Unfortunately, two contemporary trends contribute significantly to the convolution of the economics behind taxation: the lack of public education on the fundamentals of economic theory and the widespread superficial evocation of economic theory in popular political discourse (“pop economics” as I call it: it’s “economics” in the same way that Justin Beiber or One Direction are “musical artists”). I have noticed that in recent years, the general public has forgotten how our tax system works and why. For this diary, I’m going to go into some very (and I mean very) basic economic concepts important for navigating the tax debate, what our tax system currently does, and what we, as progressives, should want it to do. Now, for those of you who know the economics, you can skip to the end and the discussion about what we should aim for. It's a long post, but I think you'll find it worth your while below the fold.
Agree with it or not, economics has risen to such dominance and prominence in the social sciences that the field will likely receive the first consultation in framing the debate over taxation, rightly or wrongly (personally, I think it’s because economists have charts and sophisticated mathy-looking stuff that people don’t understand, but assume it must be brilliant because they don’t understand it all despite their own sophistication). Consequently, there are some things we need to understand at a fundamental level to understand what kind of deal Democrats should be drafting and why.
Incentives: Income taxation versus Consumption taxation
All too often, pundits, politicians, and even academics appearing in the media refer to taxation as a catch-all term that means the same thing in every instance. It doesn’t. Taxes have different effects on different behaviors in different contexts, and should be analyzed using models of understanding that incorporate what we know (or think we know) about those effects for each specific policy consideration. However, the way taxation is discussed in public often leaves out these technical (and important) differences, which detrimentally distorts the public’s understanding of the economic effects of taxation and the discourse surrounding taxation becomes unnecessarily convoluted. Below, I present a very basic, economics 101 graph of the effects of an excise tax levied on good X in the market for good X. The reason I present this to introduce my segment on the economics of taxation is that, unfortunately, this mirrors the average person’s understanding of taxation and the public discourse surrounding taxation often operates from a framework founded on an understanding similar to this graph. In the public discourse, even more sophisticated sources of economic knowledge begin and end their conversation about the economic effects of taxation with this model.
In the graph above, P0 represents the market equilibrium price of good X (See "market equilibrium" in glossary at the bottom of the post). Now, the presence of an equilibrium price must meet a litany of assumptions about the dynamics of the market for good X that are also oft ignored in pop economics, but that is not for this diary. And excise tax is passed and Pt is the equilibrium price plus the tax. GR is the government revenue from the tax, and DW is the deadweight loss (DWL) associated with the tax (see the glossary at the bottom of the post for a definition of deadweight loss). As you can see, the tax raises the price, the quantity demanded is lower for the good at the higher price, the government revenue is not enough to fully offset the loss in activity, and the deadweight loss shows that the taxes have created inefficiency.
In pop economics, this is what all taxes look like. Not a specific excise tax on a specific good in a specific market under certain market conditions. No. All taxes, all the time, regardless of context reflect this elementary graph. At least, listening to the pundits, politicians, and analysts discussing this in mainstream public forums would have you believe this. It is no surprise, looking at the graph, that the punditry would refer to a tax increase as a “fiscal cliff” or that taxes hurt the economy and may (I always love that lame qualifier they use to push idiotic, unfounded conclusions in the safety of plausible deniability) cause a recession. Of course, as we know, that’s only part of the story, and the misdirection from the pushers of this terrible framework leave out two important pieces to the puzzle.
First, we will focus on the example from the graph, an excise tax on good X. You see, what is left out of the graph, and typically the discussion, is what is done with that government revenue (GR). The government revenue is often used on productive enterprises that build our society's capacity for industry. The enterprises have multiplier effects that provide a greater than 1:1 return on the dollar spent. For instance, schools provide the education needed to have a productive and innovative workforce capable of producing new, innovative goods, services, markets, and industries, which obviously have cascading effects throughout the economy. The teachers paid at those schools also use their salaries to demand goods, and pay taxes on those goods and their income. Depending on how a society spends its government revenue, the return on those expenditures can more than compensate for the dead weight loss in the original market.
To give a concrete, real-world picture of how this works using an excise tax, let’s take the federal gas tax that we pay. The federal tax does indeed raise the price of fuel, and, in areas where substitution is available for transportation, may lower demand for fuel consumption at the margin. BUT, the government revenue from that excise tax funds the building and maintenance of our national highway system. The presence of these roads increases demand for fuel as now travelers by car can reach new destinations. In addition, towns, and their businesses, along the highways have a new, steady stream of consumers passing through their areas. They have more efficient ways to get goods into and out of their towns. Obviously, the government revenue is expended on an activity that more than closes the deadweight loss. (And this doesn’t even get into negative externalities, etc. [for a definition of externalities in economics, see the glossary at the bottom of the diary]) But in pop economics pushed in the media discourse and hawked by the political right, the discussion ends at deadweight loss (inefficient) and lower demand (economy hurt).
Unfortunately, the distortion doesn’t only come when discussing taxes on goods, or consumption taxes. Although the graph above and the supply-demand model used to analyze market effects should only apply to consumption taxes (taxes levied on consumption of a good), pop economics would have you believe that taxes on personal income function the same way. The framework usually begins with “punishing success,” or in its milder forms “disincentivizing earnings,” and concludes that the disincentives on earning income through income taxation lowers output, slows overall growth, and thereby hurts the economy. Now, if you apply our elementary graph to this scenario, it makes sense. You pretend that “income” is good X, in a normal, perfectly competitive market (you can already see the foolishness of applying this model for analyzing income…a perfectly competitive market for income....), and the tax on income lowers demand and increases the price on income. See? Taxes damage the economy and lower output.
Only, that makes no sense, even in basic economic theory. “Income” in the sense of our income tax system refers to “income from wages, tips, and salary.” In economic theory, different models apply to wages. You see, in economic theory, everybody has a set amount of time to allocate between two activities: labor and leisure. Each person has some different ratio in which they value labor relative to leisure. Wages serve as an incentive to trade leisure for labor towards some goal (the fundamental misunderstanding of wages is probably why popular discourse and “businessmen” treat labor as a purely budgetary “cost,” as if they receive no value-added from that cost, but I digress…). The reason wages effectively incentivize such a trade is because people desire to consume things that bring them pleasure (in the aggregate, demand for goods); thus, towards the end of satisfying demand for consumption, rational actors will pursue a trade of labor for the highest wages with their lowest sacrifice of leisure. Of course, in the real world, there are all kinds of distorting and complicating things even to this…but all we need are basics, and those are the basics. As all of the above shows, “income” is not a perfectly competitive market with clear supply and demand curves and an equilibrium point. Income is simply a means to acquire the goods and services demanded in various markets.
You see, rational actors will always accept cost-free income (that is, income in which no additional leisure must be traded for the additional income) because it enables them to satisfy a higher proportion of their demand for consumption without losing leisure. This final point from labor economics sets us up for why income taxes are significantly different from consumption taxes. In America, thanks to the labor movement, we have laws that define acceptable work days, full-time work weeks, etc. Although some work weeks do get into 60-80 hour weeks for full-time work in a single position, there is a cap on hours worked per week for a full-time salary or full-time wages. In other words, once an employee is reaching that cap on hours worked per week, increases in income from wages, tips, and salary beyond that point are cost-free income. What this means in practice is that individual income beyond a given bracket associated with full-time employment is cost-free income to the individual; therefore, the individual will accept any amount of additional income, as there is no leisure sacrifice associated with the additional money. Income taxation can take advantage of this fact by taxing this additional income at a significantly higher rate without disincentivizing the individual from accepting the remaining higher income (taxing a marginal increase in income at a different rate than the previously earned income).
Now, to be clear, there are complications to take into account, like the cost-of-living to minimum wage ratio, in which full time employment may not be enough to cover basic needs and so additional jobs are taken on (thus making the new income from the second job not cost free), and a litany of other considerations to be taken into account. That’s why we can’t just raise taxes willy-nilly without thinking through these different variables and how the change will affect average people. My point in laying all of this out is to show two things: 1. Income taxation is not a “punishment for success” or a “disincentive to earn more” and 2. pop economics that guide the framework and narrative for discussing the effects of personal income taxation on the economy are just plain false. Period.
What Progressives Should Look for in the Coming Negotiations
Now that we are all on the same page with the fundamental economics underlying taxation, we can be better equipped to discuss what we, as progressives, should hope for in the coming fiscal policy deal and why.
Deductions versus Income
As laid out above, the dynamics of incentives and behavior responses to taxation on income differs significantly from the dynamics of incentives and behavior responses to taxation on consumption. The differences underscore the policy significance of a deal structured around reductions in deductions and loopholes versus a deal structured around higher marginal rates on income from wages and salaries in brackets only reached by the wealthiest among us. Tax deductions can be thought of as similar in nature to consumption taxes, as laid out in the graph towards the beginning of my post. Deductions are often used to encourage (or in rare cases, discourage) certain consumption behaviors by lowering overall tax burden commensurate with participation in the desired behavior. A good example is the tax deduction given on interest payments to home mortgage loans, which encourages home ownership over renting or leasing. Sometimes this is used because a certain consumption activity creates socially or economically valuable externalities. In the case of home ownership, a greater sense of shared community can result from setting down permanent residence in an area (although, in all honesty, I personally think our model of “home ownership” is environmentally and economically unsustainable and inefficient under current community development practices, but, again, I digress…).
Returning to our basic graph above, we can think of a deduction as having the reverse effect on the market. By subsidizing the consumption of a good, the demand is higher for that good, resulting in higher consumption. Not only is there no GR in this situation, but any negative externalities to consumption of good X are amplified. Now, you can see where accepting a tax deal of simply eliminating deductions, as Republicans (and probably ConservaDems) are pushing, would be a bad idea. In the short run, there will indeed be an increase in revenue, as consumption patterns are a little slow to react to the policy change. However, over time, the consumption of the subsidized good will fall into normal consumption levels, reducing revenue from that source over the long-term. For instance, using the home mortgage interest deduction as an example, the elimination may reduce home purchasing, decreasing property tax revenue for already strapped local governments. In addition, desirable side effects of these behaviors will be reduced.
On the other hand, the structure of income incentives tells us that under higher marginal rates, those at full employment will still seek increased income under higher marginal rates, as long as the higher rates isolate income levels that only affects people already in full employment. Using this structure, by demanding higher rates as a significant proportion of increased revenue in the deal, we can increase our revenue over the long-term while not creating the recession inducing decrease in demand used as a scare tactic when discussing marginal income rates.
A brief example of why marginal rates will not disincentivize earning more money and decrease output:
The following are current tax rates for an unmarried individual:
0-$8,700 = 10%
$8,701-$35,350 = 15%
$35,351-$85,650 = 25%
$85,651-$178,650 = 28%
$178,651-$388,350 = 33%
$388,351+ = 35%
Pretend that steveholt makes $380,000. It’s a safe bet that steveholt must work full-time for a salary like that. steveholt’s boss offers him a raise to $400,000 annually. Before the raise, steveholt’s total tax burden was $109,927.67, or about 28.9% of his gross salary. After the raise, steveholt would gasp be in a higher tax bracket. What will this do to his burden? Will he suddenly lose 6.1% of his now higher annual salary? No. steveholt’s new burden would be $112,683.50 (the sum of the previous brackets at their given rate) plus 35% of the amount over $388,351. Got that? The 35% only applies to the $11,649 that steveholt makes above the highest bracket cut-off. That would amount to $4,077.15 for a total burden of $116,760.65 or 29% of his new salary. His net pay would have gone from $270,072.33 to $283,239.35, an increase of $13,167.02. In other words, a pretax increase of $20,000 still yielded a net pay increase of $13,167.02. And, since steveholt was already being paid over a third of a million dollars annually, it’s safe to say he was already at full employment before the raise. So would there be a disincentive to take the raise if it meant the additional $12k was taxed at 39.6% (or 50% for that matter)? Obviously not. steveholt would be taking home more money for the same number of labor hours. It's just arithmetic.
Now, to be clear, there are deductions that should be eliminated and would improve both revenue and economic efficiency. My point is that any deal centered on deductions as the only (or main) source of increased revenues is a loss. Income taxes provide a more effective, efficient, and sustainable way to increase revenues. Of course, there are many technicalities left out of this that, time permitting, I will address in comments later (after I’ve earned my actual salary) if they come up or discuss in other posts. The complexity of income to cost-of-living, for instance, makes it hard to identify an income level that truly reflects “cost-free” income, but there is little denying that six-figure brackets, particularly those reaching a quarter of a million, are a good place to start. Also, there are effects if capital gains taxes are left at a differentiated rate from wage/salary income taxes, but again, I think I’ve covered the basics here.
What Progressives Should Demand (In My Opinion)
We should create a new bracket at $1,000,000 and tack on a marginal tax rate of 50-60% of income above $1,000,000. In addition, we should reinstate Clinton era marginal tax rates on income above $250,000. That should be our starting point. Deductions and spending cuts to make up the remainder of the deficit should be the only thing we negotiate over after starting from the marginal rate increases as our baseline demands. Why? Well, here is a (slightly outdated) breakdown of our deficit:
Bush Tax cuts - $2.5 trillion
Wars in Iraq and Afghanistan - $853 billion
Other tax reductions - $480 billion
TARP - $224 billion
Defense - $1.4 trillion
Medicare D - $180 billion
Mandatory spending (mostly recession-related increase in reliance on public services) - $324 billion
Now, the Affordable Care Act already provided the means to pay for Medicare Part D, and the expansion of it that filled in a gap in coverage, and provided some additional deficit reduction. The American Recovery and Reinvestment Act funds are almost fully expended and will soon not be on the budget. The wars in Iraq and Afghanistan were added to the books by Obama, but as the draw down continues, these expenditures will begin to fade from the budget. The mandatory spending above is operating as it was designed to operate to provide automatic counter-cyclical stimulus to ensure the recession does not become a depression (food stamps and unemployment insurance (UI), for example, provide a cushion to protect aggregate demand from dipping too low), is necessary so we must protect it, and will decrease significantly as the economy improves and UI and food stamp rolls decline. TARP is mostly off the budget now. So that leaves us with defense and taxes.
Taking the measures I describe above can ensure that we do not undermine demand in a struggling economy while raising the revenue we need to close our deficit (not that we should be focusing on such things in a recession anyway, but this is making the best of our current political reality). It will not close the gap completely. But, we can go back to Clinton rates on the rest of the country when the economy has recovered and can sustain the higher rates on the lower brackets. The marginal rates I described can provide some temporary budgetary relief to see us through until then. Indeed, by the time we reach that point, recession and war related spending may have faded off the budget, making it even easier to close the deficit with revenue measures only (a bit pie in the sky politically, but doable fiscally). Then we can begin focusing on the larger, longer term structural issues we are facing as a nation, how to attack them with public resources, and how many public resources need to be raised and leveraged for attacking them. In the mean time, we need higher marginal rates on the wealthy. It makes sense in terms of equity, and it makes sense in terms of economics.
I share this because I’ve seen some widespread lack of understanding how taxes work in economics, both here and elsewhere, and I think getting progressives together on this so we can push back on the messaging from the right about this issue is important. We have let them use voodoo economics, half-witted arguments, and an over-simplification of this issue to misinform the public and undermine progressives on this issue for long enough. I think it’s time we start building a message around these fundamentals that can be communicated to the general public in a way that allows us to move forward as a country in a very real, non-campaign-related way. We can’t afford to let them cloak their ideological opposition to federal provision of public services and safety net programs in economic arguments about taxation any longer. If they want to "starve the beast" because they do not believe Social Security of Medicare and Medicaid are appropriate programs for a democratic society to vote in favor of funding, then they should be forced to be clear and honest about their true motivations. No more pretending that this is about the economy or economic growth or efficiency. That has warped the debate for decades, and enough is enough.
Glossary of economic terms in this post:
Externalities: In economics, an externality refers to a situation in which the actions of one economic agent affect at least one other economic agent through some mechanism other than prices. In effect, an externality is something associated with an economic transaction that has an affect beyond the transaction itself (and so is not captured by a conventional, simple economic model of that particular market). So for instance, a company manufactures a good through a process that emits mercury into the water nearby. The price of that manufactured good only reflects the costs of producing the good and the demand for the good. The pollution (and the negative health affects from it) is a cost incurred as a direct result of the market, but is not included in the market transaction.
Deadweight loss: Essentially, it is the loss in market activity for which there is not an offsetting gain elsewhere. Deadweight loss refers to the idea that without the presence of a tax, more consumer demand would be met, making consumers happier, and suppliers could sell more of the taxed good, increasing revenue. The tax takes away from both groups, but it does not result in a dollar-for-dollar transfer to the government. The dollar value of the difference between government revenues raised and the market value of the goods not sold due to the higher price caused by the tax is the deadweight loss. For instance, in the real world, these deadweight losses manifest themselves as the administrative needs to fund and enforce the tax. The funds used for the administration of the tax offset part of the revenue from the tax.
Market equilibrium: When the quantity demanded of a good or service is exactly equal to the supply provided by producers of that good or service. When market equilibrium is reached, the price charged for a good or service reflects the "equilibrium price" and the quantity consumed reflects the "equilibrium quantity." NOTE: This only occurs under very specific market conditions that rarely exist in reality.