Mailbag: Progressive Taxation and Inequality

Here's a message we received recently:

Hi. I was hoping you could help me to think through this email I got from a friend...

... I would like to focus on the tax issue ... Use $250,000 as a perfect example of "rich". Say you're an average American whose parents can't pay for college and probably don't know the system that well in terms of scholarships. To get into a top tier school expect to pay $100K in tuition and living expenses ...and let's not forget the expenses related to the MBA, law degree or medical degree that are most likely the prerequisites to pay for the right to earn that salary. If you add all that up, the net result is over $1000 a month in student loans and $250K in debt...or NEGATIVE wealth! You are now sitting in the bullseye of the "rich" when in fact you have NEGATIVE wealth.

Should 50% of my salary go to Uncle Sam because I was able to outmaneuver others through the system? Do I not pay for roads, health care, etc in a disproportionate share already through not only my income tax, but real estate taxes as well?

The message raises three issues:

1. Are people making $250,000 "rich"?
2. Is it fair that people who make over $250,000 but have lots of student loan debt have to pay higher rates?
   
3. Why have progressive taxation, and should it be more progressive than it is now?
   

On the first question, if your family makes over $250K, you're bringing in more than 98% of American families. (This is according to 2007 data from the March CPS.) While I don't have the exact figures on the worldwide income distribution handy, roughly this would mean you're income is higher than that of 99.9% of humanity. You're not among the ultra-rich like the McCains, but you're not hurting.

On the second question, it's hard to understand why having negative wealth per se should mean you pay less in taxes. You can be extremely rich--with high income and high consumption levels and still be in major debt. I think Donald Trump was in this category for a while (and may still be). You could think of lots of different ways to conceive of how taxes should be structured, but I don't see an argument for why having low or negative net wealth should mean lower taxation.

The correspondent's friend presumably means to say that because of his debt, his consumption is lower than income of $250K+ would imply. Fair enough, and indeed many economists would say that ideally a progressive tax structure should be based on consumption rather than income. But we're not talking about huge differences here. For people paying $1000 a month in student loans, their consumption is only lower than their income by $25K, not much if they're making over a quarter million.

Now to the fundamental question: why have progressive taxation at all, and should it be more progressive, as Obama is proposing? The first answer is that in order to pay for the things we value as a society, we have to go where the money is. To pay for roads, tanks, universal health care, schools, and everything the government does, we need money, and given the extreme level of inequality--now at levels higher than that seen since the 1930s--it's at the very top where the money is. We don't want the rich to contribute more because we want to punish them but because those resources are needed to pay for what the country values.

But is it fair to raise taxes on the wealthy? Consider what the Obama tax hikes would mean for a very higher earner, relative to where they would have been ten years ago. The NY Times article in the Sunday Magazine made this comparison:

Obama would raise taxes on this top 0.1 percent by an average of $800,000 a year. It’s hard not to look at that figure and be a little stunned. It would represent a huge tax increase on the wealthy families. But it’s also worth putting the number in some context. The bulk of Obama’s tax increases on the wealthy — about $500,000 of that $800,000 — would simply take away Bush’s tax cuts. The remaining $300,000 wouldn’t nearly reverse their pretax income gains in recent years. Since the mid-1990s, their inflation-adjusted pretax income has roughly doubled.

For those who are not ultra-high earners, the gains since the mid-90s have not been as extreme, but the tax increases under Obama would be lower as well.

By Table A6 of Emmanuel Saez's IRS data, the income group that is the top 5% but excluding the top 1% ($148K-$376K in 2006) saw average real wage growth of $35,505 between 1996 and 2006. How much would taxes go up under Obama for this same group? According to the Tax Policy Center's analysis, that would be $5686 in 2012. In other words, even after the tax hikes on the wealthy, people in this group would be far better off than they would have been at the same point in the distribution in 1996--21% better off to be exact. Incomes grew much more slowly for those not in the top ranks: 7% overall for those in the bottom 90% of the distribution.

The larger point is that lifting tax rates at the high end is in part a response to the huge rise in inequality in the United States. (See Emmanuel's very readable summary documenting the rise in inequality)

Why has inequality risen so dramatically, with the gains being overwhelmingly concentrated at the top end? This is a complicated question that I'll save for another post. But it's clear that inequality rose not because education levels at the top increased or because higher earners started to work harder. Inequality rose because something (or many things) changed about the economy. In his new book, The Predator State, Jamie Galbraith argues that the distribution of income doesn't just "happen"--rather we decide the distribution we want as a society and the economy conforms. I'm not sure I'd subscribe to quite such a bold assertion, but it is evident that society--and the government--do a great deal to shape the institutions that determine how much inequality we have. Those institutions are many, and our control over most of them is highly imperfect. Tax policy is our most direct tool, and we shouldn't be shy about using it to have those who prospered most in recent years to contribute more.