Chapter Nine

Taxation

            Up to this point, our emphasis has been on policies that transfer income to certain groups of people.  Of course, transferring income to some implies that it is transferred from others, and in this chapter our attention shifts to the effects of the most important policies implicated in the taking side of the transfers, namely federal tax policies.  Some government transfer programs do not directly involve taxation at all, but most of the larger transfer programs are government expenditure policies, and these policies must be financed by taxes.  That is true, at least, unless the expenditure is funded through deficit finance, which we will discuss in the last section of the chapter.

Who Bears the Tax Burden?

            Do you know how large a share of your income goes to the federal government in the form of taxes?  Few people do, although most people are sure they are paying too much while they believe that others, principally the rich, are avoiding paying their fair share.  Before looking at the evidence, you might find it instructive to guess the federal tax burden as a share of income for the household income quintiles (fifths) we discussed in Chapter Two.  We will also be looking at the tax burdens for the top 10 percent and top 1 percent of households separately, to see how the “rich” are treated.  As a guide, keep in mind that federal taxes average about 20 percent of household income, so if some quintiles have a tax burden greater than this, others must have a lower burden.

            What we will be looking at are estimates of what economists call “average tax rates”.  The average tax rate is simply a ratio, calculated for each household or income class, where the numerator is the total tax burden and the denominator is total (before-tax) income.  It indicates how much the tax reduces your disposable income, or as I earlier put it, the share of your income going to government. 

            Tax rates vary among income classes, and the way they vary forms the basis for classifying the tax as progressive, regressive, or proportional.  When the average tax rate is higher for higher income classes, the tax is said to be progressive; when the rate is lower for higher income classes, the tax is regressive; and when it is the same at all levels of income, the tax is proportional.  These terms have found their way into popular usage, but surprisingly few people understand the distinction between them.  Even the Wall Street Journal, which you would think would know better, has characterized a progressive tax as one that “…taxes the rich more than the poor.”

            It is true that a progressive tax taxes the rich more than the poor, but so does a proportional tax and so do most real world regressive taxes.  Under a proportional tax which takes, say, 20 percent of everyone’s income, a rich person with a million dollar income will pay $200,000 in taxes, while a poor person with a $10,000 income will pay only $2000 in taxes.  The rich person is paying a hundred times as much in taxes as the poor person, but the tax is a proportional tax because it is the same percentage of income for both persons.  For the tax to be progressive, the tax must take a larger proportion of the higher income, not just a larger absolute amount. 

With these preliminaries out of the way, let’s see who bears the burden of federal taxes.  The figures in Table 9.1 are from the Congressional Budget Office (CBO) and show average tax rates for households by income group (household quintiles, and the top 10 and 1 percent separately).  There are four major federal sources of tax revenue.

 In terms of revenue, from largest to smallest, they are: Individual income tax; Social Security payroll tax; Corporation income tax; and excise taxes.  Part A of the table aggregates the rates from these separate taxes into one overall tax rate for the federal tax system.

            As you can see from the last column in Table 9.1A, the overall federal tax system is, as of 2004, quite progressive.  Households in the lowest income quintile give up 4.5 percent of their incomes to federal taxes, with that rate rising steadily to 25.1 percent for the highest quintile.  The table also separates out the top 10 percent and top 1 percent; they are, of course, already included in the highest quintile, but many people are particularly interested in how the tax system treats the very well-off so they are shown separately.  Progressivity continues within the highest quintile, with a tax rate for the top 10 percent of 26.9 percent, and 31.1 percent for the top 1 percent.

            Since the table deals only with the federal taxes, these figures do not include state and local taxes.  Add about 11 percentage points to each income class’s tax rate to get a rough idea of the total tax burden.

            Table 9.1A also shows how federal tax rates have varied since 1979.  There have been a half dozen major changes in tax policy over this period, as well as changes in before-tax household incomes, that have combined to make the federal tax system more progressive today than in 1979.  This may seem surprising since accompanying all the policy changes (except for the one in 1993) there have been charges of unfair “tax cuts for the wealthy” presumably leaving too large a burden on the struggling middle class.  Yet higher income households are paying tax rates today that are higher relative to other groups than they did in 1979. 

Every group’s average tax rate is lower in 2004 than it was in 1979, but the declines have been greater for the lower income classes.  Note that the top quintile in 1979 had an average tax rate that was 3.4 times as great as the lowest quintile (27.5 compared to 8.0), whereas in 2004 the rate for the top quintile was 5.6 times greater than that of the bottom quintile.  Comparisons for other groups show the same pattern. This increased progressivity means that the tax system is having a greater equalizing effect on after-tax incomes than it did in the past. 

We are interested in these facts, of course, because we want to know (among other things) whether the tax system is “fair”.  As always, that judgment cannot be objectively made since it relies on differing individual values, but at least the figures in Table 9.1 should help in arriving at such a determination.  In one sense, however, I think it is misleading to rely on the figures in Table 9.1A for the total federal tax system to determine whether people are sharing fairly in the burden of supporting the federal government.  It is misleading because the figures in  Part A include tax rates for the Social Security payroll tax, and that tax differs from virtually all others and should be treated separately.

            The Social Security payroll tax differs from other taxes in that individual taxpayers are scheduled to receive benefits in retirement that are related to their earlier tax contributions.  For this reason, making a judgment about fairness for this tax requires considering the effects over people’s entire lifetimes, both when they pay taxes and later when they receive benefits.  It makes no sense to speak of the Social Security tax as unfair without also taking into account the promised later benefits. 

            We have already examined Social Security taxes and benefits in Chapter Seven.  There, we saw that low wage workers can expect to receive back more for each dollar of payroll taxes they pay than will high wage workers (recall the higher rates of return for low wage workers in Table 7.1A).  A judgment of fairness about the Social Security system should be based on its redistribution in favor of low wage and other groups, including the way it favors earlier retirees and harms future generations.

            For these reasons, I think it appropriate to focus on taxes other than Social Security payroll taxes when considering whether the tax burden is fairly shared.  Specifically, I will concentrate on the federal individual income tax.  That tax alone provides 80 percent of the revenues supporting all federal government spending programs except Social Security (and Medicare). 

            Part B of Table 9.1 shows the CBO’s figures for the average tax rates of the various household groups for the federal individual income tax.  Looking at 2004, the first thing you may notice is that the two lowest quintiles have negative tax rates.  How can anyone pay a negative tax?  This is a reflection of the fact that the IRS treats refundable tax credits, such as the Earned Income Tax Credit, as negative taxes.  The EITC is, of course, only one of many transfers to low income families, but other transfers are defined as income and put into the denominator (before-tax income—if they are counted at all, as many aren’t) of the ratio determining the average tax rate, rather than in the numerator as a negative tax.  There is, therefore, an inconsistency in treatment between refundable tax credits and all other transfers, but as long as we understand what is being done that should not be an issue.  The important general point is that most low income households pay little or no federal income taxes.

            The individual income tax is clearly much more progressive than the overall federal tax system.  The top quintile in 2004 incurred a tax rate of 13.9 percent, almost five times as large as the 2.9 percent rate imposed on middle income households.  In contrast, when all taxes are combined in Part A, the rate for the top quintile is less than twice the rate for the middle quintile. 

            It is also clear that the income tax has become more progressive in recent decades, as judged by the ratio of the tax rates in higher income classes to those in the lower income classes.  Note, in particular, that the middle class, or middle quintile, in 2004 had a tax rate less than half the rate of 1979, 2.9 percent as compared with 7.5 percent.

            The struggling, hard working, beleaguered middle income household is often portrayed as bearing a disproportionate share of the tax burden.  As New York Times reporter David Cay Johnston put it in a recent book: “Since at least 1983 it has been the explicit, but unstated, policy in Washington to let the richest Americans pay a smaller portion of their incomes in taxes…while collecting more in taxes from those in the middle class.” Many people seem to believe this, but examination of Table 9.1 shows the exact opposite to be the case: tax rates are higher for the wealthy than in 1985 and lower for the middle class.  Is the middle class, or middle quintile, overtaxed when it pays an income tax rate of 2.9 percent?  In fact, the middle quintile devotes a larger share of its income to expenditures on entertainment (4.6 percent of income), dining at restaurants (5.8 percent), and gasoline (5.1 percent), than it contributes to income tax revenues.

            Another way to characterize the distribution of the tax burden is to consider the share of total tax revenues that is paid by the different income classes.  In the same CBO study that produces the data in Table 9.1, it is reported that in 2004 the highest quintile paid 85.3 percent of all federal income tax revenues!  Perhaps even more astounding is the fact that the wealthiest 5 percent of households paid more than half (58.4 percent) of all income taxes.  The 60 percent of households in the lowest three quintiles contributed a grand total of 0.9 percent of income tax revenues.  What this way of looking at the distribution of taxes makes clear is that higher income households pay for almost everything the federal government does outside of Social Security, and a majority of “taxpayers” contribute almost nothing.