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COMPASSION FOR THE SIX-FIGURE EARNERS

October 09, 2007

The TaxProf linked to the Tax Foundation's report on the progressivity of the income tax, the report we mentioned here. The TaxProf's post has generated over 30 comments so far, one of which asked "What are the numbers as a % of income (rather than absolute dollars?"

Excellent question. The full Tax Foundation report has this table that answers it:

Click to enlarge

The top 1% paid an average income tax rate of 23.13%, contrasted with a 12.45% rate for all taxpayers and a 2.98% rate for the bottom 50% of taxpayers. The adjusted gross income cutoff for the top 1% was $364,657 for 2005; the top 5% cutoff was $145,283.

Another TaxProf commenter referred to a "rebuttal" of the notion that the income tax was highly progressive by pointing to this Kevin Drum post at Washington Monthly. He uses a picture to illustrate his point:

This chart originally appeared in the New York Times, using data from the Tax Policy Center. Click to enlarge.

So the tax system is moderately progressive until you get up to the 5,000 richest people in the country, at which point it becomes regressive.

However, this includes only federal income tax and payroll taxes. It doesn't include excise taxes, state income taxes, sales taxes, or property taxes. If you add in all that stuff, things get even flatter.

The lower rates for the "top 5000" echoes the observation that New York Times tax reporter David Cay Johnston has made. The question is - is this really a problem, and if so,can it be fixed without causing more damage to the tax law and to other taxpayers than it is worth?

To understand why the top 5000 taxpayers would pay at a lower rate, you have to look at the items of income that generate lower tax rates: dividends and capital gains. Almost certainly these items, which have a top rate of 15%, make up a bigger portion of income for the "top 5000" than for other taxpayers.

Of these top 5000, there will be two sets of taxpayers. Some are the Bill Gates of the world, who receive large chunks of annual dividend income and will be in the top 5000 every year. Others are in the top 5000 only once in their life, when they sell a business they have built up for a large gain, taking advantage of the reduced capital gain rates.

So the obvious way to increase the tax rate on the top 5000 is to tax capital gains and dividends as ordinary income. There are several problems with that approach. One is economic; while it certainly isn't undisputed, there is a lot of sentiment that high capital gain rates are bad for the economy. That's why even under the Clinton administration, there was always a capital gain rate break (though not a dividend break).

Another problem is that dividends and capital gains represent a second tax on the same income. Dividends are paid by corporations that have already paid their own corporation income tax when they've earned the income; combining the 15% individual rate with the 35% corporate rate gives you a 50% rate, which doesn't look quite so attractive. Capital gains are often also a second tax, if they represent a sale of a C corporation. By excluding the 35% corporate rate, these figures understate the real effective rate on this income.

Finally, these breaks aren't just for the top 5000. The little guys that Kevin Drum worries about, with incomes from $100,000 to $200,000, also use these breaks, so to "equalize" the top 5000, you'd still hurt these folks.

Mr. Drum is obviously right that the income tax isn't the only tax. Still, it's hard to argue that much more can be done in the way of "middle class" income tax breaks, as statistically the middle class already pays a very low federal income tax. Unless, of course, you define "middle class" to include six-figure incomes.

But who knows? Maybe the country is ready for a revolt of the Volvo drivers against the Ferrari set.

UPDATE: This post initally failed to correctly attribute the chart above. It originally appeared in a New York Times piece by David Cay Johnston. I apologize for the misattribution, now corrected above.

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