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The Paradox of "Taxing the Rich"

e21 | 04/02/2012

The share of income taxes paid by the top 1% of income earners has hovered at around 40% for the past several years. This is the highest share in the history of Internal Revenue Service (IRS) tax statistics and due largely to the progressivity of the tax system rather than income concentration. Since 2004, the pre-tax income share of the top 1% has been around 20%. This means that the share of income taxes paid by the top 1% is about twice as large as their share of income. Even when including all federal taxes, including payroll taxes that are paid back to contributors in the form of Social Security and Medicare benefits, the tax share of the top 1% is still about 50% greater than its income share.

Despite the fact that the top 1% is contributing a disproportionate share of tax revenues (however defined) relative to income, the Occupy Wall Street movement believes that increasing tax rates on the “rich” should be a top domestic policy priority. So, why the disconnect?

First, as e21 explained previously, it partly reflects a mistaken understanding about the “income share” of the top 1%. The share of income captured by the top 1% is somewhat meaningless because “the 1%” is a different collection of 1.2 million (or so) households each year. Treasury data makes clear that a household in the 1% today has less than a coin flip’s chance of being in the top 1% ten years from now. The income growth of the top 1% is a statistical illusion because different households (summing to well over 1% of the population) share in those income gains.

Perhaps more significantly, the clamor for higher taxes on the “rich” reflects a paradox of tax policy: the lower the rate, the more income gets reported. The income statistics that analysts use to assess inequality depend critically on the way taxpayers choose to organize their businesses and the types of assets they hold in their portfolios. Income reported on tax returns can tell us very little about wealth or income disparities because it is partly a function of tax policy. When rates on a certain form of income are punitively high, the value of tax-planning services increases. Tax planning is the use of legal and accounting advice to structure businesses or investments in such a way as to minimize total tax liability. The effect of tax planning is to reduce the amount of income that gets reported in high tax brackets or income categories.

Income disparities today are attributable, in part, to lower tax rates, which have reduced the marginal benefit of tax planning. If Congress responds to the large increase in the incomes reported by the rich by increasing tax rates, tax planning services will increase in value, causing measured income inequality to decline because of the reduction in the amount of income that gets reported in higher tax brackets. For this reason, those who seek to dramatically increase taxes on the rich are setting themselves up for a Pyrrhic victory, as the rich respond to the tax increase by relying more on deductions and reducing the share of their income that’s received in a taxable (and high rate) form. As Martin Feldstein’s research uncovered, the 1993 Clinton tax increases reduced the amount of taxable income reported by high-income taxpayers by 7.8%. The reduction was tied to an increase in “deductible consumption,” such as spending more on housing by taking out a larger mortgage or accepting more nontaxable fringe benefits like a more generous health insurance policy at work. The tax increase also caused more investments to be shifted into low-or-no-tax form, like municipal debt.

Average Income, Top 1%

 19792007Annualized Growth Rate
Business Income$64,714.18$328,416.976.0%
Interest Income$30,491.80$88,607.263.9%
Capital Gains$56,605.88$229,119.835.1%

Piketty, Thomas and Saez, Emmanuel (2007). "Income and Wage Inequality in the United States 1913-2002"; in Atkinson, A. B. and Piketty, T. (editors) Top Incomes over the Twentieth Century. A Contrast Between Continental European and English-Speaking Countries, Oxford University Press, chapter 5.

To understand the distinction between forms of income and their impact on measured income disparity, consider the composition of the top 1%’s income in 1979 compared to 2007 (the peak of the most recent business cycle). In percentage terms, the category that witnessed the largest increase was business income, which grew at a compounded annual rate of 6%. Did the top 1% become more entrepreneurial during this period? Probably not. The growth was more likely a function of changes in tax policy that made “flow-through” business income more tax-advantaged.

When forming a business, entrepreneurs can choose to incorporate as a “C” corporation or form a partnership, limited liability corporation (LLC), or S-corporation. A “C” corporation pays taxes at the corporate income tax rate, while the income of the other business entities “flows through” to the owners where it is taxed at the individual rate, whether the income is actually distributed to owners or not (i.e. retained earnings are taxed at the individual level). In 1979, the top individual rate was 70%, while the top corporate tax rate was 46%. The differential in tax rates led business owners to prefer to organize their businesses as “C” corporations, in which case the net income earned by the business would not show up on the owners’ individual tax returns. In 1980, C corporations accounted for more than 85% of total business receipts and nearly 80% of total business net income.

The elimination of the tax differential (both top rates are now 35%) made it far more attractive to organize as a flow-through business. Between 1979 and 2007, the share of business income reported by “flow-through” businesses like partnerships and LLCs more than doubled. By 2004, flow-through businesses accounted for over 50% of all business income and this share continued to grow. Nearly all of the increase has come in the top tax brackets, which Treasury estimates to account for over 70% of flow-through business income and more than 80% of the taxes on flow-through business income. In 2007, the Treasury Department estimated that 75% of the taxpayers in the top tax bracket reported business income and 84% of the tax benefits from a top rate of 35% instead of 39.6% that went to flow-through business owners.

Consider the impact of this tax change on income disparity: income inequality has risen because business income once reported at the corporate level is now being reported at the individual level. Consider a hypothetical business worth $25 million with $10 million in net income. In 1980, this $10 million would have been more likely to be reported as the income of a C corporation, which would make the personal income of the owner seem lower than if that income flowed through directly to the owner’s tax return, as occurs with LLCs and S corporations. But in both situations, the economic reality is the same: the taxpayer is the owner of a $25 million business that generates $10 million in net income.

Had the tax system continued to favor keeping retained earnings inside of C corporations, the reported income of the top 1% in 2007 would have been more than 10% lower, not because of any change in economic reality, but simply because less business income would have been reported at the individual level. (This assumes that reported business income would have grown at the same rate of wages. Although the capital gains on the C corporation stock might be realized and increase capital gains income, such transactions could be avoided by using the stock as collateral for secured loans to finance consumption expenditures.) By incentivizing business income to be reported in “C” corporate form, a large tax increase on the top 1% would also increase the use of internal cash for business investment, which would increase the deferral of personal taxes from dividend and interest income. This means that income that could otherwise have been reallocated by owners for more productive investment gets trapped inside of the corporation because of tax impacts. The net result would be less reported income disparity, less tax revenue from the top 1%, but no material change in the underlying economic circumstance.

The same result could be observed from the reporting of capital gains income. Capital gains are only taxed when realized. The higher the tax rate, the more powerful the incentive to avoid realizations. A “Buffet rule” or similar device to increase the capital gains tax rate on the top 1% would lead to economically damaging “lock-in effect,” where capital is not allocated to its most efficient use because of the tax disincentive to liquidate an existing investment. (A related issue is the elaborate tax-planning schemes where some investors use derivatives to replicate a sale without triggering tax liability.)

Capital gains loom so large in the taxable income of the top 1% that changes to the tax rates on this source of income can swing average income of the top 1% wildly from year-to-year. When the capital gains tax preference was eliminated in 1986 for tax years beginning in 1987, the average income of the top 1% increased by 35% in 1986 and declined by 24% in 1987 as the new tax went into effect. Similarly, when capital gains taxes were reduced to 15% in 2003, the average income of the top 1% increased by 18% the year after the new capital gains tax took effect. There was no change in the wealth of these taxpayers in these circumstances; the only difference is whether that wealth was liquidated and triggered a tax payment. Thus, increasing taxes could meaningfully reduce realizations, capital gains income, and reported income inequality, but lead to reduced revenues without doing anything to change the underlying economic reality.

Finally, consider the impact of the dividend tax reduction in 2003, which the Obama Administration proposed to undo in this year’s budget. Bush’s proposal earlier in the decade to eliminate the tax on dividends was actively opposed by municipalities because it meant the tax-exempt municipal debt market would face competition from stocks. Even when Congress only agreed to cut the rate down to 15%, there was a dramatic increase in the share of income (on average) of the top 1% reported as dividends from 4.2% in 2002 to more than 8.5% in 2007. This was not likely the result of these taxpayers actually receiving more net income, but simply the product of a shift in the portfolio from municipal debt to dividend-paying stocks. Increasing taxes on dividends now would almost surely cause portfolios to revert back to tax-exempt municipal bonds, which would reduce the average income of the top 1% by nearly 5%, but, again, do nothing to change economic reality.

Low rates on high income earners generate more reported income equality, which, paradoxically, serves as a rationale for higher rates. Proposals to increase tax rates on the income of the top 1% would inevitably lead to a sizeable reduction in income reported in those categories where the tax rate is raised. In response to a tax increase, reported income would be shifted to new categories, investment portfolios would shift to tax-favored assets, and consumption towards tax-deductible items like housing, health care, and renewable energy. This may reduce reported income inequality, but could actually lead to less revenue (depending on the tax rate), and would almost certainly do little to change substantive wealth disparities across households.