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Injecting Some Honesty into the Tax Cut Debate

e21 | 10/26/2010 |

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When making the case for his plan to increase the top two personal income tax rates, President Obama tends to downplay the fact that taxes will rise for anyone making more than $208,850. Instead, he focuses on the impact of the tax change on the households at the very top of the income ladder. At a recent town hall meeting, the President explained that 85% of the revenue lost from extending current tax rates would go to the benefit of “millionaires and billionaires.” In a recent speech in Richmond, Virginia, the President went a step further, claiming that the extension of the top two tax rates would benefit people who are “typically millionaires and billionaires.” The President’s obvious intention is to distract voters from the rather large swath of income between $208,850 and $1 million and instead point to the benefits received by what he calls the “wealthiest Americans.”

The claim that the “typical” household impacted by the proposed tax increase is a millionaire or billionaire is false. According to most recent IRS data, of the 4.375 million taxpayers with gross income above $200,000, 4.054 million (93%) make less than $1 million. It’s difficult to see how “millionaires” typify those households in line for a tax increase since they account for just one-in-14 of the households with gross incomes above $200,000. However, the President could argue that this language was not incorrect, but simply imprecise, because the impact of the tax increase would be borne disproportionately by households with income greater than $1 million. The 85% figure the President cites comes from the Tax Policy Center (first table on page 2), which shows that the average tax increase for households with incomes over $1 million would be nearly $50,000. By contrast, households with income between $500,000 and $1 million would pay only about $4,000 more, on average.

A close look at the distributional consequences of raising taxes seems to provide ephemeral support for the claim that extension of current tax rates is a “giveaway to the rich.” The problem with this construction is what is meant by both “giveaway” and “rich.” A giveaway implies that imposing a lower rate of taxation on a household’s income is equivalent to mailing that household a check, as though they won the Publishers Clearinghouse sweepstakes. While some progressives undoubtedly feel that’s true, the analogy ignores that the household has to engage in some form of economic activity to generate the income; at the very least, the household cannot access the “giveaway” without first providing substantial amounts of investment or value-added labor to generate the income necessary to be in that tax bracket.

Designating high-income households as “rich” also mistakes correlated, but distinct, economic phenomena; wealth is a “stock” statistic, while income is “flow” statistic. Wealth is calculated as household net worth: the sum of all of the household’s physical and financial assets net of liabilities like mortgages, car loans, and other kinds of debt. Income relates to the amount of cash generated (or recognized) that year. A 72-year old widow with a $3 million net worth and $100,000 of interest and Social Security income should be thought of as “rich,” while a two-earner household in their early-40s with a $75,000 net worth (after accounting for student loans and other debts), three children, and a combined $350,000 income probably should not. A recent New York Times article spent time discussing what level of income made someone “rich” without considering that income itself was a flawed measure of the construct.

It is no accident that proponents of tax increases insist on describing high-income households as “wealthy” or “rich.” They are perfect foils to the term “working class” because they imply idleness and leisure. But this is exactly backwards: the households in the top two tax brackets have such high incomes precisely because they tend to work far more and have more specialized work skills. Since income is derived from labor and investment (with the investment income coming from savings generated by previous labor income in excess of consumption expenditures), it is not surprising that income and the number of hours of labor supplied would be positively and tightly correlated. When one thinks of what it means to be “high income” rather than “rich,” the kinds of households one could imagine being impacted by the tax increase are those with two earners who work as doctors, lawyers, and business professionals, tend to live in high-cost metropolitan areas, and happen to be in their peak earnings years.

As a Tax Foundation analysis of Census data shows, this is precisely the impacted demographic. Households in the top two income-tax brackets are nearly three times more likely to have two earners, tend to work 27 hours more per week, on average, than households in the other tax brackets, and are 60% more likely to be headed by a worker between the ages of 45 and 64. These households are nearly 50% more likely to live in a metro area with a population of greater than 2.5 million, are nearly four times as likely to be headed by a worker with a graduate degree, and are more than twice as likely to be headed by a worker in the financial services, health care, or professional services industries. In short, taxpayers impacted by the tax increases tend to have high skill levels, work in competitive, high-value added jobs, and spend much more time working than other households.

Establishing the economic character of these households is not done for rhetorical purposes, but rather is explored here to establish the economic case against tax increases. Were these households idle, the economic cost of tax increases on “millionaires and billionaires” would be much more manageable, as it would largely consist in some shifts in consumption and investment (into tax-exempt bonds, etc.). But because of the amount of labor supplied by households in the top two percent of the income distribution is so great, so too is the likely impact of increasing the government’s share of each dollar of incremental income they earn.

Tax increases would cause these households to reduce their supply of investment and labor and result in a smaller economy, all else equal. Some analysts scoff at the notion that highly paid employees would actually work less in response to a tax increase. Certainly the caricature of the Fortune 500 CEO who looks at the updated IRS tax table and decides to cut back on his hours misses the point entirely. And since the bulk of business executives are salaried, a reduction in hours would not result in any immediate fall in taxable income. The channels through which the tax increase exacts its economic costs are more subtle.

First, the adjustment most obviously falls on second earners, whose income is taxed at the couple’s marginal tax rate. A second earner who sees a $50,000 reduction in after-tax income may have second thoughts about continued work, especially when the couple would continue to have a high income on one salary. The empirical results suggest this effect is rather strong, as marginal tax increases reduce second earners’ workforce participation.

Second, salaried professionals who depend on bonuses for a significant portion of their compensation can choose more leisure if the after-tax pay associated with the late nights or Saturdays at the office is much lower than it once was.

Third, high-income households report 83% of all partnership and S-corporation income. These businesses pay no tax at the entity or “corporate” level. Instead, these businesses’ earnings are included in their owners’ gross income and taxed at the individual level. In many cases, high-income households are the operators of these small businesses. In other cases, these households are the investors who provide the capital that allowed the business to start or grow. In both cases, the attractiveness of devoting discretionary capital to these kinds of inherently risky ventures is inversely related to the tax rate applied to the income, if any, generated by the business. The choice between investing $50,000 in the business of a local software entrepreneur instead of using the same $50,000 to buy a new car is conditioned on the expected after-tax income to be derived from the investment.

The cumulative effect of the behavioral changes in response to the tax increase affect far more households than those in the top two brackets. The decision of a second earner to leave the workforce could result in a reduction in the enrollment at a daycare, which reduces the income of the child-care worker. The taxpayer no longer spending time at the office on Saturdays could be inclined to pursue home improvement projects, depriving the contractor of income that would have come from building the new deck or repainting the home. And, most obviously, the increase in tax rates could deprive entrepreneurs unable to tap public markets of the risk capital they need to start or grow their business. The cumulative economic costs are large and are borne by households whose adjusted gross incomes are nowhere near $1 million.

The President’s rhetoric on the tax increase debate is unfortunate. At every opportunity, he has left audiences with the impression that his proposal amounts to simply canceling payment on checks scheduled to be delivered to a few hundred thousand yachts next January. Rather than making the economic case for the tax increases, the President has chosen instead to focus on labels like “millionaires and billionaires” and the “wealthiest two percent” of Americans. Closer analysis of impacted households reveals a demographic and economic impact far different than the one implied by President Obama.


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