The belief that there is an irreconcilable conflict between government benefits and the freedom to pursue dreams can only arise among those who have never had to worry about the reality of equality of opportunity in America. For most Americans, public schools are a critical piece of the machinery of economic mobility. Things like unemployment insurance and social security, meagre though they are, sometimes mean the difference between destitution and the possibility of a second chance or a non-wretched standard of living. For many Americans, the ability to even contemplate dreams for a better life is down to the small cushion and basic investments provided by governments, provided for precisely that reason, because an economy in which only those born with a comfortable financial position can invest in human capital and take entrepreneurial risks is doomed to class-based calcification.
America’s welfare state is far from perfect. But it is necessary; indeed, it’s hard to imagine a just and sustainable system of free enterprise without a robust social safety net. Republicans need to recognise this and acknowledge that the past three decades have meant rising income inequality and falling economic mobility alongside top marginal tax rates that are among the lowest of the postwar period. A party that can’t come up with a better answer to this dynamic than to conclude that half of America simply isn’t trying hard enough probably isn’t a party destined or deserving of electoral success.
Archive for the 'Taxes' Category
Mitt Romney in a recent Fortune magazine interview: “I indicated as I announced my tax plan that the key principles included the following. First, that high-income people would continue to pay the same share of the tax burden that they do today.”
That’s odd. Sensible debates about tax fairness and tax policy focus on what rate each group should pay, not on what each group’s share of total tax payments (the “tax burden”) should be.
High-income people’s share of tax payments is determined by their average tax rate, their share of total pretax income, and the average tax rate among all taxpayers.
Policy makers have a lot of control over tax rates. They have some, but far less, influence on the share of pretax income that goes to each group. Hence they have limited ability to control the share of total tax payments paid by a particular group.
In the past several decades federal tax rates on the top 1% of Americans have been lowered (Reagan), raised (Bush I and Clinton), then lowered again (Bush II). If all else stayed the same, that would have reduced the top 1%’s share of total tax payments. But this effect has been dwarfed by the large rise in the top 1%’s share of pretax income, which causes their share of total tax payments to increase. Here’s what the numbers looked like in 1979 and 2007, two years at comparable points in the business cycle (data are from the CBO).
The top 1%’s share of pretax income doubled, from 8.9% to 18.7%. Although the average tax rate they paid fell, their share of total tax payments increased, from 14.2% to 26.2%, because their income share jumped so much.
Consider what the Romney approach would have implied for tax rates paid by the top 1% during the 1979-2007 period. In 1979 their average federal tax rate was 35%; in 2007 it was 28%. Suppose policy makers had promised to keep the top 1%’s share of total tax payments at its 1979 level of 14%. Given the sharp rise in the top 1%’s income share, the average federal tax rate paid by the top 1% would have needed to fall to just 15%.
What does this mean going forward? In pledging to maintain the tax share of the richest Americans at its current level, Mitt Romney is in effect promising that if that group’s pretax income share continues to rise as it has in the past three decades, he will slash their tax rates.
Mark Thoma adds: “He is also promising that if the income share falls, he’ll raise tax rates for upper income households. Anyone think he’d really do that?”
The Bush tax cuts of the early 2000s reduced the progressivity of federal taxes, but not that much. The chart below shows the effective federal tax rate for each quintile of households and for the top 1% in the business-cycle peak years of 2000 and 2007. The tax rate dropped by a similar amount for each quintile, and only slightly more for the top 1%. (For more discussion and analysis, see pages 24-31 of this CBO report.)
What should we make of this? On the one hand, it’s good that there was little reduction in progressivity. The progressivity of federal taxes helps to offset the regressivity of state and local sales taxes.
On the other hand, there was a compelling case in the early 2000s (and still today) for increasing the progressivity of federal taxes. One of the chief rationales for progressive taxation is that those with high income can afford to contribute a larger share of that income. In the 1980s and 1990s, the top 1% of Americans enjoyed whopping income gains. Between 1979 and 2000, the average (inflation-adjusted) income of households in the top 1% jumped from $350,000 to $1 million. For households in the bottom 20%, average income barely budged; it was $15,300 in 1979 and $16,500 in 2000. Given these developments, it would have been sensible to increase the effective tax rate a bit for those at the top and perhaps reduce it a little for those at the bottom. President Bush and the Congress instead chose to reduce rates for everyone.
The chief harm inflicted by the Bush tax cuts wasn’t to progressivity. It was to government revenues. The average effective federal tax rate for all households dropped from 23% in 2000 to 20.4% in 2007. Judging from the CBO’s data on income, that two-and-a-half percentage point decline subtracted roughly $300 billion from federal tax revenues in 2007. Proponents of the tax cuts hoped the economy would grow faster, mitigating the revenue loss caused by the lower rates, but that didn’t happen.
$300 billion a year wouldn’t address all of our revenue needs, but it could do a lot of good.
Taxes reduce the payoff to entrepreneurship, investment, and work effort. If taxation is too heavy, these disincentives will weaken a nation’s economy. But at what point does the harmful impact kick in? And how large is it?
Half a century ago, in 1960, taxes totaled about a quarter of GDP in Denmark, Sweden, and the United States. The tax take then began to rise in Denmark and Sweden, reaching half of GDP by the mid-1980s, where it has remained. In America it has barely budged, hovering between 25% and 30% of GDP throughout the past five decades.
Has heavy taxation hurt the Danish and Swedish economies? If so, how much?
Begin with GDP per capita. America’s is higher than Denmark’s or Sweden’s. But that’s a legacy of the distant past. Growth of per capita GDP in the three countries has been virtually identical, both in the five decades since 1960 when the divergence in tax levels began and in the three decades since the 1970s (shown in the chart) when the tax difference has been most pronounced.
(Here and throughout I use 2007, the peak year of the pre-crash business cycle, as the end point. Adding the crash and its aftermath would improve the standing of Denmark and Sweden relative to the U.S.)
Each year since 2001 the World Economic Forum has scored most of the world’s countries on a “competitiveness” index. The index aims to assess the quality of twelve components of a nation’s economy: institutions, infrastructure, macroeconomic stability, health and primary education, higher education and training, goods market efficiency, labor market efficiency, financial market sophistication, technological readiness, market size, business sophistication, and innovation. In 2007 Denmark and Sweden were judged to be nearly identical to the United States in competitiveness. That was true throughout the decade. It also was true for the “innovation” components of the index in particular.
Employment, measured as average hours of paid work per working-age person, is a little lower in Denmark and Sweden (more here ). A larger share of working-age Danes and Swedes are employed — around 76%, compared to 72% in the U.S. But employed Danes and Swedes tend to work fewer hours than employed Americans — about 1,600 per year versus 1,800. This is due in large part to the fact that Danes and Swedes have more than five weeks of legally-mandated paid vacations and holidays, whereas Americans have none. This gap, in turn, is a function of historical differences in the strength of unions.
Employment hours increased between 1979 and 2007 in all three countries. The rate of growth was fastest in Denmark, followed by the U.S. and then Sweden.
Household income (after taxes and transfers) is higher in the United States at the ninetieth percentile (p90) of the distribution and at the median (p50). This owes to differences in per capita GDP, in income inequality, and in the degree to which citizens receive their income in the form of (tax-financed) public services. Here too the U.S. has not gained ground in recent decades. Household incomes in the middle of the distribution have grown more rapidly in Denmark and Sweden than in the U.S. (shown in the chart), and at the ninetieth percentile they’ve increased at about the same pace.
Denmark and Sweden have done better than the United States at keeping government debt in check.
Have high taxes required a sacrifice of liberty? Not according to the Freedom House measure of civil liberties or the Heritage Foundation-Wall St. Journal measure of economic freedom.
Finally, consider two social indicators of well-being: life expectancy and life satisfaction. On both counts, Danes and Swedes fare, on average, just as well as or better than their American counterparts.
If heavy taxation has harmful economic effects, why have Denmark and Sweden performed similarly to the United States during a period of several decades in which their taxes were much higher than America’s?
Three explanations that sidestep the puzzle
One common explanation is that small size facilitates administrative efficiency. The Danish and Swedish governments can function effectively because their scale is manageable. They are “big” governments, but in small countries. This might be true, but to say that heavy taxation isn’t a problem if government works well is to say that heavy taxation isn’t in and of itself a problem.
A second explanation looks to the mix of taxes countries use. The Nordic countries rely disproportionately on consumption taxes; in 2007 consumption taxes totaled 16% of GDP in Denmark and 13% in Sweden, compared to just 5% in the U.S. These are said to create less in the way of investment and work disincentives than do taxes on individual and corporate income.
Yet there is a sizeable difference in income taxation too. In the U.S. income taxes were 14% of GDP in 2007, versus 19% in Sweden and a whopping 29% in Denmark. More important, to suggest that heavy taxation isn’t harmful given an effective tax mix is to suggest that a high level of taxation per se is not necessarily harmful.
A third explanation points to tax compliance. Each April most Swedes receive a pre-prepared tax form. The relevant information about income, deductions, and the amount still owed or to be refunded has already been filled in by the Swedish Tax Agency. If the information is correct, the taxpayer simply confirms that by mail, telephone, or text message. Pre-prepared tax returns not only are more convenient for taxpayers; they also reduce cheating. Greater compliance, in turn, is likely to make heavy taxation more workable. If cheating is extensive, tax rates need to be higher in order to raise a given quantity of revenue, which increases the likelihood of disincentive effects on entrepreneurship, investment, and work effort. In a tax system with minimal cheating, more revenue can be raised at moderate tax rates.
This can’t be done in the United States, so the argument goes, because the American tax code (unlike its Swedish counterpart) has too many available deductions and rebates. But the U.S. could simplify its tax code to enable pre-preparation. Moreover, even with this advantage, income tax rates in Denmark and Sweden are a good bit higher than in the U.S. And a large portion of Danish and Swedish tax revenues come via payroll and/or consumption taxes, which are less vulnerable to evasion, in those countries and in the U.S. as well.
Two explanations that attempt to address the puzzle
Here are two accounts of Danish and Swedish economic performance that don’t sidestep the question of tax levels’ impact.
The first is hypothetical; I don’t know of anyone who’s offered this argument explicitly. It says that the adverse effect of taxation kicks in once a country passes 15% or 20% or 25% of GDP, and it doesn’t worsen the farther beyond that you go. Denmark, Sweden, and the United States each exceeded 25% already by 1960, so in this story we would expect the three countries to have experienced similar (poor) economic performance in subsequent years.
This hypothesis doesn’t strike me as especially compelling. None of the world’s rich nontiny democracies have had tax levels below 25% of GDP since the 1970s, and only a few have been below that level since 1960. Yet a number of these countries have had relatively good economic outcomes during this period.
A second explanation says the Danish and Swedish economies have performed similarly to America’s despite heavier taxes because they have some advantage(s) that I haven’t adjusted for. This certainly would be true if I had chosen Norway as one of the comparison countries. Norway’s economy has been boosted by extensive oil resources. Has Denmark or Sweden had any such advantage?
One possibility is catch-up. Laggard countries can get an economic growth boost by borrowing technology from the leaders. But this has become less relevant for Denmark and Sweden in recent decades, as they’ve invested heavily in education and R&D and become technological leaders in their own right (more here).
Ethnic and cultural homogeneity is sometimes mentioned as a key economic asset of the Nordic countries. This might help, though in rich nations diversity may have some benefits as well.
Corporatist policy making, which features institutionalized participation by business and labor representatives, is associated with faster economic growth in affluent countries in recent decades. This may have helped Denmark and Sweden. Yet both countries have made their share of policy mistakes.
Of course, the United States has some important advantages of its own, including a huge domestic market, excellent universities, a culture that prizes innovation and entrepreneurship, a well-developed venture capital system, bankruptcy laws that facilitate risk-taking, a tradition of regional mobility, and an attractiveness to talented immigrants. The question is: If taxation at Danish and Swedish levels has a significant negative economic effect, do Denmark and Sweden have advantages relative to the U.S. that are large enough to have fully offset that effect in recent decades? It’s a difficult question to answer with any certainty, but I think probably not.
At what point does the harmful impact of taxes on the economy kick in? And how large is it? The Danish and Swedish experiences over the past generation pose a challenge for those who believe the answers to these two questions are “somewhere below 50% of GDP” and “large.” It’s a challenge that in my view has yet to be met.
Working-age Belgians, French, and Germans spend, on average, about 1,000 hours a year in paid work. In the United States, Switzerland, and New Zealand, by contrast, the average is around 1,300. This is a pretty big difference.
These averages are determined by the share that have a paying job and the number of hours worked over the course of a year by those with a job. In the United States, for instance, the employment rate in 2007 was 72% and those employed worked an average of 1,800 hours (.72 x 1,800 = 1,296). In France, the employment rate was 64% and the average number of hours worked by those with a job was 1,550.
In a paper published in 2004, Edward Prescott concluded that taxes are the principal cause of the cross-country variation in working time. Prescott’s conclusion was based on the association between tax levels and work hours in the early 1970s and the mid-1990s in Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States.
The hypothesis is sensible. Taxes reduce the (direct) financial reward to paid work. This encourages people not to work at all or to work fewer hours.
But how large is the effect? After all, some people will work more when taxes are higher, in order to reach their desired after-tax income. More important, lots of other things affect people’s calculations about whether and how much to work, including wage levels, employment and working time regulations, paid vacation time and holidays, availability and generosity of government income transfers, access to health insurance and retirement benefits, the cost of services such as child care, and preferences for work versus leisure. A good recent study of work hours among those who have a job concludes that taxes seem to have an effect for women but not for men, and that taxes account for a limited portion of the cross-country variation. In own my research (here and here), I’ve found pretty strong indication that the tax mix matters; heavy reliance on payroll taxes is associated with slower increase in the employment rate over the past three decades. But that doesn’t necessarily tell us anything about the impact of overall tax levels.
Here is the association between annual work hours per working-age person in 2007 (before the crash) and tax revenues as a share of GDP over the years 1979 to 2007. The pattern looks supportive of the notion that high taxes reduce work hours.
But knowledgeable comparativists will notice a familiar clustering of countries. Here’s the same chart with three groups highlighted.
One group, in the lower-right corner, includes Germany, Italy, the Netherlands, France, and Belgium. These countries, along with Austria, have several features that might contribute to low work hours. One is strong unions. Organized labor has been the principal force pushing for a shorter work week, more holiday and vacation time, and earlier retirement. These nations also have been characterized by a preference for traditional family roles: breadwinner husband, homemaker wife. This preference, often associated with Catholicism and “Christian Democratic” political parties, is likely to influence women’s employment and work hours. It is manifested in lengthy paid maternity leaves, lack of government support for child care, income tax structures that discourage second earners within households, and practices such as German school days ending at lunch time and French schools being closed on Wednesday afternoons. These countries also fund their social insurance programs via heavy payroll taxes, the kind most likely to discourage employment growth.
A second group consists of the four Nordic nations: Denmark, Sweden, Finland, and Norway. These countries too have strong unions. But they also have had electorally successful social democratic parties, which have tended to promote high employment. Denmark and Sweden, in particular, have been at the forefront in use of active labor market programs to help get young or displaced persons into jobs, public employment to fill gaps in the private labor market, and government support for child care and preschool to facilitate women’s employment.
A third group of countries, in the upper-left corner, includes the United States, Japan, Australia, New Zealand, and Canada. These nations have relatively weak labor movements and limited influence of social democratic parties and Catholic traditional-family orientations.
The other five countries — Ireland, Portugal, Spain, Switzerland, and the United Kingdom — are a hodgepodge. (Some would include Ireland and the U.K. in the “weak labor” group and Spain and Portugal in the “traditional family roles” group. Doing so doesn’t alter the conclusion here.)
Based on their institutional-political makeup, we would expect the weak-labor countries to have comparatively high work hours, the social democratic countries to be intermediate, and the traditional-family-roles countries to have low hours. As the following chart indicates, that’s exactly what we observe.
So is it really heavy taxation that produces comparatively low work hours? Or is it strong unions and preferences for traditional family roles? If we adjust for institutional-political group membership, the negative association between tax levels and work hours disappears.
Given that the institutional-political groupings account for much of the cross-country variation in levels of work, we might be better able to detect the true impact of taxes by examining changes. The following chart shows change in work hours from 1989 to 2007 by change in taxation from the 1980s to the 2000s. There is no association to speak of; the regression line is negatively sloped, but it is nearly flat and the countries are widely dispersed around it. Perhaps most revealing is the pattern among the twelve countries bunched around zero on the horizontal axis; despite little or no change in tax levels over this period, these nations varied sharply in the degree to which average work hours changed.
Is it levels of taxation, rather than changes, that cause changes in work hours? No; here too we find no association.
While heavy taxation surely creates some work disincentives, the overall tax level doesn’t seem to be an important determinant of differences in employment hours across the world’s rich countries.
Kip Hagopian says no. He considers various arguments in favor of progressivity and isn’t persuaded. I appreciate Hagopian’s attempt to engage these arguments. Unfortunately, he says little or nothing about the three I find most compelling.
1. Luck. Many of the things that determine our incomes — intelligence, creativity, physical and social skills, motivation, persistence, confidence, connections, discrimination, occupation, employer, spouse, inherited wealth — are in significant measure a product of chance. They are heavily influenced by genes, our parents, our childhood neighborhood and schools, timing, and various fortuitous occurrences. Opponents of progressive taxation often emphasize the role of effort, but much of the variation in effort is itself a product of luck. (Progressive tax proponents sometimes fall into the trap of accepting the distinction between effort and luck; they’re then forced to argue that the latter matters more than the former.)
2. Ability to pay. Higher-income households tend to be able to pay not only more dollars but also a larger share of their income without suffering. One sign that this is true is that the savings rate increases with income; those with higher income tend to save a larger percentage. This may owe partly to a stronger future-orientation, but it’s mainly because they can afford to.
3. Income tax progressivity helps to offset the regressivity of other taxes. Some taxes are regressive, with higher-income households paying a smaller share of their income than lower-income households. Payroll (Social Security) and consumption (sales) taxes are the most prominent. If income taxes weren’t progressive, the tax system as a whole would be regressive.
Fairness is not the only criterion by which a tax system should be judged. We also need to consider how much revenue we want to raise and taxes’ impact on the economy. For my thoughts, see here and here.
On policy grounds, I’m not happy about President Obama’s decision to go along with a two-year extension of the Bush tax cuts for those making over a million dollars and with a scaled-back estate tax. But there’s an economic and political logic to it.
Economic: The most important thing our federal government can do at the moment is to help the economy. Fiscal policy options are limited; there’s no chance of a second stimulus package. Extending the tax breaks for the richest will help — not a lot, since much of the money the rich get to keep will be saved rather than spent, but a little. More important, in exchange the administration got an extension of unemployment benefits for several million people and additional tax reductions for low- and middle-income Americans.
Political: The general line of commentary on the left suggests that compromising with Republicans on this issue hurts Obama politically. Comparisons to Jimmy Carter are becoming commonplace. But Bill Clinton got the same kind of flak. In the end, the key difference between the Carter and Clinton presidencies wasn’t clarity of vision, a big idea, decisiveness, toughness, progressiveness, or partisanship. It was how the economy performed as each approached reelection. If our economy gets back on its feet, President Obama and his party are likely to fare well in the 2012 elections, and images of Obama as Carter redux will be a distant memory.
More from Dean Baker, Jonathan Chait, Clive Crook, Kevin Drum, Howard Gleckman, Robert Greenstein, Greg Ip, Simon Johnson, Ezra Klein, Paul Krugman, Greg Mankiw, Robert Reich, Felix Salmon, John Sides, Mark Thoma, Matt Yglesias, and others.
At the same time that the rich have been pulling away from the middle class, the very rich have been pulling away from the pretty rich, and the very, very rich have been pulling away from the very rich.
The current debate over taxes takes none of this into account…. Our system sets the top bracket at three hundred and seventy-five thousand dollars, with a tax rate of thirty-five per cent…. This means that someone making two hundred thousand dollars a year and someone making two hundred million dollars a year pay at similar tax rates….
This makes no sense — there’s a yawning chasm between the professional and the plutocratic classes, and the tax system should reflect that. A better tax system would have more brackets, so that the super-rich pay higher rates. (The most obvious bracket to add would be a higher rate at a million dollars a year, but there’s no reason to stop there.) This would make the system fairer, since it would reflect the real stratification among high-income earners. A few extra brackets at the top could also bring in tens of billions of dollars in additional revenue.
How will the proposed top-end tax rate increases affect taxes owed by the rich and by the middle class?August 13, 2010
Who stands to gain the most if Congress extends the middle-class [but not the top-end] Bush tax cuts: a middle-income worker or a millionaire? The millionaire….
The income tax operates as a staircase, not an elevator, so people who make $1 million a year don’t go directly to the top “floor” (i.e., to the top marginal tax rate, currently 35 percent) but instead take the “stairs,” paying tax on the first increment of taxable income at the bottom rate of 10 percent, paying tax on the next increment at 15 percent, and so on until reaching the top rate.
As a result, the 2001 tax law’s reductions in the lower tax brackets benefit not only middle-income people whose incomes fall into those lower brackets, but also people in the very highest brackets.
In fact, a family making more than $1 million will receive more than five times the tax cut benefit, in dollar terms, as a middle-class family making $50,000 to $75,000, if Congress extends the middle-class [but not the top-end] tax cuts.
From the New York Times:
If the president gets his way, in 2011 the top two income tax rates — now 33 percent and 35 percent — would revert to the levels before the Bush administration, 36 percent and 39.6 percent, respectively…. Republicans … say Mr. Obama is about to spring a big tax increase on many small-business owners who file their taxes as individuals. Analyses from the Joint Committee on Taxation and the Tax Policy Center, a nonpartisan research organization, show that less than 3 percent of filers with small-business income pay at the top two income tax rates, and many of those are doctors and lawyers in partnerships.
More on this from Howard Gleckman.