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How 'progressive' do we want to be?

January 30, 2009

Our favorite champion of highly-progressive income taxation returns to our comments section after a long break. Erich critiques yesterday's post on the top 400 tax returns by AGI:

First, he notes:

Alas, you may have missed the most salient point! The average tax rate of 17.17% in 2006, down from 26.38% in 1992.
I pray these people get the tax relief we know they deserve! Lest we return to the turmoil of 1999, when the average tax rate was 22.23%! Heavens, no!

He then helpfully adds:

My apologies. Obviously, the 1.77% stat you cited appears next to the fact that this represents 17.17% of AGI, so you did not miss it, you ignored it.
Carry on, top 400 taxpayer advocate!

Can't slip one by old Erich! The low effective rate, of course, is explainable by simple arithmetic. As we noted, the biggest single income component in the top 400 returns is capital gains. As they are taxed at a top rate of 15%, that dramatically brings down the top rate.

This reduction in the effective rate for the very highest-income taxpayers has been noted before, most famously by David Cay Johnston. It begs the question: is this a problem?

There seems to be a widespread belief that low capital gain rates are a good thing. The top capital gain rate was lowered to 20% (from 28%) during the Clinton administration, which also increased the rate on ordinary income to 39.5%. The Bush administration lowered them further, to 15%.

It's to be expected that the biggest capital gains, the ones that push you into the top 400 returns, only happen once in a lifetime - say, when you sell your business or take it public. As the Tax Policy Blog notes, 73% of the returns in the top 400 are only there once in the 15-year period measured. As long as you have favorable capital gain rates, the very top income returns will normally have a lower effective rate than the merely wealthy.

The highest effective tax rate is for the top 1% of returns below the top 400 or so filings. Their average tax rate is around 22.79%. Erich is clearly moved by this injustice to the top 1% of taxpayers, whose AGI starts at $388,806 in 2006. The top rate goes down from there, with an average rate of 17.48% for the top 2-5% of filers, and a 12.6% rate for the top 6-10% of filers. You can see the details here.

To raise the effective rate of the top 400, you would have to make a major tax policy change in the taxation of capital gains. In effect, you would say capital gains should be taxed at a lower rate, except when they really matter, unless you oppose a capital gain break for everyone.

I don't know what Erich considers as the ideal top rate, though I suspect he might begin to be satisfied with 55% marginal rates, like Linda Beale.

I'd prefer to broaden the base and lower the rate for all income. Lower rates lower the stakes for loopholes and enable taxpayers to make decisions for business reasons, rather than tax reasons. It takes the government out of the decision loop - which politicians don't like, as it weakens their power and their ability to raise funds to carve loopholes. I like the Tax Foundation's idea of a broad based system with a 9% rate on all income that would raise as much revenue as the current system. But if we must be progressive, this broad system could stand 5% and 15% brackets. And no capital gain preference.

Tags: statistics of income.top 400.