The Late, Great Income Tax
Max B. Sawicky
April 15, 2005
Max B. Sawicky is an economist at the Economic Policy Institute. He has worked in the Office of State and Local Finance of the U.S. Treasury Department and the U.S. Advisory Commission on Intergovernmental Relations. He also serves on the at-large national board of the Americans for Democratic Action.
Taking a cue from my boyhood hero Richard M. Nixon , the last great liberal president, it's time to talk about what's right with America, specifically with our tax system. The U.S. economy, largest in the world, magnet for foreign capital, spawn of miraculous technical innovation—and among advanced industrial nations one of the fastest growing—surely must be the beneficiary of an excellent tax system. Otherwise, how could we be doing so well?
Let us count our blessings.
The cornerstone of the U.S. system is the taxation of income and estates. Income is the broadest conceivable base for taxation, permitting the lowest possible rate for a given amount of revenue. (Estate taxation is an indirect means of taxing income that has never been taxed.)
The high point of income tax reform was the base-broadening achieved under the Tax Reform Act of 1986. Since then, of course we have seen backsliding, in the form of a blizzard of new deductions, credits and exclusions. As we speak, the Estate and Gift Tax is under assault in Congress.
The most infamous of the post-'86 reforms is the increasing favor afforded to income received by the wealthiest Americans—capital gains and dividends. Legislation to this effect was signed by Bill Clinton in 1997, and later by George W. Bush, seemingly once a month. This trend marks the evolution of the income tax into a wage tax, shifting, as John Edwards says, the federal tax burden from wealth to work.
Even so, the income tax is still progressive, just not as much as it used to be. The average effective rate of the tax is 8.6 percent, according to the Brookings/Urban Institute Tax Policy Center but the rates vary enormously by income class. (The numbers are here)
For the bottom 40 percent of the population, the average rate of the individual income tax is negative—taxpayers get more back from refundable credits than they pay in. For the middle 20 percent, the rate is just 3.3 percent, and for the fourth quintile it's 6.3 percent.
Pity the poor Republicans—it's the top quintile that pays 86 percent of the income tax (at an average rate of 12.2 percent of income).
Insofar as there is genuine popular animus towards the income tax, surely it has as much to do with where Americans would like to be, rather than where they are now economically. The tax that tolls for most people is not the income tax, but the payroll tax. Should this upset us?
I would say no. The payroll tax finances our vital Social Security and Medicare programs. Gene Steuerle and Adam Carasso have estimated that the lifetime benefits of these programs are huge. Converting the projected streams of benefits into lump sums, they find that for a married couple with average wages and life expectancy reaching age 65 in 2030, Social Security's value will be the $470,000, and Medicare's $490,000. What a country.
It could be pointed out, accurately, that current payroll taxes are more than sufficient to pay current expenses. But present-day workers are not contributing for the sake of receiving benefits at current levels. They can look forward to higher real benefits commensurate with their wages at retirement time, as long as privatizers don't succeed in carving up the program.
It could also be pointed out, again accurately, that more revenue will be required in the future. The first resort would be base-broadening, in effect reversing tax cuts over the past decade. A second would be rate increases. We did fine in the 1990s with the bad old rates. We did all right in the 1950s too, even with a top marginal rate of 92 percent.
Can't the income tax be improved? Sure, but there is less gain there than might be apparent.
One common notion is to transition towards a consumption tax. The hope is that savings and economic growth would get a boost. The fact is that for many people, the income tax is already a consumption tax. Anyone who has unused opportunities to contribute to a deductible pension or IRA—and there are many such people—does not face income taxation on the margin. If they put a dollar in a tax-preferred savings vehicle, the returns to their saving would go untaxed. If they instead spend that dollar on consumption, it is subject to tax. So the existing income tax—really a hybrid income-consumption tax—already provides savings subsidies. These could be extended for lower-income persons, but that is a reform that is completely feasible under the current tax system. Since we are talking about low-income people, however, it would not promise much for national saving.
Greater savings subsidies aimed at the higher-income end of the population run the risk of simply offering new channels for savings already in the pipeline, not net increases. If you are really determined to do something about national saving, the logical place to begin is the Federal budget deficit.
Isn't the income tax too complicated? Sure. How to simplify it?
One way is to tax all income under the same rates, rather than favoring wealth over work, as above. Another is to consolidate deductions and credits into fewer, simpler ones. For instance, my pet project is to merge the Earned Income Tax credit, the Child Tax Credit and the dependent exemption into a Simplified Family Credit. Both liberal and conservative Democrats like this idea. It's sad if predictable that simplifying taxes for moderate and low-income families with children is not the favorite thing of the current Congress.
Many of the deductions in the income tax would work better as expenditure programs. They are run through the income tax because we are captive to irrational thinking about the Federal budget that favors a tax break over an outlay, even though both have the same impact on the deficit.
Is the income tax fairly administered? Less so each year, because Congress clutters up the tax code each time they sally forth to reform it, and because the Internal Revenue Service receives less in the way of resources these days than it did years ago, when the economy was smaller, taxpayers were fewer and financial shenanigans were less pervasive.
Even so, the bulk of tax revenue is paid voluntarily and on time. This enables rates to be lower than they otherwise might be, the IRS to be less intrusive, and the economy to enjoy an advantage over other systems benefiting from less social cooperation.
So weep not for the income tax. Rather, be wary of those who have been fixing it. If they keep on, we will end up with a tax system focused like a laser beam on moderate and low-income working families, providing grossly inadequate revenues.
As Justice Holmes said, with taxes we buy civilization. Let's avoid the bargain-basement version.