Thursday, July 19, 2007

Do the rich pay their fair share in taxes?


Do the American rich pay their fair share in taxes?
By N. Gregory Mankiw
July 16, 2007 | International Herald Tribune

Do the rich pay their fair share in taxes? This is likely to become a defining question during the U.S. presidential campaign.

At a recent fund-raiser for Hillary Clinton, the billionaire investor Warren Buffett said that rich guys like him were not paying enough.

Buffett asserted that his taxes last year equaled only 17.7 percent of his taxable income, compared with about 30 percent for his receptionist.

Buffett was echoing a refrain that is popular in some circles. Last year, Robert Reich, labor secretary during the Clinton administration, wrote on his blog that "middle-income workers are now paying a larger share of their incomes than people at or near the top."

"We have turned the principle of a graduated, progressive tax on its head," Reich added.

These claims are enough to get populist juices flowing. The problem with them is that they don't hold up under close examination.

Recent calculations by the Congressional Budget Office of U.S. tax rates show a highly progressive system. (The numbers are based on 2004 data, but the tax code has not changed much since then.) The poorest fifth of the population, with average annual income of $15,400, pays only 4.5 percent of its income in federal taxes. The middle fifth, with income of $56,200, pays 13.9 percent. And the top fifth, with income of $207,200, pays 25.1 percent.

At the very top of the income distribution, the CBO reports even higher tax rates. The richest 1 percent has average income of $1,259,700 and forks over 31.1 percent of its income to the federal government.

[We must also keep in mind how much we pay in state and local taxes. When you take those taxes into account, then taxation is much less progressive. As the conservative Tax Foundation reported in April 2007:

"For the bottom 40 percent of households, property taxes, payroll taxes, and state/local general sales taxes was each a larger hit on households than the federal individual income tax.

"The federal individual income tax is much more progressive than state/local income taxes. As a quick illustration, for every dollar in federal individual income taxes paid by the middle income group, the top quintile paid $7.86 in federal individual income taxes. At the state/local individual income tax level, that number was $5.36."

The NYT reporter who broke the story that Enron was not paying any taxes thanks to offshoring, and author of the book "Perfectly Legal," David Cay Johnson goes even farther. He has said repeatedly that if you add up all U.S. sales taxes, Medicare taxes, social security taxes, unemployment taxes, gasoline taxes, excise taxes, etc., the top 20 percent of Americans pay about 19 percent of their income vs. 18 percent by the poorest 20 percent. In other words, for top and bottom 20 percent of Americans we already have a flat tax.

Moreover, the completely different tax systems for taxing wages vs. capital allow owners of capital to delay payment of taxes for 30 years or more. The straight percentages don't tell you about that. Tax deferred is tax unpaid, thanks to the time-value of money. – J]

One might wonder how Buffett gets away with a tax rate of only 17.7 percent, while a typical millionaire is paying so much more. Most likely, part of the answer is that Buffett's income is made up largely of dividends and capital gains, which are taxed at only 15 percent. By contrast, many other top earners pay the maximum ordinary income tax rate of 35 percent on their salaries, bonuses and business income.

The distinction is crucial for understanding how much the rich pay. Indeed, the share of top incomes coming from capital is much lower now than it has been historically. According to Emmanuel Saez, an economist at the University of California, Berkeley, for the richest Americans - those in the top 0.01 percent of the distribution - the percentage of income derived from capital fell to 25 percent in 2004 from 70 percent in 1929.

If your image of the typical rich person is someone who collects interest and dividend checks and spends long afternoons relaxing on his yacht, you are decades out of date. The leisure class has been replaced by the working rich.

Another piece of the puzzle is that Buffett's tax burden is larger than it first appears, because he is a major shareholder in Berkshire Hathaway.

When the CBO studies the tax burden, it includes all federal taxes, including individual income taxes, payroll taxes and corporate income taxes. In its analysis, payroll taxes are borne by workers and corporate taxes by the owners of capital. For the richest 1 percent of the population, 9.3 percentage points of their 31.1 percent tax rate comes from the taxes that corporations have paid on their behalf. The corporate tax would undoubtedly loom large if the CBO were to calculate Buffett's effective tax rate.

[So… what difference does that make to Warren Buffett? We've already seen that top CEOs are more than willing to make a quick buck at big corporations, then exit the company after a few years with a huge "golden parachute" compensation package. Why should it bother them that the company is paying taxes on their behalf? – J]

None of these calculations, however, say whether the rich are paying their fair share in the United States. Fairness is not an economic concept. If you want to talk fairness, you have to leave the department of economics and head over to philosophy.

[True enough. Fairness is a partly a "gut" judgment. But we can also look at the growth of the economy vs. growth in average wages and net worth. If the economy is growing like it is now, but wages and incomes are stagnant in real dollars, then something is wrong. The tax system is probably not fair. Personally, I believe that just as the Fed regularly interferes in the market to control interest rates, tax rates on income and capital gains should be regularly adjusted in relation to how well the economy is paying dividends for average workers. Sometimes tax cuts may be just the thing; and other times, they may be dead wrong. But tax cuts are definitely not a panacea. – J]

The quintessential political philosopher of modern liberalism is John Rawls, the author of the 1971 classic "A Theory of Justice." Rawls concluded that the primary goal of public policy should be to redistribute resources to help those at the very bottom of the economic ladder. If Rawls were alive today, he would most likely want to raise the top income tax rate of 35 percent in order to finance a more generous safety net. And for much the same reason, he would probably raise taxes on the middle class as well.

Rawls would get a vigorous debate from his Harvard colleague, the libertarian philosopher Robert Nozick. In his 1974 book, "Anarchy, State, and Utopia," Nozick wrote: "We are not in the position of children who have been given portions of pie by someone who now makes last-minute adjustments to rectify careless cutting. There is no central distribution, no person or group entitled to control all the resources, jointly deciding how they are to be doled out. What each person gets, he gets from others who give to him in exchange for something, or as a gift. In a free society, diverse persons control different resources, and new holdings arise out of the voluntary exchanges and actions of persons."

To libertarians like Nozick, requiring the rich to pay more just because they are rich is little more than officially sanctioned theft.

There is no easy way to bridge this philosophical divide, but the political process will, inevitably, try to forge a practical compromise among those with wildly divergent views. At the 2000 Republican National Convention, the candidate George W. Bush made clear where he stood: "On principle, no one in America should have to pay more than a third of their income to the federal government." As judged by the CBO data, he has accomplished his goal.

N. Gregory Mankiw is a professor of economics at Harvard. He was an adviser to President George W. Bush and is advising Mitt Romney, the former governor of Massachusetts, in the campaign for the Republican presidential nomination.

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