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Richmans' Trade and Taxes Blog
Pres. Obama succeeded in getting the Congress to increase the progressivity of the federal personal income tax by raising the top marginal rate from 35 to 39.6 percent and increasing the rate on dividends and capital gains from 15 percent to 20 percent for taxable incomes over $400,000 for single filers.
The Congressional Budget Office (CBO) published an analysis of the progressivity of the personal income tax and of all federal taxes. Its summary includes the following paragraph:
In 2007, the bottom quintile’s average rate for the individual income tax was -6.8 percent, which means that refundable earned income and child tax credits exceeded the income tax owed by that group. On average, households in the second quintile also received more in credits than they paid in individual income taxes. The average income tax rate was 3.3 percent for the middle quintile and 6.2 percent for the fourth quintile. For the highest quintile, the rate was 14.4 percent. The top 1 percent, on average, paid 19.0 percent of their income in individual income taxes.
So the personal income tax average rates range from -6.8 percent in the lowest quintile to 19.0 percent for the highest one percent. Raising the marginal rates in the top brackets will increase the progressivity of the tax system very little, but will have the wrong economic incentives. And taking government expenditures into account is already very progressive.
Prof. Obama believes that raising the marginal rates on high income taxpayers will be popular among his supporters. Warren Buffett, a billionaire whose effective tax rate was about 17 percent, supported Obama’s proposal saying that his secretary is taxed at a higher rate. That wasn’t true in 2007 and is not true today. The data above show that the personal income tax is highly progressive. And the increased rates will have very little effect on the very rich like Buffett.
The principal purpose of taxation is to raise revenues. But the increase in progressivity will have very little effect on revenues and cause a number of economic distortions.
The increase is revenues will likely to be much less than expected because there are ways for taxpayers to avoid the higher tax rates. Actually, redistribution is accomplished, not by higher progressive rates of tax but by the progressive way government spends its money. For example the poor receive free public education whose cost averages more than $10,000 per student. Medicaid benefits are equivalent to an income of more than $1500 per person. And redistribution is accomplished further by the progressive nature of welfare expenditures. The social security system’s benefits are not taxed for lower income groups taxed but are taxed if reported income is above a certain amount. In addition, social security makes payments to millions for alleged disability. Medicaid benefits are about $7500 for a family of four. In addition there are many free public goods like public parks and libraries to mention two.
And there are some government expenditures that worsen the distribution of income, e.g., subsidies to wind and solar energy which raise the price of electricity, rebates to those who buy hybrid and electric vehicles that are purchased only by the wealthy, etc. Some have called these government expenditures “crony capitalism” the effect of which is to reduce the burden on a few which has to made up by higher taxes on the rest of us.
Revenues will fall short of expected because taxpayers can avoid the higher marginal rates. For example, one way is for corporations to buy back shares of their stock, a common practice whose only purpose is to convert dividend income which is taxable at rates up to 39.6 percent into long-term capital gains which are taxed at a maximum rate of 20 percent. Reducing the number of shares raises the market value of the remaining shares, other things equal. Even if they do not sell their shares, the shareholders enjoy an increase in the value of their shares without paying any tax. So the higher rates will not increase revenues as much as the President claims.
Another avoidance is for corporations to reward their top executives with astronomical bonuses in the form of options to buy shares at the existing price. If and when the price of the shares rises, the recipients can sell some or all of their shares in effect converting ordinary income into capital gains.
High rates of income tax also have the effect that taxpayers will work and invest less, and retire earlier.
Those who would like to see greater progressivity in the personal income tax often dissemble. They ignore the fact that employed workers in the lower income brackets not only pay no income tax at all but receive a payment from the IRS in the form of an earned income credit.
Moreover, taking the benefits of expenditures into account and benefits like the earned income tax credit, social security, and Medicaid, one has to conclude that the tax and expenditure system is highly progressive. Government revenues grow with economic growth. Making the tax system more progressive will not increase economic growth at all, won’t diminish unemployment at all. To the contrary it will tend to stifle economic growth.
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