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The Progressive Income Tax




























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"...you can put me on record as saying that your arguments on tax policy are among the best that I've seen..."


Cornell University's Robert H. Frank--Author of: Luxury Fever: Weighing the Cost of Excess (2010), The Economic Naturalist: In Search of Explanations for Everyday Enigmas (2008), The Principles of Economics (2001), The Winner-Take-All Society: Why A Few at the Top Get So Much More Than the Rest of Us (1995), Microeconomics & Behavior (1991), Passions Within Reason: The Strategic Role of the Emotions (1988), Choosing the Right Pond: Human Behavior and the Quest For Status (1987)

THE PROGRESSIVE INCOME TAX

Theoretical Foundations






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Introduction

The Progressive Income Tax has an impact on the welfare of an economy's participants that few people understand.  This is because most economists have overlooked the impact that an across-the-board change in disposable incomes will always have on market prices.  In this article, we review the merits of the Progressive Income Tax from an analytical perspective that fully incorporates the impact of this crucially important variable.

Our analysis leads to some conclusions that many will perhaps find stunning:

  • Even a steeply progressive income tax---right up to 99% on the highest incomes---would impose no loss of purchasing power on wealthy income earners

  • Reducing the income tax rates of rich citizens will weaken the economy if Congress cuts spending to pay for the tax cuts

  • Increasing the amount of taxes collected from wealthy citizens will actually provide a stimulus to the economy
  • The rich cannot get richer---in real terms---by getting their taxes cut, but they can become richer if they pay more in taxes

  • The government is a major producer of Real Wealth

  • An increase in the size of government is almost always quite desirable

  • Wealthy citizens who are wise should be lobbying for an increase in government spending and an increase in their tax rates


Flawed Logic

We begin by focusing on a certain type of logical fallacy, one which bears primary responsibility for the failure of many economists to recognize the supreme wisdom of the Progressive Income Tax. The FALLACY OF COMPOSITION is an error in logic that observers make when they mistakenly assume that all the members of a group will benefit from a certain behavior if a single individual clearly appears to benefit from that behavior.  In economics, there are many times when that assumption is simply false...

  • During a recession, it is prudent for an individual---who doesn't know if she will have her job four months from now---to postpone purchases of durable goods, avoid taking on new debt, pay off old debt, and save for new purchases.  But unfortunately, if everyone were to do that, the recession would quickly become much, much worse.

  • In an economy where there is significant and gradually accelerating inflation, it would be wise for an individual to borrow money to pay for purchases today, and then pay off that debt with cheaper dollars in the future.  But if everyone were to do that, the inflation would simply get much, much worse.

  • An individual firm, in an effort to expand market share at the expense of its competitors, might be inspired to cut prices.  But what happens if all of them do the same thing?

  • Saving money is always a good thing, right?  But what if everyone started saving for all of their purchases and no one ever again borrowed money?  One of the celebrated benefits of saving money---earning interest income---would disappear.  It turns out that savers need borrowers if they want to benefit optimally from saving money.

More often than people realize, it is exceptional behavior that is rewarded by the economy.  Let's consider one more hypothetical example:


Lottery winners vs. "Everyone a Millionaire!"

When individual lottery winners collect their millions, they enjoy a dramatic increase in their purchasing power.  Suddenly, they are able to make a claim on the scarcest goods & services that the economy makes available.  But what if our politicians in Washington were to decide one day to simply hand out a million dollars to every household in America?  We’d all be able to share the same great experience of luxury living then, wouldn't we?  Well...no.

Economists understand that such a plan would simply cause an explosive round of inflation.  Over a fairly short period of time, the price of everything would skyrocket dramatically.  After the hyperinflation had finally run its course, there would still be the same number of rich and poor and middle class citizens in the country as there were before the million-dollar gift was distributed.1  Why?  Because the amount of goods & services that would be available in the country the day after the million dollar giveaway would be essentially the same as the amount that had been available the day before.

The end result?  The same quantity of good & services would be consumed as before, just purchased at dramatically higher prices.  In real terms, there would be no overall improvement in the standard of living of the citizenry because it is not money, itself, which gives us our standard of living, but only the real goods & services that people are able to obtain with their money.  An increase in the amount of money that everyone has to spend will only improve everyone's quality-of-life if a general increase in production occurs at the same time.

From this example we can derive a couple of important points.  An increase in your disposable dollar income will give you an improvement in your standard of living only if one of the two following conditions is also a reality:

  • Relatively few others get the same increase in disposable dollars that you got, or

  • There is an actual increase in the available quantity of those things you would want to buy with your extra dollars

The Progressive Income Tax is widely misunderstood today because people do not realize that it collects money from taxpayers in a way that always preserves every citizen's purchasing power.  Each is spared the decline in purchasing power she would otherwise have experienced if only she had paid the tax.  This will become clearer as we look more closely at how markets respond to widespread changes in dollar-expressed demand.

 

How Markets Respond To Tax Cuts

An income tax cut is a compound event.  Its ultimate impact on taxpayer welfare is attributable to two separate effects:

  • The Purchasing Power Effect - the impact a tax cut/hike will have on the purchasing power of a taxpayer's disposable income

  • The Supply Effect - the impact a tax cut/hike will ultimately have on the availability of goods & services in the economy

In the United States, the government is currently being run by a political party that never misses an opportunity to tell voters that they will be better off if they get another income tax cut.  When they do this, they are focusing on the purchasing power effects of income tax cuts, or at least on what they think are the purchasing power effects of income tax cuts.  They typically assume that the cuts they propose will increase the purchasing power of all taxpayer incomes because all taxpayers will clearly possess more disposable dollars.  In this section we shall question that assumption, relying on some very basic microeconomic analysis.

It is easier to conceptualize the ultimate consequences of across-the-board income tax cuts if we first assume that the supply side of the economy is "fixed."  If such were the case, it would be quite obvious to us that no actual improvement in material well-being overall would be possible for a population that receives such a tax cut.  That is to say, the outcome would be the same as that described in the "Everyone a Millionaire!" scenario above where we implicitly assumed that the supply side of the economy was unable to produce any additional output.  Taxpayers would try to obtain more 'stuff' with their extra disposable dollars, but since output cannot increase, their collective efforts would do nothing more than produce a round of price inflation.

What is the mechanism that accounts for this?  In a market economy, suppliers can be counted on to charge the highest prices that their markets will bear.  That is to say, they will charge as high a price as they can, so long as they are able to sell everything they have.  If a shortage develops in some market, sellers will raise their prices because they know that some people will be willing to pay a higher price for what little there is.  Buyers will pay the higher prices because (1) they have the money to do so, and (2) they don't want to do without.  Sellers also raise their prices if they notice that an increase in disposable incomes has occurred.  They want to get as much money as their customers are willing to pay, period.  The only way they can find out what the optimal price might be is by raising the price until they are no longer able to sell what they have.

It helps in this discussion if you understand conceptually why we say that markets auction off the scarcest goods & services to the highest bidders.  We have already noted that suppliers will always set their prices as high as they can.  Consumers who are willing and able to pay those prices get to be successful bidders.  Those who cannot afford to pay a seller's asking price will "submit their own bids" only if the official selling price is lowered to a level that they can afford.  In other words, in this kind of "auction", the only bids that are offered are those that are certain to be accepted.

If a supplier sets her prices higher than she should, she won't be able to sell all of her product.  She will then have to lower her prices to a level that more consumers find affordable.  If, on the other hand, she doesn't charge the highest price she can get from the market, she'll find that she has too many customers clamoring for the limited amount of things she has to sell.  She will then want to raise her prices until she finds out which higher price imaginable is still low enough for her to sell all of her product.

Due to the limitations imposed on us by Nature, our economy is not able to produce enough of the "best quality" goods & services so that everyone can experience them.  In a market economy, if you want to be one of those who is able to experience the rarest of economic privileges, you must obtain a level of disposable income/wealth that is high enough for you to outbid other potential consumers for them.  This is essentially why it is the distribution of income/wealth that ultimately determines who gets to experience them and who doesn't.

What is important is not the dollar wealth you are able to accumulate; it's the dollar wealth you are able to accumulate compared to everyone else.  The purchasing power of your income is determined solely by its relative position amongst all accumulations of disposable income/wealth.  Because we have a market economy, an individual can improve her claim on the scarcest goods & services only if she can improve her comparative bidding position within the hierarchy of national income/wealth distribution.

Whenever an individual household is able to increase its disposable income, its purchasing power will either increase, decrease, or not change at all depending on what has happened to the disposable incomes of all other households.  If your disposable income remains the same next year but everyone else's income declines you will actually see the purchasing power of your stagnant income increase.  Suppliers would be forced to drop their prices and you would discover that you have acquired a bidding advantage over others.  Even if your income were to drop next year, you would still be better off if everyone else's income dropped even more.

 

Rankings Within The Hierarchy Of Income Distribution

Understanding how markets respond to widespread changes in dollar incomes makes it easier to see why The Progressive Income Tax does not impose any real sacrifice on taxpayers in terms of lost purchasing power.  If there are no loopholes or special allowances written into the tax code, those who earn more pre-tax income than you end up with more disposable income than you after everyone pays their taxes.  Those who earn less pre-tax income than you end up with less disposable income than you.  The same reality holds true for every other taxpayer.  Let's look at a more detailed example of how this would work out if our top tax bracket was set at 99%.

Imagine that one year Bill Gates is the top income earner with a gross income of one billion dollars.  If all of that income were taxed at a 99% rate, he would be forced to somehow get by on 1% of a billion dollars, or $10,000,000.  Let's say that Paul Allen earns $800,000,000 in gross income that year and all of that income is taxed at a 98% rate.  This would leave him with $16,000,000 of disposable income.  Such a result would be extremely unfair because Bill would end up with less disposable income ($10,000,000) than Paul ($16, 000,000) after taxes even though he earned more than Paul in gross income.

This kind of result does not occur, however, when you employ marginal tax rates, like we do now with our current tax code.  Let's say that in our imaginary scenario the first 800 million dollars of income is subject to a 98% marginal tax rate.  That means that both Paul and Bill would pay the same amount of taxes on the first $800,000,000 of their income.  But Bill would pay more in taxes than Paul because he made an extra $200,000,000 in income.  In a marginal income tax system, Bill would pay the 99% tax rate only on that extra $200,000,000.  This would leave him with $2,000,000 more in disposable income than Paul would end up with.

What about within a tax bracket?  Well, if Warren Buffett grosses $900,000,000 the same year, he would also pay the same amount of taxes as the others did on the first 800 million dollars of their income.  He would also pay 99% on the extra $100,000,000 that he earned.  This would leave him with $1,000,000 more in disposable income than Paul ends up with, but with still $1,000,000 less than Bill ends up with.  The comparative bidding positions of all three men within the hierarchy of national income distribution would be preserved.

With the Progressive Income Tax, taxpayers do not need to be concerned about the shrinking of their disposable incomes.  They can know with certainty that prices will drop to levels they can afford if all consumers have their disposable incomes reduced in a way that preserves everyone's relative 'bidding positions.' The ultimate reason why prices must drop is because 1) there will not be enough dollars in the hands of buyers to sell everything at the higher pre-tax prices, and 2) markets work.  Smaller disposable incomes end up buying just as much as higher disposable incomes did previously.

When we began this section, we imagined that the supply side of the economy was fixed to make it easier to see why a tax cut's Purchasing Power Effect is zero.  But what if a change in supply did occur [for some other reason] following a tax cut?  Would that change anything?  Well, it turns out that a tax cut could not improve the purchasing power of any household's income in such a scenario. If an increase in supply were to occur in the months that follow an income tax cut, the larger disposable incomes that households would have would not be able to buy any more than the smaller disposable incomes that households would have had if the tax cut had never gone into effect.

If, for example, more automobiles---relative to the population---were brought to the American market by the Chinese after an income tax cut went into effect, some households would become better off in real terms because they would be able to buy cars that were not previously available.  But we can now see that the extra disposable dollars that the eventual buyers received from their tax cuts would not have been needed in order for them to purchase the extra automobiles.  If they had not received the tax cut, the number of automobiles available and the number of households in the economy would still have been the same. The comparative bidding positions of all households would still have been the same.  Markets would have simply adjusted prices to produce the same market-clearing outcome.

In any market, an increase in Supply relative to Demand will force prices down to a level that more potential customers can afford.  If the buyers in our scenario had not received a tax cut, they would still have had enough to outbid others for their automobiles because sellers are always going to want to sell any of the new product that they bring to market.  They will always adjust their prices in response to demand-side realities.  Understanding the Marketplace in this way helps us to see why it is true that even though some people may become better off following an income tax cut, the reason for it is never because they obtained more dollars from a tax cut.

In this section, we have seen why it is a misrepresentation of the truth when politicians or economists encourage voters to believe that an income tax cut will improve the purchasing power of their incomes.  We can only hope that in the future---with a basic understanding of market dynamics---voters and legislators will be able to see that an income tax cut can only benefit them in real terms if it leads to positive Supply Effects.  That is to say, if it leads to an increase in the availability of desirable goods & services.  In the sections that follow, we shall see why this is something that never happens

 

How Income Tax Cuts Affect Production

In order for us to understand the ultimate impact that income tax cuts have on the welfare of taxpayers, we need to understand both their purchasing power effects and their supply effects.  In the previous section we saw why the purchasing power effect of income tax cuts is neutral.  Let us now look at the supply effect.

One important lesson that economics students learn when they are first exposed to macroeconomic theories is that producers and retailers are strongly influenced by aggregate demand.  Assuming nothing else changes, an increase in aggregate sales (expressed aggregate demand) generally prompts suppliers to produce and bring to market more goods & services.  If it appears you can sell more, it makes sense for you to produce or obtain more product to meet increasing demand.  Thus, if we want to understand the ultimate impact that across-the-board income tax cuts have on the supply-side of the economy, we will need to understand how they affect aggregate demand.

It is no surprise that income taxes deprive taxpayers of some of the money that they would otherwise have spent on consumption.  If this reduction in consumer spending was the only consequence of taxation, we'd be forced to conclude that tax increases always have a negative impact on the health of the economy.  Why?  Because any time money is spent in the economy, it becomes someone's income (wages, profits).  Virtually all incomes earned are dependent on the spending of others.  When aggregate spending drops, there is less money available to pay those incomes, so people lose their jobs. Spending must occur in order for people to have jobs

But there is more to the story.  The only reason why governments collect tax revenue from citizens is in order to spend it.  When governments spend money, it automatically becomes income to a large number of citizens.  So instead of causing aggregate spending to drop, an increase in tax rates actually causes it to increase.  Why?  Because some of the money that people receive as income from the government---that was originally obtained from taxpayers---would have been saved, if certain taxpayers (typically wealthy ones) had not used it to pay their taxes.  When the government collects & spends money that would have been saved, it is pumping money into the economy that would otherwise have been removed from it.

This can be a very desirable outcome if your country is suffering from any kind of unemployment.  The act of saving money may not be egregiously harmful to the economy most of the time, but it can do an incredible amount of damage if it "gets out of hand."  The Great Depression, for example, occurred for one very simple reason: those who had money that they could have spent chose to save it instead, denying people jobs.  Those who would have been happy to spend that money did not have it in their possession.  It is a reality that economists summarize in the equation: Income = Savings + Consumption (spending).

This relationship between spending, saving, and jobs is important.  The only reason why there is ever any unemployment is because too much saving takes place.  The only way it has ever been possible to reduce unemployment is through the increased spending of either individuals or firms or governments.  When can we say that an economy has finally achieved its optimal level of savings?  Answer: when there is no unemployment.  When can we say with certainty that there is too little saving taking place in an economy?  Answer: when the economy is booming, there is no unemployment, and hyperinflation is threatening.  Only then will an increase in net savings not threaten jobs.

Advocates of Supply-Side economics have apparently never realized that when they recommend across-the-board income tax cuts and matching reductions in government spending, they are proposing a policy that---all else equal---is guaranteed to either cause a recession or make any ongoing recession worse.  Across-the-board income tax cuts are contractionary (assuming matching spending cuts) because wealthier recipients of income tax cuts will save some of the extra disposable income they are given.  Since not all money that is saved is lent out to borrowers, there is a net leakage of money out of the economy whenever money is saved.

Tax cut enthusiasts like to refer to tax cuts as though the incomes of other people are not dependent on the money that would be returned to taxpayers.  They suggest, instead, that everyone's tax money ends up being sucked into a powerful Black Hole known as Big Government where it disappears forever.  The truth they ignore is that even if an income tax cut were designed to give refunds only to people who would be certain to spend all of it (poor people), it would still not provide any net stimulus to the economy.  When spending-cut-dollars match tax-cut-dollars, the money that refunded taxpayers would get to spend would have been spent by the federal government anyway.  This means that no net increase in aggregate spending can occur, so there is no net increase in jobs or incomes.

A fiscal policy initiative can properly be described as expansionary only if it ends up increasing total spending in the economy.  Tax cuts by themselves cannot do that.  In spite of this fact, nearly every introductory economics textbook in America today mentions tax cuts as one of the federal government's expansionary fiscal policy tools and fails to mention that tax increases are far more effective than tax cuts in stimulating the economy when the money that is collected in taxes would have otherwise been saved.  One unfortunate consequence of this educational failure is that we now have politicians in charge of America's federal government who have cut taxes repeatedly over the past few years in the mistaken belief that they would stimulate the economy. 

The only reason why the Bush Tax Cuts did not plunge the economy into an even deeper recession is because the federal government increased its spending after Nine-Eleven using borrowed money to finance it instead of tax revenue.  Unfortunately, the stimulative effect of this increased spending was largely offset by the contractionary effect of the tax cuts.  Giving the largest share of a tax cut to rich people who are most likely to save a great deal of it is not a very intelligent thing to do when the economy is struggling to pull out of a recession.  The result has been a sputtering and long overdue 'recovery' that has created far fewer jobs than almost any economic recovery in American economic history in spite of the added benefit of historically low interest rates.

We are currently witnessing yet another failure of Supply-Side tax policy to produce the results that its advocates have always cheerfully predicted.  Their vain hopes have been driven by an almost theological belief that increases in aggregate savings will lead directly to increases in investment spending.  Many economists have encouraged acceptance of this presumed causal relationship because they've understood that---if true---such a premise would provide them with the ultimate justification of their constant efforts to reduce the tax "burden" of rich people.  With it, they've been able to depict an activity that can be very damaging to the economy (saving money) as something of a Supreme Economic Virtue.  Unfortunately, very little of this wishful thinking is true...

 

What Tax Burden?

Ultimately, taxes impose a burden in real terms when they deprive taxpayers of some of the goods or services they’d otherwise be able to enjoy if they hadn’t been taxed at all.  Our analysis has shown that if the government were to increase taxes on all citizens and then simply put that extra money in its account at the Fed (where the money could not be lent out to anyone), no burden would be imposed on any taxpayer because there would be no change in the aggregate supply of goods & services in the economy as a direct result of the tax hike.  Prices would drop until all goods & services became just as affordable to taxpayers as they had been prior to the tax cut.2

On the spending side of a tax cut event, we have learned that the economy will contract if wealthy citizens (big savers) receive an income tax cut (unless, of course, the government borrows to make up the shortfall in revenues).  If, instead, the income tax cut were given only to spenders (poor people), then there would be neither a contraction nor an expansion of the economy, since the total spending level would remain unchanged (assuming the government only spends money it has collected in taxes).  Given our pay-as-you-go assumptions, the only time we can expect a change in tax policy to increase economic growth is when the income taxes of the wealthy are increased.

Indeed, there are only a couple of tax cut/hike scenarios we can point to that actually have the potential to impose a real sacrifice on taxpayers:

  • When tax cuts are given to the wealthy and government spending is cut "to pay for them"

  • When taxes & government spending are both increased in a full-employment economy

The first scenario is one that the Bush Administration would supposedly like to carry out during the next four years.  Only the massive borrowing of the federal government has kept the economy from plunging into a recession this year.  The second scenario is one that we see only rarely. The last time it happened was during World War II. 

Once America was brought into that war, huge increases in government spending quickly used up all of the economy's excess productive capacity.  The severe unemployment problem that had plagued the nation throughout the Great Depression disappeared.  But there was still a great need for more soldiers and military hardware.  The only way the economy was able to provide more military goods & services was by employing fewer people in the production of civilian goods & services.

Any time the government wants to reallocate resources, it can do so through the marketplace by simply outbidding private sector suppliers for the resources it needs.  Most of the time, this is done indirectly.  For example, if the government uses contractors to provide for its needs, it can pay them a high enough price that they are able to outbid civilian producers for the materials and skilled labor that are needed to produce the tanks and soldiers that the government wants.  The offer of higher wages or superior benefits would persuade individuals with the needed skills to leave their civilian jobs for jobs in the war industry.

With fewer inputs available, civilian suppliers would be unable to produce as much output as they had previously.  All else equal, if fewer cars and appliances are available, their market prices will increase until some lower income earners are priced out of the market.  That is the moment when taxpayers actually make a sacrifice.  In a full-employment economy, increased government spending will---in the long run---inevitably force some taxpayers to give up some private consumption in real terms.  We note that it is not the loss of disposable dollars to taxes that imposes a sacrifice on taxpayers; it is the government's spending [that causes the reallocation of resources] that does it.

 

Revenue Questions

If the federal government needs to increase spending in a full-employment economy, how should it go about obtaining the money it needs?  We noted earlier that in a less-than-full-employment-economy it makes sense to tax savings to finance additional government spending.  Doing so provides the government with the money it needs without threatening either current consumption or investment spending.  Taxing consumption in a less-than-full-employment-economy would simply replace one type of spending (consumer) with another type of spending (government) while doing virtually nothing to reduce unemployment.  But taxing consumption is not always a bad idea.

The one time when it is unambiguously sensible for the government to tax consumption is when all of the nation's human resources are fully employed.  Taxing savings in a full-employment environment would be irrational because it could cause money that would have been saved to be spent instead.  Increasing aggregate spending in a full-employment economy has the effect of pouring gasoline on the fires of inflation.  Borrowing money instead of taxing savings would produce the same result: money that was saved ends up being spent.  The inflationary pressures that increased government spending would create in a full-employment economy could be minimized, however, if the government were to pay for the additional spending by taxing consumption instead of savings.

If Congress realizes that it should tax consumption to pay for more government spending in a full-employment economy, it has a few options to choose from.  One would be to simply increase the income tax rates of those who typically spend all of their income on consumption, i.e., poor people.  If, however, legislators believe that it's important to also discourage consumption by wealthier citizens, they could simply morph the existing Progressive Income Tax into a Progressive Consumption Tax.  If rich citizens were to balk at these "luxury taxes" and choose not to buy, then the tax policy would be working perfectly since its purpose in a full-employment economy would be to discourage consumption and encourage savings, instead.

When the economy's resources are not fully employed, there is little reason to fear that an increase in government spending could force sacrifices on taxpayers even though many of the resources needed for government projects might be currently employed by private firms.  In such a scenario, the marketplace would simply reallocate resources as the government's spending begins to outbid the spending of private sector suppliers.  If, for example, the government wants its military organizations to exploit the most advanced technologies available, it would likely need to hire some very talented individuals (either directly or through contractors) away from the private sector, where they were previously paid to create high-tech consumer goodies.

Firms that lose skilled personnel to the government would be forced to do what firms have always done when they can't afford to hire the "fully skilled" human resources that they would like to employ: they must train the most qualified people they can find.  If the 'most qualified' of those who are not working for the government work for other firms, then they could perhaps be persuaded to leave their current employers if they are offered better salaries/benefits.  This ripple effect would continue throughout the labor market until unemployed souls with few skills are hired by firms that have no choice but to accept whatever workers they can find.  It's a reallocation process that is carried out whenever a significant increase in spending occurs (whether initiated by the government or by firms/industries that have launched major investment projects).

The end result of this reallocation process is: 1) the public sector gets the resources it needs, and 2) the private sector is still able to obtain the resources it needs to satisfy  consumer demand.  When there are sufficient resources available for both, no real sacrifice is imposed when the government pays for its increased spending with tax hikes (i.e., no private consumption must be given up by taxpayers).  Yes, if all available resources are already fully employed when the government increases its spending, a real sacrifice would be imposed.  But even then we can't say that the increase in taxes is a burden unless the sacrifice that is imposed is perceived to be undesirable.

During World War II real sacrifices were made by taxpayers, but according to reports, most Americans did not mind the fact that the government was "stealing" some of the economy's productive capacity away from them.  They wanted to win the war and were quite happy to endure any sacrifice they might have to make if there was a chance it might help to secure a final victory.  Instead of lamenting their sacrifices, most citizens were quite happy to make them.  They felt as though they were contributing to an effort that was going to help a lot of people and that made them feel good about themselves.  In other words, they got something quite valuable for their money.

 

The Ironic Results of Misguided Tax Policy

It is no secret that many wealthy people believe they would be better off if their tax obligations were reduced.  Most of them believe this because they can't stop thinking about what they'd otherwise be able to do with the many thousands or millions of dollars that they give to the government when they pay their taxes.  If they find that they have to pay, say...$50,000 in taxes, they think to themselves that such a sum would have bought them a very nice automobile.  That is the "sacrifice" they imagine they are making when they pay their taxes.

If only they understood the role of money in the marketplace.  If they did, they would know that the purchasing-power-benefit that a large sum of money gives to an individual gets wiped out if everyone else also gets a large sum of money.  It is a principle in market economics that only exceptional achievements earn the greatest rewards.  If we try to advance ourselves The Easy Way---i.e., by joining others in a political effort to increase everyone's disposable incomes---the marketplace will "punish us" by making sure that no one gains anything in real terms.  That is the simple lesson that inflation teaches us.

All of the time, expense, & energy that anti-tax rich people have invested in their political efforts to get their shared tax "burden" reduced have been utterly futile.  Since all rich people received big gains in disposable income from the Reagan & Bush Tax Cuts, none of them benefited in real terms.  As Cornell economist Robert H. Frank has pointed out, the extra luxuries that rich people might all have obtained after receiving those tax cuts would have provided them with very little additional utility/satisfaction (primarily because their gains were not exceptional).  On top of this, there is the realization that those minor & ultimately ephemeral gains would have been just as affordable to rich taxpayers if they had not received any tax cuts at all.

Instead of seeking to enrich themselves with "easy money" through foolish collectivist political schemes, rich people do have the option of improving their financial status The Old-Fashioned Way---i.e., by earning it in the marketplace.  In a market economy, wealthy individuals can enhance their claims on the scarcest goods & services (become richer, in real terms) by innovating and bringing to market some good or service that becomes so popular with consumers, the income from sales gives them a significant increase in pre-tax income compared to all other rich people.

Yes, it is ironic that the income tax cuts that so many rich people bleed for will not provide them with the material gains they seek.  But that's just the beginning of the irony.  Getting their taxes cut deprives them of a very real opportunity to improve the quality of their lives---in real terms---in a way that would impose no real sacrifice on any of them.  If, instead of lobbying for tax cuts, they were to give their political support to the idea of taxing themselves more, they would be able to put money into the hands of the government that could then be used to improve the quality-of-life that they experience as Americans.

It may sound too good to be true, but it is nevertheless a fact that wealthy citizens can, all at once:

  1. Arrange to have themselves taxed more

  2. Enjoy the benefits of increased government spending on services that improve the quality of their lives, paid for with their higher tax contributions

  3. Discover that they actually gave up nothing at all in terms of purchasing power in order to obtain the benefits of public spending that they are enjoying

If you are a wealthy citizen, what this means is that The Government can legitimately come to you during a recession and say that it can provide you with an improvement in both public services and the public infrastructure while emphasizing that it won't cost you---as a taxpayer---anything in real terms.  When you ask The Government representative what the catch is, she will tell you that she needs to collect more $$ from you in taxes, but assures you that prices will subsequently be lowered [by market forces] until everything is just as affordable for you as it was before your taxes were raised.

It's almost as though you are getting something for nothing, and in a way, you are.  All that you---as a wealthy citizen---are doing is moving some paper around in the economy in a way that ends up putting a lot of otherwise unemployed people to work producing public wealth that benefits you without anybody actually having to give up any of their real purchasing power to get it done.

It turns out that it is not humanly possible---through taxation---to deprive wealthy people of their claims on the scarcest good & services available in the economy.  Even during the Great Depression, the wealthy---as a class---did not suffer at all in real terms.  Yes, the nominal incomes of the upper classes dropped dramatically because sales dropped dramatically, but none of the mansions or yachts or beachfront property disappeared, and neither did any other real asset.  Because they still had the highest incomes in the land, the wealthy still had all the income and/or dollar wealth they needed in order to purchase the scarcest goods & services that the economy could produce.  Prices simply dropped to a level that they could afford.

All of this is predictable because we know that market forces will drive down the prices of luxuries (relative to the general price level) in response to any across-the-board reduction of the disposable incomes of all wealthy people.  We can see that with any tax hike, the extra money that the wealthy would have to pay in taxes is actually "excess" money that they really don't need in order to make the purchases they desire as long as their comparative rankings in the hierarchy of income distribution are unchanged.

The ultimate truth that we are all faced with is that the marketplace only cares about relative income rankings when it distributes the real goods & services produced by the economy, not the absolute dollar amounts that any individual household might possess.  It (the marketplace) always wants to know what all the other households have in the way of disposable income.  It never deals with just you, alone.  Market prices are never set (or never hold, anyway) without taking into consideration the disposable incomes of all other potential buyers.

 

The Rich Get Richer...(really!)

What can a rich person do to get richer, really?  Well, as we noted earlier, she can become authentically richer The Old Fashioned Way, which means she can become richer at the expense of some other rich person (whom she displaces within the hierarchy of income distribution).  But there is still something rich people can do collectively to increase the real wealth that all of them will enjoy.  They will all become richer in real terms if they employ---through their government---any human resources that might be idle, in the production of public wealth.

Most people do not realize that there is an important difference between financial wealth and real wealth.  We all understand what financial wealth is, but few understand that money only has value because it gives us a claim on the productive efforts of others.  If we were to all somehow become extremely rich in dollars one day, and we all decided that we wanted to retire and live off of our accumulated "wealth", we would soon find that we actually possessed no real wealth at all because no one would be producing anything that we could buy. A nation's real wealth is its productive output: the real goods & services its citizens are able to produce with their work efforts.  Money is just money.

One of the wonderful things that productivity improvements in the private sector have made possible is the increased production of public wealth.  The term 'public wealth' does not refer to accumulations of money or financial assets held by the government.  In real terms, 'public wealth' normally refers to the valuable services and investments (in infrastructure, human capital) that are generated by government spending.  These services and investments are defined as real wealth because they improve the quality of the lives of citizens in real terms.

As rich as he is, Bill Gates cannot personally afford to reduce the traffic congestion he must deal with on the highways, nor the blight that he often sees from them.  He can afford to keep his primary living environment clean and healthy, but he can't afford to buy pollution-free air and water wherever he goes.  He might feel a certain amount of pride in his ability to keep up the appearance of his own properties, but he can't personally afford the cost of making his city, his state, and his country look equally attractive.  The good news for wealthy individuals like Bill Gates is that they can afford to buy significant improvements in the quality of their lives through their governments.

The bad news is that many rich people---perhaps a majority---have historically opposed any and all political efforts to expand the government's production of public wealth.  Their greatest fear has been the extra taxes they'd have to pay to be able to enjoy that public wealth.  It's not that they wouldn't enjoy the improvements wrought by government spending; it's just that they haven't wanted to give up the purchasing power that they've always been certain they'd have to give up.  Could it be possible that they will start to give their political support to expanded government programs, now that they know that it won't really cost them anything?

Smart-Selfish vs. Stupid-Selfish.  There is one more big reason why many wealthy citizens oppose the government's use of their tax dollars to produce public wealth.  They've decided that logical rich people will always prefer the option of private philanthropy over the option of using their government to express their generosity.  They note that the government option typically deprives them of the opportunity to personally witness the good that their tax money might be making possible.  Or perhaps what they prefer is the opportunity to use their money in a way that will ennoble them in the eyes of others.

It is true that current government practices do not provide major tax contributors with a feeling of "ownership" in the wealth-producing activities of government.  One would think that intelligent professionals would be able to innovate some new practices that would provide that feeling of ownership.  Perhaps taxpayers could be charged a premium above and beyond their basic tax obligations for the opportunity to obtain "shares" of the cost of certain federal projects and perhaps also for the right to dedicate all or most of their tax contributions to specific government projects.  Unlike shares of ownership that are purchased in stock markets, share-of-contribution documents, or bills, would establish in a publicly observable way the magnitude of the contribution of individual taxpayers.

The premium paid would cover the cost of keeping your personal tax dollars from being "lost" in the pool of general tax revenue.  Individual taxpayers would be able to identify themselves with certain government projects, helping to define their personal "brands."  In other words, the government could sell "sponsorship" opportunities.  Such practices might complicate things, but perhaps they would be worth the cost of implementation if rich people end up feeling better about the contributions they make to the public treasury.  But even if that were never to happen, there are still some very compelling reasons why rich people ought to enthusiastically prefer the idea of giving the government their money to produce public wealth over the option of private philanthropy.

There is, after all, the payoff noted earlier: more total wealth consumed; no purchasing power sacrifices made.  But there is yet another important reason why private giving is not such a good idea.  As things stand now, rich Americans who act on their generous instincts make a real sacrifice when they choose to give to charities or civic causes.  Why?  Because those rich people who choose not to give---or who give less---end up improving their purchasing power in real terms---relative to their more generous peers---for no reason other than because they choose not to be generous (or as generous).  When you give money privately to others, it reduces the size of your disposable income relative to the disposable incomes of all other rich people.

The bottom line?  Individual acts of charity can re-order the hierarchy of disposable-income distribution in favor of non-givers.  This means that individuals face a market-based incentive to ignore the needs of others because they stand to gain a real purchasing power reward if they do so.  Rich people who believe that economically privileged citizens ought to help finance the Common Good should be especially annoyed by this state-of-affairs.  It's not that they aren't willing to make a personal sacrifice if it's needed.  They obviously are.  It's just that it is difficult to psychically tolerate the continued existence of perverse institutional incentives that reward indifference toward others when it is not necessary.

We have two options.   The first one is to set up our tax code so that all rich people are required to be equally generous in contributing to the Common Good.  If this option is pursued, no rich person ends up having to make any material sacrifice.  The other option is to continue to allow some rich people to contribute to the common good if that is their desire.  This option forces those who are conscientious to pay a material penalty for having done The Right Thing.  Forcing others to contribute---who might rather prefer to enrich themselves at your expense---may not sound like such a bad idea, when you think about it.

If rich people are able to see that this is the clear choice they face, it should encourage them to see The Government in a new light.  Instead of perceiving The Government only as a threat to them, maybe they'd begin to realize that it could actually end up being a very good friend of theirs, an institution worth defending, the KEY to a very desirable future.  After all, The Government is their organization, isn't it?  Like all other organizations, The Government may be flawed, but even flawed organizations are able to produce a lot of things that are of great value.  It becomes very difficult to demonize an organization that can make a lot of very good things happen for you.

In economics, economic agents are not condemned for being selfish, but only for being stupid-selfish instead of smart-selfish.  Those who have advocated lower taxes for wealthy citizens and a reduction in the size of government have been quite foolish in their political aims.  They have not only hurt others in their quest for ever larger piles of "dollars", but have also hurt themselves, having deprived themselves of the gains in real wealth that they would have enjoyed if only they had understood markets better.  If you are a rich person who is Smart-Selfish, you will probably want to start heaping a lot of ridicule on your Supply-Side friends, taunting them for being so incredibly Stupid-Selfish.

 

Changing The Tax Code

In order for wealthy Americans to dramatically improve the quality of their lives, by using the federal government to produce new wealth, it is necessary to "fix" the Progressive Income Tax.  The federal tax code needs to be rewritten so that the tax is paid only on gross income, period.  No exemptions.  No deductions.  No allowances.  No special categories of income.  No exceptions of any kind.  One obvious benefit of doing this is that it would dramatically simplify the tax filing process for filers.  But there is a more important reason.  Paying income taxes on the gross income earned assures that the relative purchasing power of all after-tax incomes would exactly match the purchasing power of all pre-tax incomes.

It is not necessary that we abandon those who have been getting special tax breaks in order to do this.  Any kind of "tax break" that is written into the code does nothing more than give money to people who are believed to have a legitimate need for financial assistance.  If these breaks are justified, then they are justified.  But there is no reason why Congress must give these breaks through the tax code.  If they believe that certain individuals or interest groups deserve more money in order to meet their expenses, or in order to create incentives for certain kinds of behavior, then they can choose to have the Treasury Department write them a check after they've proven their worthiness (perhaps through some kind of means-testing).

A word of warning.  If Congress wants to shift the tax burden "onto the backs of the rich", it should probably do so in a way that is not too dramatic.  Although the rich would not suffer in real terms from a dramatic decrease in their disposable incomes, the deflation that would occur---that would preserve their purchasing power---can have a profoundly negative impact on the psychology of business owners. It may only be money illusion, but if firm owners react to deflation by cutting costs (jobs) in a panic, a severe recession could be the result.  Any plan to shift the tax burden back to the wealthy should be phased in very gradually over a number of years.  Also, a great effort should be made to educate the public in order to minimize a serious backlash by The Uninformed.

James J. Kroeger

2004

 

Notes...

1 Some_individuals/households might consume more than they had before, but only at the expense of other individuals/households.  Those who might choose to save a big chunk of their money in this environment would be the big losers, since the purchasing power of those saved dollars would eventually be reduced to a pittance as a consequence of the hyperinflation.

2 Over a reasonable period of time, of course.

3 Yes, disposable dollar wealth is a variable that can sometime supersede the importance of income when it comes to dollar-expressed demand.  But since it is income that ultimately determines levels of wealth in the long run, we can simplify matters by simply focusing our attention on income.

4 If all the money that is taken out of the economy (saved) was automatically put back into the economy (borrowed & spent), then there would never be recessions.

5 Income tax cuts alone can never provide a stimulus to the economy.  "Stimulus packages" that include income tax cuts will only provide a true economic stimulus if there is enough compensating borrowing to sustain necessary levels of government spending.

6 Not all firm expenditures are economic investments.  An example would be money spent by firms on advertising that either misleads consumers or does nothing to help them with their purchasing decisions.

7 Usually at the expense of other financial investments, like savings accounts.  All schemes to provide tax cut "incentives" to spur more economic investments are predicated on the spurious assumption that owners of financial "capital" (money) need to be given special incentives to make their money available to entrepreneurs who would otherwise face a shortage of such funds.  If there were actually a shortage of such funds, the federal government could easily make them directly available to start-up entrepreneurs by simply lending the government's money to them in spite of the risks that banks and venture capitalists and angel investors were not willing to assume, themselves.  Using the tax code to achieve this purpose is not only preposterous; it is also a very naked attempt to enrich individuals who are actually contribute nothing whatsoever to improvements in economic investment.

8 Brealey & Myers, Principles of Corporate Finance, 2000, pp. 383-384.

9  Flow of Funds Accounts, The Board of Governors of the Federal Reserve System, www.federalreserve.gov

10 Confirmed by a spokesman for the Fed Board of Governors.

11 Many have argued that international capital flows have been even more important than domestic savings rates in determining America's recent, historically low short-term interest rates.  It must be kept in mind, however, that  foreign investors paid for their purchases of America's financial assets (U.S. Treasuries, e.g.) with U.S. dollars.  Where did these dollars come from?  Primarily from U.S. bank reserves (the size of foreign bank reserves of U.S. dollars is ultimately determined by the size of domestic bank reserves).  When a foreign investor buys an American asset, she "activates" unused reserves of dollars, injecting them into our economy's money supply.  Ultimately, however, the Fed's unlimited control of the money supply is so profound, it can easily compensate for any fluctuations in international capital flows.  If, for example, foreign owners of U.S. Treasuries (typically, foreign banks) were to try to sell all of their holdings, The Fed could easily maintain the money supply and the interest rates it desires by buying all of them.

12 As with most generalizations that are made in economics, there are the exceptions.  Rich foreign nationals are not normally affected by changes in America's income tax code, but they would still be free to bid on American assets that are up for sale.  Consequently, some rich Americans might find that their bidding positions within the worldwide hierarchy of income/wealth distribution would deteriorate following a significant increase in their income tax rates.  The good news is that it should be a rather easy matter for Congress, or U.S. government officials, to pressure other countries to begin taxing their wealthy citizens just as heavily as we are taxing ours.  Because of the size of our economy, we would be able to achieve much more in this regard than most other nations could ever hope to.

13 Unless the government borrows and spends enough money to make up for the net decline in total spending that the cuts would otherwise bring about.

 

 

Related Economic Analysis:

MAKE THE AMERICAN PEOPLE RICHER

THE RELATIONSHIP BETWEEN SAVINGS & INVESTMENT

DO TAX CUTS STIMULATE THE ECONOMY?

ARE INCENTIVES NEEDED TO STIMULATE INVESTMENT?

MEASURING SAVINGS AND INFLATION

GOVERNMENT BUREAUCRATIC WASTE VS. PRIVATE SECTOR EFFICIENCY

UNIVERSAL HEALTH CARE