Designing a ‘Fair’ Tax (2 of 2)

October 20, 2011

Second of two parts; for release Oct. 27 (762 words)


Commentators from the left often refer to the “Bush tax cuts for the rich.” A 5.6-percent surtax on incomes above $1,000,000 has been proposed. The clear implication of the rhetoric is that the rich are under-taxed, are not paying their fair share and that the progressiveness of the federal income-tax code ought to be increased.

Before these normative claims can be assessed it is useful to examine their empirical underpinnings. Just what did the Bush tax cuts do for the rich relative to their middle-class counterparts? What degree of progression is implied by the proposed changes?

Let’s continue with Ms. Jones and Mr. Smith, the examples used in an earlier column, but elaborate on their positions a bit: Ms. Jones has $2,000,000 in taxable income and Mr. Smith has $20,000 in taxable income. Note this is income after deductions and exemptions and is labor income subject to statutory federal rates. (An analysis of the impact of so-called tax expenditures on tax liabilities will be the subject of a future column.)

If we examine the 2000 federal income-tax code we find that high-earning Ms. Jones paid $756,386 while low-earner Mr. Smith paid $3,000. While Ms. Jones was earning $100 in taxable income for every $1 Mr. Smith earns, Ms. Jones was paying $238 in federal taxes for every $1 Mr. Smith paid. [1]

Fast-forward to 2011. Under the so-called Bush tax code the $2-million-a-year earner Ms. Jones now pays $669,871, her tax bill is $85,515 less than it was in 2000. Her tax bill has declined by 11.4 percent from 2000. Yes, the tax cuts of the Bush years reduced the federal income-tax liability of the “rich.” But the analysis is not complete until $20,000-a-year Mr. Smith is in the picture. In 2011 Mr. Smith pays $2,150 in income tax. His tax bill has declined by $850 and by 28.3 percent. While Ms. Jones is still earning $100 in taxable income for every $1 dollar Mr. Smith earns, Ms. Jones is now paying $312 in federal taxes for every $1 Mr. Smith pays.

Those critical of the Bush tax changes often focus on the dollar value of the tax cuts contrasting the $85,515 tax benefit for the “rich” as grossly inequitable when compared to the paltry $850 benefit accruing to the lower-income taxpayer. Yet, as a percentage of the original tax bill the $20,000-Mr. Smith actually received a larger tax break than his wealthy counterpart. Moreover, the more disciplined measure of relative tax liability, dollars paid by the richer taxpayer per dollar paid by the lower-income taxpayer, indicates progression actually rose.

In October of this year, Senate Majority Leader Harry Reid (D., Nev.) proposed an additional 5.6 percent tax on Adjusted Gross Income (AGI) above $1,000,000, announcing “It is time for millionaires and billionaires to pay their fair share . . . ” [2]

Making the unlikely assumption that Ms. Jones’s AGI is no different from her taxable income, Senator Reid’s proposal would raise her tax liability by $56,000 to $725,871 while having no impact on Mr. Smith’s tax bill. While Ms. Jones still earns $100 in taxable income for every $1 dollar Mr. Smith earns, Ms. Jones would now pay $338 in federal taxes for every $1 Mr. Smith pays. (This is a lower boundary as Jones’s AGI is almost certain to be higher than her current taxable income.)

So how much progression is enough? Is a 338:1 ratio sufficient to generate “social justice?” How does one arrive at an empirical measure of a “fair share?” These are rhetorical questions but the bipartisan answer for the last two decades seems to be more progression. The Republican tax cut was carefully designed to increase progression, although this did nothing to assuage criticism that it was a sop for the rich or to quell calls for even more progression. It is almost axiomatic among Democrats that fiscal problems are to be solved by increased taxes on the rich — and only the rich.

We are reminded of F.A. Hayek’s point, “all arguments in support of progression can be used to justify any degree of progression.” [3] Hayek also noted that a commitment to progression tends toward “arbitrariness” in contrast to a rule of law. Indeed, Senator Reid’s proposal seems grounded in no principle except the political calculation that the many are likely to go along with a tax hike on the few — of course, wrapped in lofty but meaningless rhetoric about fairness. But what can fairness in income distribution via tax progression possibly mean if there is never any end to it?

Cecil Bohanon, Ph.D., an adjunct scholar of the Indiana Policy Review Foundation, is a professor of economics at Ball State University. © Copyright Cecil Bohanon; distributed with permission for the use of member newspapers; all rights reserved.


[1]  All data are from the Tax Foundation and are adjusted for inflation. http://www.taxfoundation.org/taxdata/show/151.html

[2] From: http://online.wsj.com/article/SB10001424052970203476804576612930412626412.html

[3] From F. A. Hayek “Constitution of Liberty,” Chicago, University of Chicago Press, 1960.  p.308.



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