Saturday, August 8, 2009

The Progressive US Tax System, part 2

Let's do an exercise examining the federal tax system.

According to this site, the 2010 Federal Budget is composed of the following:

23% Medicare and Medicaid
17% Social Security
17% Defense
10% Interest on the debt
32% Other

Adds to 99% due to rounding.

According to Wikipedia, Federal receipts are the following:

44% Income Tax
35% Payroll Tax
15% Corporate Tax
7% Other Tax

Adds to 101% due to rounding.

Here's where it gets interesting.
The whole point of Social Security is, in a sense, "forced savings". You pay X over the course of your career and you receive back an inflation-adjusted X during retirement, which ensures that everybody has money to spend in their old age. Similarly, Medicare is "forced prepayment for health insurance" - you pay Y over your career in exchange for health insurance when you're old. In a world of perfectly rational, linearly discounting people, this would be unnecessary, but because we're human, it is necessary.

Because you pay X and are supposed to receive X, or pay Y and receive insurance that is supposed to be worth Y, the point of payroll taxes is not to be redistributionary. They are forced forms of saving - you are guaranteed receive the money back in the long run. This is why Social Security has an income cap, above which you aren't social-security taxed. If you're making enough money that you're likely to save it anyway, there's no reason to be forced to save it, and the government probably shouldn't be responsible for paying out ridiculously large social security checks, because the point is to keep people out of poverty in retirement. The amount you're paid should keep you roughly in the same lifestyle you enjoyed while working.

Medicare doesn't have an income cap and doesn't factor in lifestyle factors, but most people are paying something remotely approximating a person's expected health fees. Because the cost of health insurance is roughly equal for a poor person and a rich person, a little bit of redistribution happens so the people who pay more than they cost buy health insurance for people who pay less. I would prefer a system in which the money is given back to old people with the stipulation that it could only be spent on private health insurance, but government-run medicare is simply an inferior version of that. Either way, in sum, all the Medicare taxes collected should pay for Medicare, and that's it, and the purpose of Medicare taxes is that people should generally approximately save up for their own health insurance costs. A little bit progressive, but the underlying purpose is not to redistribute income - it's for people to finance the costs of their own retirement to the best of their ability. It's a savings mechanism.

Instead, progressivity should (and does) manifest in income taxes. Income taxes are the principal mechanism by which the non-savings portions of the government are run. Those able to pay more (the rich) do so, and those able to pay very little don't pay much, if anything. Back to these in a second.

Corporate taxes are intended to be similar to this, and probably are so. The additional corporate profits that come from cutting corporate taxes mostly flow through to capital-holders, who, in the public equity or debt markets, are generally people with savings. Poor people probably have very little savings, so they are taxed very little by corporate taxes (though corporate taxes may strip them of jobs by making it more expensive for companies to start up and operate). Middle-class people have some savings (for example a 401k), and richer people tend to have a lot of savings. Corporate taxes are thus functionally a tax on savings and paid overwhelmingly by the rich. (Sales taxes can be seen as the counterpart to corporate taxes - they are taxes on individual consumption. Consumption and savings are the two components of individual income. Consumption taxes are probably less progressive than savings because poor people still consume.)

Anyway - the idea is that almost all other taxes that go to the government are designed to be progressive because they fund government operations, and it isn't unreasonable to ask those who are able to pay more of government operations than those who do not have as much money.

So, to recap, before moving forward:

1) When looking at progressivity, ignore Social Security, and, if implemented, Medicare should only be progressive enough to fund itself.

2) Progressivity to fund government should come from income tax and corporate tax, with only a small amount from other taxes (mostly excise and gift/estate).

3) For the purposes of this structure, corporate tax is functionally a tax on savings. In our country, the savings rate is very low for all but rich people. (Cultural factors probably determine this)

4) The income distribution should generally be narrower than the savings distribution, because the richer you are, the greater the percentage of your income you can save.

Here is where my previous post, here, comes into play.

"In 2007—the most recent data available—the top 1 percent of taxpayers paid 40.4 percent of the total income taxes collected by the federal government. This is the highest percentage in modern history. By contrast, the top 1 percent paid 24.8 percent of the income tax burden in 1987, the year following the 1986 tax reform act.

Remarkably, the share of the tax burden borne by the top 1 percent now exceeds the share paid by the bottom 95 percent of taxpayers combined. In 2007, the bottom 95 percent paid 39.4 percent of the income tax burden. This is down from the 58 percent of the total income tax burden they paid twenty years ago.

To put this in perspective, the top 1 percent is comprised of just 1.4 million taxpayers and they pay a larger share of the income tax burden now than the bottom 134 million taxpayers combined.

Some in Washington say the tax system is still not progressive enough. However, the recent IRS data bolsters the findings of an OECD study released last year showing that the U.S.—not France or Sweden—has the most progressive income tax system among OECD nations. We rely more heavily on the top 10 percent of taxpayers than does any nation and our poor people have the lowest tax burden of those in any nation."

Nobody can really know how corporate taxes would flow to people if abolished, but it's a safe bet that between income taxes and our corporate taxes (the highest of all developed economies, I believe, and one of the highest rates in the world), the United States government relies on the contributions of the rich more than any other country. It's also a safe bet that the middle class in America contribute less to government than any other middle class in the world.

Does the income distribution contribute to part of this? Certainly, but the middle class in America are still richer than the vast, vast majority of middle classes in the rest of the world (maybe the richest, I don't know). They can afford to support the government.

In other words, if the government thinks it can or should fund a massive fiscal expansion by taxing the rich and leaving the middle class untouched, it may have another thing coming. The rich already fund most of the government, and there is very little reason why a rich person can't just leave the country if taxes get too high relative to what they receive from the government. Given the skills and the savings of most rich people, that would be very, very bad for the future of the US.

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