Stop Worrying and Love the Income Tax…

I’ve been busy. I’ve done a whirlwind business trip through Europe to be followed immediately by hosting a video game-themed birthday party with 11 fourth-grade girls. While still jet-lagged.  Then more business stuff, then more family stuff.  You know, busy.  So I’ve been remiss in posting here and somehow the longer I don’t the harder it is to get started again.

During a layover at the Paris Charles de Gaulle airport I found myself defending progressive taxation. We were discussing Ron Paul and his flat tax, and my companions were exactly the type of people who tend to argue for regressive taxation: engineers and nerds. These men grew up in very middle class neighborhoods with nice parks and well-stocked libraries, went to very white schools with programs for gifted and talented students, took advantage of publically funded work experience programs that grounded them in science and technology, and earned their degrees from state universities. In short, the very people who have benefited most from strong public institutions seem to be most confused about how those services should be funded.

They are a microcosm of the red-state phenomena.  As “D” verifies for Alaska – hotbed of Ron Paul supporters – federal tax money flows into this libertarian stronghold at a rate of 2:1 relative to tax revenue, and yet they all still think that they are self-sufficient cowboys. It’s one thing to live like a king; it’s another entirely to ignore who’s paying.

To start to correct this situation, first of all let me clarify a very common misconception. No one in this country is taxed for being wealthy. The income tax is – as its name implies – a tax on income. Bill Gates could choose to never pay another dime in income tax by making his income zero. He could simply consume his vast fortune while donating any interest or capital gains to charity. Conversely, if an artist without a penny to her name were to sell a sculpture for 100,000 dollars, she would pay the same tax as a fully employed engineer with a 100,000 dollar salary. It doesn’t matter that she lives in her car and eats raw ramen noodles and he has a million-dollar house and a speedboat.

(All you CPA types who have starting thinking about amortizing losses: stop it. You’re missing my point.)

Of course net worth and income are mostly correlated, but it’s important to understand that when people say “tax the rich” this is just shorthand. It would be more accurate to say “tax each incremental level of income at a higher rate,” but that doesn’t really roll off the tongue.

The second critical point is that not all income has the same value. The first 25,000 dollars you earn is far more valuable to you than the second 25,000. Without the first you’re living on the street and eating out of trash cans; without the second you’re living in a squalid studio apartment but at least you’re independent. Without the third you can’t get each of your children their own computer, without the fourth you can’t take that trip to Europe, and so forth. Since every increase in income has – in a very real sense – less value to the person earning it, it can ethically support a higher rate of tax.

But the best way to think about progressive taxation is to consider it as a usage fee. The conventional wisdom suggests that low-income people are the biggest consumers of government largess, what with the public schools and the food stamps and the welfare and the government cheese. But that is only a fraction of federal spending. The vast majority of court cases, for example, are corporate lawsuits – one company suing another – far outnumbering criminal cases. The vast majority of damage to our highway system is caused by commercial vehicles. And even if the direct costs of a public program don’t benefit business owners (say, those not in the defense industry), the indirect results do. Without the government supporting its citizen’s welfare (in the general sense) there would be no employees to hire, no consumers to market to, and no infrastructure to support sales.

Income is a measure of how much a person has used, both directly and indirectly, public services. Those with the highest income have derived the greatest benefit from government spending, while those with lower incomes have received less benefit. People who get the most out of living in this country should pay more of the costs of keeping it going. There are certainly personal differences in ambition and ability, but these are relatively meaningless for determining taxation. As we’ve seen, the people who believe they are self-made are actually not, and the debt they owe should be paid back when they make good.

- jack*

Comments

[gudden]

An excellent start at the challenging task of correcting misbeliefs about progressive taxation.

Another point that always seems like it should be convincing to flat tax proponents, and yet rarely is: One desirable characteristic of any tax, or so I was taught, is that it create a minimal distortion of incentives. This, I think, what is implicitly at play in the majority of anti-progressive tax sentiment, from Laffer-curve based arguments to that great tantrum of libertarian wish-fulfillment fantasy, Atlas Shrugged. That is, if you take away more of someone's money the more they make, you distort their incentive to make more, undermining the profit motive as a drive of human creativity, industry, etc. But behavioral science (not to mention our friends the Austrian economists) tells us something pertinent: value is subjective. When it comes to income, each dollar added loses a little subjective value. Some studies of perceived happiness find income thresholds -- in the low hundreds of thousands of dollars is one I remember -- beyond which additional income correlates poorly with increased happiness. Even without particulars like that, the general principle is certainly and obviously true; $100 dollars has vastly different subjective value to a poor man and a rich one, and vastly different actual power to affect each man's life positively.

The significance of this is that progressive taxation of income is a powerful tool for minimizing the distortion of incentives across the entire tax regime. Because increasing income has progressively less subjective value, increasing proportions of it can be paid as taxes without causing distructive distortions. And since a progressive income tax can raise so much more revenue than a flat income tax, it can reduce the pressure to turn to other forms of taxation, with entirely different distoring effects on behavior, in order to generate the same revenue.

Or so my thinking goes, anyway. Hope you don't mind the blathering, I quite enjoy your blog.

[jack*]

Your point about incentive distortion is an excellent expansion on the same theme, and your "tantrum of libertarian wish-fulfillment" made me laugh out loud. Feel free to blather anytime!