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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 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), Choosing the Right Pond: Human Behavior and the Quest For Status (1987)

Is The Income Tax Unfair To Rich People?

 

 by James Kroeger

 

 

 

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According to a survey published by the Gallup organization a few years ago, most rich people believe the Income Tax treats them unfairly.

The feelings of victimization tend to well up within them whenever they 1) look at the total number of dollars that the Income Tax takes from them, and then 2) imagine what that money would have bought for them in the marketplace at current prices.

Thinking of all those un-bought possessions is what usually convinces many rich people that they are forced to give up too much when the government taxes their incomes at very high rates.

But alas, it turns out that the only thing these privileged souls are being victimized by is simplistic reasoning. What they have never understood is that one of the key assumptions they rely on is spectacularly flawed.

There are actually two key assumptions in play. The first one---which absolutely no one disputes---is that increasing the tax rates of rich people will reduce their disposable incomes.

The second assumption is one they’ve simply never thought to question; they’ve always just assumed it is true. It is that the prices of the things which rich people would prefer to buy with the money they are handing over to the tax man would not change.

In this article, I’ll be using a review of marketplace dynamics to explain why it is actually 100% predictable that prices would change if rich people were taxed at higher rates. Indeed, prices of luxuries would drop so much that rich people in general would actually experience no reduction in their purchasing power whatsoever as a consequence of the higher tax burden they’d be taking on.

 

   History Teaches

We begin by looking back at the last time Congress decided to dramatically increase the top marginal rates that the richest Americans were required to pay on their incomes.

The year was 1932, in the depths of the Great Depression. At that time Congress increased the Income Tax’s top marginal rate from 25% to 63%. Fours years later, it was raised again to 79%.

Just how bad did it get for the country’s millionaires, once the government started to take huge amounts of money away from them? Answer: they got along just fine.

When we look at what actually happened to rich people at the time, it becomes clear that dramatically increasing the tax obligations of these people did not actually inflict any kind of real suffering on them at all.

In the years that followed the 1932 tax hike, none of the mansions, or the yachts, or the beachfront property disappeared. Throughout the Great Depression, rich people still owned all of the economy’s luxuries and they continued to enjoy them fully.

They may have had fewer disposable dollars to throw around than they used to, but that just meant that they were able to get all the luxuries that the economy produced at lower prices.

You see, in spite of the much larger tax bills they were paying, rich people still had the highest disposable incomes in the land, and in a market economy, that’s all the money you need to claim the scarcest luxury goods & services that the economy brings to market.

Why this is true is something that becomes apparent once you’ve learned a thing or two about how market economies determine prices.

 

   Markets Determine Prices By Auction

Any competent economist will tell you that the marketplace sets prices by auctioning the scarcest goods & services to the highest bidders. The auction process we see in most markets is different from the one we observe at Sotheby’s, but the results are the same.

The essential element driving the process is the freedom sellers have to charge the highest price for their products that they think the market will bear. With extraordinarily few exceptions, this is precisely what sellers in competitive markets always do.

If sellers become aware that---for whatever reason---supplies of the product they sell will soon be in short supply relative to demand, they will immediately raise their prices. They understand that, given the anticipated shortage, many people will be willing to pay a higher price for the product rather than do without.

How high will the price ultimately go? That is what the auctioning process ultimately determines.

A seller starts off by trying to guess the highest price she can charge while still being able to sell all of her products. If her guess is too high, product will remain on the shelf unpurchased.

But if instead she finds her products are ‘flying off the shelf’ at the original price she set, she will increase her prices further to see what happens. If they are still flying off the shelf, she will proceed to raise them again.

The price she charges will continue to go up until sales slow to a trickle and product remains on her shelves unpurchased. When this happens, she will then lower her price just enough to move the product off the shelf, but no lower. Equilibrium---for the moment---is achieved.

In this Markets’ Method of auction, sellers try to guess the winning high bid in advance, ask for it up front, and then allow potential buyers some time to respond. Potential buyers only participate in the auction if they believe they can afford the winning high bid that the seller/auctioneer has set.

In a free-market economy, prices are always going to go as high as they can possibly go, limited only by the quantity of $$ that potential buyers have available to them. That is why the scarcest luxuries always end up in the hands of those who possess the most disposable dollars because sellers are always going to do their best to price everyone else out of the market.

It is a process that is every bit as effective as a Sotheby’s auction at delivering the scarcest goods & services generated by the economy to the highest bidders.

 

   Purchasing Power In Market Economies

From this explanation of marketplace dynamics we derive a supremely important economic truth: purchasing power is not determined solely by the number of dollars you have. What determines your purchasing power is the number of dollars you have compared to everyone else.

The purchasing power of your disposable income is ultimately determined by its ranking within the hierarchy of all disposable incomes. Those who have more disposable dollars available have a higher ranking than those who have fewer. The higher your ranking, the more able you are to ‘outbid’ others for the scarcest luxury experiences.

One principle stands out above all others: whenever a household experiences an 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.

  • Your household income may increase next year, but that seemingly happy development would only provide your household with an increase in purchasing power if your gain in $$ earnings is exceptional (e.g., you win the lottery, or land a much better paying job).
  • If the only reason your disposable income increases next year is because you and everyone else got a nice tax cut, then none of you is going to experience an improvement in your ranking within the hierarchy, and that means none of you will see an improvement in your purchasing power, all else equal.
  • A third possibility: your household income increases next year at a time when everyone else’s is going up more. In this case, your household’s purchasing power would actually decline, even though your nominal income had increased, because your ranking within the hierarchy would decline relative to everyone else.
  • Yet another possibility: your household’s disposable income declines next year, but because everyone else’s disposable income declines even more you actually end up experiencing an improvement in your purchasing power.

With this more sophisticated understanding of purchasing power in market economies, we are able to see why it is indeed a fact that imposing steeply progressive [marginal] income tax rates on rich people does not actually impose any kind of material sacrifice on them whatsoever.

Through its use of marginal tax rates, the Income Tax is structured in a way which preserves the disposable income rankings---and therefore the purchasing power---of all those who are taxed. Once the luxury markets have adjusted their prices through the auction process to the new disposable income realities, rich tax payers will find that their privileged lifestyles are just as ‘affordable’ as they were before their taxes went up.

You see, decreasing the number of dollars that rich people have available to spend does not decrease the quantity of the luxury experiences that are brought to market. The same luxuries will still be offered for sale to the same people and they will still be bought by those same people once the price has dropped to a level that they perceive to be affordable.

In the real world---the world of actual goods/services consumed---nothing changes.

And thus the fear that rich people have always had of deprivation and unfair treatment via the Income Tax has never had any basis in reality. It turns out that they have feared the specter of steeply progressive income taxes, not because they are evil, but because they have simply never understood the nuances of marketplace dynamics.

 

   So Does The Income Tax Victimize Rich People?

No, it does not.

In the world of Public Finance and Taxation Theory, it is simply not possible to conceive of a method of taxation that is more fair to rich people than one which actually preserves both their purchasing power and their material possessions in spite of the fact that they are being asked to hand over large amounts of money to the government to pay for its bills.

All the Income Tax really does is take excess dollars/euros from all rich people that they don’t actually need to be able to purchase their very privileged lifestyles at the top of the economic ladder.

And yet, though the Income Tax is ideally fair in its construction, there are still some important fairness issues that rich people ought to be concerned about.

There is, for example, the high likelihood that if the Income Tax’s top marginal rates were made much more steeply progressive, certain disreputable rich people would feel inspired to defy the supremely virtuous intent of the Income Tax by acting to enhance their own disposable income rankings at the expense of all other rich people.

Which is to say they will seek to cheat, lie, or otherwise game the system that has been set up to calculate the government’s share, often by not reporting all of their sources of income. If/when they do such things at the same time the majority of rich people are following the rules they would indeed be able to improve their rankings within the hierarchy of all disposable incomes.

So maybe all rich people should copy their behavior? Well if they did, it would negate the benefit that is enjoyed when only a few are cheating the system. If everybody were to follow their example, then none of them would be able to improve their rankings (assuming they all cheat equally).

You see, in order for these scoundrels to truly benefit as they desire, they need for most rich people to play by the rules while they are cheating.

So if you are a rich person who has come to realize that the income tax is indeed the fairest method of taxation you could ever hope for, it does not mean that all of your concerns about fairness have gone away.

It simply means that you need no longer be an unwitting dupe manipulated by sycophants and political opportunists into wrongly blaming 1) the Income Tax itself, and/or 2) the Federal Government as the ‘victimizers’ who threaten you with unfair treatment.

The people who are actually trying to victimize you with unfair treatment are those ‘other’ rich people out there who don’t want to play by the rules, rules that are set up to protect all rich people from any loss of purchasing power in the marketplace.

How then should Good Rich people respond to this kind of unfairness/victimization?

I would suggest that they A) stop giving money to the idiots who are currently demonizing the Income Tax, and then B) join together with other Good Rich souls out there to put political, moral, and social pressure on The Bad Rich to persuade them to abandon their truly immoral behavior.

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Related Economic Analysis:

MEASURING SAVINGS AND INFLATION

MAKE THE AMERICAN PEOPLE RICHER

ARE INCENTIVES NEEDED TO ENCOURAGE INVESTMENT?

DO TAX CUTS STIMULATE THE ECONOMY?

ECONOMIC POLICY