Is the Income Tax System Fair?

Is the Income Tax System Fair?

via John Goodman's Health Policy Blog by John Goodman on 9/26/11

No one in the health policy community has been more critical of the unfair way the tax code treats health expenses and no one has been more diligent in suggesting alternatives to it than yours truly. Also, no think tank has been more aggressive in promoting fairer, more progressive alternatives to the current tax system than the NCPA. (See the John Goodman/Larry Kotlikoff "progressive flat tax" proposal, for example.)
That said, Barack Obama's critique of the income tax system is way off the mark. Since the days of Ronald Reagan, says the president, Republicans have been protecting the rich at every opportunity — shielding them from the obligation to pay their fair share. Yet here are some facts about U.S. income taxes that most people don't know:

• Over the past quarter century, our income tax system has become increasingly progressive — with the tax burden almost continuously shifting through time  from the bottom half to the top half of the income distribution. (See the graph below.)
• As a result of this seismic shift in the tax burden, more than half of U.S. households (taxpayer units") pay no income tax at all and 30% of all households actually make money off the income tax system (pay "negative taxes") through the Earned Income Tax Credit.
• More than one-third of all income taxes are now paid by the top 1 percent and almost three-fourths of all income taxes are paid by the top 10%.
• According to an OECD report, the U.S. currently has the most progressive tax system among all developed countries.
• Although it's hard to assign responsibility to the two political parties, Republicans are probably responsible for 80 percent of the increase in progressivity.

If you find any of this surprising, the obvious question is: why? If the president wants to have a national discussion about the distribution of the tax burden, why are the American people not better informed? There are three reasons: Republicans, Democrats and the news media.
The most important reason for the increasing progressivity of income taxes is that virtually every Republican tax bill over the past 25 years has taken more and more people off the tax rolls. Democratic opponents inevitably point to the lowering of the highest tax rates as a "giveaway to the rich." They conveniently ignore the fact that in lowering the rates, these same tax bills also widened the base. By allowing fewer deductions, exemptions and loop holes, the bills exposed more income to taxation. More importantly, if people at the bottom of the income ladder are completely taken off the tax rolls, the burden of the tax system will shift to those at the top, no matter what rates they pay or what deductions they take.
The problem with Republicans is that it is not in their nature to promote redistribution from rich to poor. It's as though they are too embarrassed to say, "Look what we did." If you made a gift to the needy or engaged in some other charitable act, would you go around and brag about it? Of course not. Well, that's the way a typical Republican politician feels about Republican tax policies. I honestly can't remember the last time I heard a Republican boast about the fact that Republican tax bills have liberated half the population from the burden of the income tax.

Let me tell you how it will be,
There's one for you and nineteen for me,
Cause I'm the taxman.

Democrats, by contrast, tend to be redistributionists by nature. They have no reluctance to talk about taking from the rich and giving to the non-rich, whether through tax policy or any other means. And if Republicans choose to say nothing, few Democrats are going to gratuitously compliment them for engaging in more redistribution than even Democratic politicians were willing to enact. Instead, the natural tendency for everyone in public office is self-serving spin. The Democratic line, therefore, has been: Republican tax policy is benefitting the rich. It has been a distortion that Republicans have been unwilling to challenge.
The news media tends to be basically lazy. They don't dig much deeper that the latest press release. So if Democrats claim that Republican tax policies favor the rich and the Republicans don't deny it, don't expect to read anything different in tomorrow's newspaper.
Now for the facts of the matter. We don't need to dwell on anecdotes about Warren Buffett's tax return versus his secretary's. We know, very broadly, who earns what and who pays what because the IRS keeps track of it. Here, courtesy of the Tax policy Center are the effective tax rates by income level.
Looking at changes over time, Michael Stroup, an economist at Stephen F. Austin State University, has taken the IRS data and constructed a "progressivity index." It's a sophisticated way of measuring how even or uneven is the tax burden as a whole. Here's what it looks like:

In 1986, Reagan era tax reform brought the highest tax rate down from 50% to 28% and at the same time removed millions of people from the tax rolls. Stroup finds that the overall effect was no change in progressivity in the short run. But after a dip in the index (which is natural in recessions), these changes over time led to a tax burden that increasingly shifted to above-average-income earners. A Republican capital gains tax cut signed by President Clinton accelerated the trend (Yes, lower tax rates really did produce higher capital gains revenues.)
Tax changes under George W. Bush moved essentially in the same direction: lower taxes — especially on dividends and capital gains — combined with provisions that let millions of additional families escape taxes altogether. The net effect was to even more dramatically shift the burden of taxation to higher income earners. In fact, Stroup finds that the increase in progressivity was greater under Bush than at any time in the previous twenty years. He concludes:

Since the 2001 and 2003 Bush tax re­forms, the share of total income received by the wealthy has increased; however, their share of the total tax burden has increased even more than their income share… Bush's reforms have helped mitigate the income gap between rich and poor by increasing the progressivity of the income tax system.

So what is the Obama Administration proposing? They claim to be proposing a "Buffett rule," under which the wealthy would pay at least the same tax rate as middle-class taxpayers. But, as Megan McArdle points out:

[T]he Obama Administration itself has not outlined anything of the sort. At least in the White House document that I read, I saw no proposal to set some sort of AMT on millionaires. Instead, it [is] rehashing a bunch of things that the administration has long proposed: allowing the Bush tax cuts to expire for those making more than $250,000; changing the treatment of carried interest income accrued from capital gains; and altering the treatment of deductions for very high earners. If all of these things were passed, guess who would still pay a lower effective tax rate than his secretary? Hint: his initials are WB, and he lives in Omaha, Nebraska.

In case you don't keep up with these things, most of Warren Buffett's "income" is in the form of unrealized capital gains. That means during the tax year the value of his stocks and bonds and other unsold assets rises.
Under the current system, and under the new Obama tax regime, the tax rate on unrealized capital gains is ….  you guessed it …. exactly zero.
See David Henderson and Alan Reynolds on these issues as well.