-minded answers at both extremes. The radical right-wing response is that ones income, since it reflects the free market, is the sole measure of ones worth, and that beyond an exemption for strict cost-of-living or survival expenses, taxes should be flat all the way out on even the highest incomes. (Well, the really radical position would be 0 taxes beyond a certain range, but few would go that far.) The radical left-wing approach might be strictly graduated taxes above cost-of-living, with a salary cap, beyond which taxes would be close to 100%. Remember the Beatles' line, reflecting the British tax (at that pre-Thatcher time) on their very high income: "One for you and nineteen for me, 'cause I'm the Tax Man."? (A 95% top tax bracket for them.) In the not too distant past, the highest bracket here in the USA was at least 70%.

What we have now is a sort of compromise. Here are the current brackets, which include the Bush cuts due to expire next year.

Year 2012 income brackets and tax rates

Marginal Tax Rate Single Married Filing Jointly or Qualified Widow(er) Married Filing Separately Head of Household
10% $0 – $8,700 $0 – $17,400 $0 – $8,700 $0 – $12,400
15% $8,701 – $35,350 $17,401 – $70,700 $8,701 – $35,350 $12,401 – $47,350
25% $35,351 – $85,650 $70,701 – $142,700 $35,351 – $71,350 $47,351 – $122,300
28% $85,651 – $178,650 $142,701 – $217,450 $71,351 – $108,725 $122,301 – $198,050
33% $178,651 – $388,350 $217,451 – $388,350 $108,726 – $194,175 $198,051 – $388,350
35% $388,351+ $388,351+ $194,176+ $388,351+

Note that the graduating cuts out above $388,351; i.e. the tax is flat above this income.

In some sections of the country -- mostly parts of the East and West coasts -- this salary is also roughly the cut-off for the "1%" as it's called these days (99% of earners make less). Few people who work for wages ever make a salary this large. (After 42 years of college teaching I never made it into the 6 figures, though some professors and lots of college administrators do much better; many college presidents make it into the 1%.)

Anyway, it's not this table that is getting folks aggravated these days, but it's the tax rate that the table doesn't show: the Capital Gains Tax. At some point lobbyists for the very rich and/or the securities industry somehow convinced Congress -- made up of plenty of wealthy people but also mostly people who could use lobbyists' money for campaigning -- that we're all equal under American capitalism, except (to quote Orwell) some are more equal than others. People who make money from the rise in value of assets held at least a year ("long term capital gains") are taxed at a maximum rate of 15% on this income. This is basically a tax rate for the wealthy, since most people don't have that much income qualifying as capital gains (IRAs don't count since they are payed for in pretax dollars.)

So why is income from capital gains given a favorable tax treatment?

The standard answer is that capital is so important to the functioning of our economic system that we must use tax breaks to encourage folks to take the risk of investing their money. The main problem with this argument is that there is no evidence to support the belief that tax policy affects how people behave with respect to investing. There is no more nor less investment now than there was when the capital gains tax was higher 30-40 years ago (20% - 28%). People invest in business because they can make very large amounts of money: that's the way most large fortunes are obtained. Professional investors also like what they do (ask Warren Buffet). It's really odd that the same people who scoff at using tax policy to affect behavior like cigarette, alcohol and candy use, so readily buy this capital gains argument. Also, one could make the argument that after the financial debacle of 2008 (and even after the Savings and Loan Crisis several decades previous), encouraging yet more risk-taking in investment may not be what we should be doing.

Another argument often given for the separate treatment of capital gains is the argument the it amounts to a double taxation. The corporate income tax is collected on a company's profits, and then investors in that company have to pay a capital gains tax on their share of these same profits. This is really a stretch of logic. First of all, the whole point of a corporation is that it is walled off from its shareholders. The value of its stock is set by the market, not by the company. Its investors are shielded from everything other than the market's determination of its worth. If the company loses more than it has, the shareholders can only lose the value of their investment. If the company acts badly, the shareholders pay no fine and serve no jail time. Most investors don't even buy their securities directly from the company but through a third party who makes a market in the stock. The corporation is a legal entity and is taxed as such; although this tax may affect the value of its shares, it is no more a tax on the shareholders than the corporate tax on the Nestle company is a tax on the purchasers of its chocolate Kisses.

This argument also begs the question: What exactly is wrong with taxing the same money twice? People may not like it, but it is not logically contradictory or inherently evil, though it is somehow made to seem that way. We do it all the time to Social Security retirees. They paid income tax when they made the money that they put into the fund, and then again when they collect their pension checks. We also do it when we pay sales, excise and gasoline taxes. We decided that certain government services are highly desirable, and we raise taxes to pay for them. The federal ones pay for some things (e.g. food and drug inspections, defense, research); the state taxes pay for other things (police, public transit, education). If we eliminated one tax we would either have to increase and redirect the other, or give up the services which we have time and again deemed important to us. So-called "double taxation" is as American (and wholesome) as apple pie.


  1. Tax rates don't impact investing? I would absolutely be less incentivized to sell stocks in my portfolio if the capital gains rate were to increase. And I would definitely sell more freely of the rate were to drop.

  2. Of course it would impact investing in this sense -- if there were a sudden change in the tax. The question is, if the tax were higher -- say permanently -- would you quit investing and become a machinist or teacher -- or would you never have become an investor? I doubt it: there were plenty of investors having a great time and making lots of money when the capital gains tax was much higher. And if pure speculators (as opposed to investors) quit? I'd say mostly good riddance.

    1. You're missing the point. I am in the 1% but like most in that group, most of my taxable income is in the form of wages. How and where I choose to invest my after-tax surplus certainly depends on the capital gains rate. If it goes higher, will I quit my job as an investment banker? No. But I will think twice about whether I buy a second home or help a friend fund a start-up. I will invest in whatever gives me the best risk adjusted after tax return. And putting money in the stock market, housing market or new business opportunity just got a lot less attractive. I'll put more of my money into municipal bonds and MLP's