Thursday, October 04, 2007

Why You Should Pay More Taxes--Yes, You

Now that I have your attention--
I'd like to explore just who "should" pay more taxes, or indeed, any tax at all on certain levels and types of income.

Long-time contributor James C. provided this commentary and links to a chart of tax rates going back to the start of income taxes in 1913:

"Your were too kind in your recent article where you discussed the possibility of the government capturing a lot of what retirees think they have in their retirement accounts. I have been telling my clients about this risk for some years now. Take a look a this tax chart. We have had a lot of years of 70-90% top tax rates.

What I see as really striking in the tax information going back to 1913 is how little (0) taxes working people were asked to pay then compared to now.

For example, in 1913 the standard deduction for a single person was $3,000! There was no dependent deduction, didn't need one, no working stiffs made enough to pay taxes anyway. The chart that I have only goes up to 2002, but it shows that the standard deduction is still $3,000. If we adjusted the original $3,000 deduction for inflation it should be $63,000 today according to an online inflation calculator which probably understates inflation considerably the last twenty years.

CHS note: according to the Bureau of Labor Statistics, $3,000 in 1913 is equivalent to $63,000 in current dollars.

So what we have is the government taking the money and deciding how to spend it rather that allowing the People to spend it themselves. Waltzing toward Facism, wouldn't you say?

Who paid federal taxes, and how much did they pay?

Top US Marginal Income Tax Rates, 1913--2003

Here is the edited chart. Note that these are rates on regular income, not capital gains, and they do not reflect actual taxes paid--in other words, deductions, adjustments and so on are not incorporated. Nonetheless, this chart is instructive. My comments follow. (NOTE: for reasons unknown, Blogger inserts about three feet of blank page here--don't ask me why.

Tax yearTop marginal
tax rate (%)
income over--
Roaring 20s
Postwar Boom
194882.13 400,000
195292 400,000
195691 400,000
196091 400,000
196291 400,000
Great Bull Mkt
199028 32,450

1. Income tax was intended for the very wealthy. $500,000 in 1913 is equivalent to $10,500,000 in today's money. How would you like a tax which only kicked on income above $10 million?

2. Having to finance an overseas war changed the policy right quick. During World War I, the amount you could earn before paying the top rate was raised, but the maximum rate jumped to "confiscatory" to pay for the war.

3. The Roaring 20s saw tax rates drop--but the number of people paying rose. As the economy entered a euphoric period of technological growth and speculative (debt expansion) activity, tax rates dropped by 2/3--but the ceiling dropped even further, meaning the well-off were starting to pay thre maximum rate, not just the super-wealthy.

$100,000 in 1926 equals $1.17 million in today's dollars. So you still needed to pull down a big chunk of moolah to pay anywhere close to the top tax rate. (Remember this is all regular income, not capital gains.)

4. As the Depression took hold, taxes returned to a "tax the super-wealthy" policy. The top rate went back up above 70%, but the income level rose to $5 million--a level only the super-wealthy attained. $5 million in 1936 would be $74.8 million in today's dollars.

5. Global total war costs a lot. Sacrifices were demanded of the wealthy during World War II; top tax rates went to 88%, and anyone making more than $200,000 then ($2.5 million in today's currency) paid confiscatory rates as part of the sacrifices demanded by war.

(Recall that the Nazis were busy preparing to occupy the U.S., and had plans for long-range bombers capable of reaching the U.S. on the boards.)

5. Tax rates remained high on the wealthy during the great Postwar Boom. $400,000 in 1956 is $3 million in today's dough; would you approve of taxing all income above $3 million at a rate of 90%?

6. As stagflation raised wages along with prices, even non-wealthy started qualifying for top tax rates. By 1980, $215,000 was still a lot of money ($542,000 today) but certainly not the preserve of the super-wealthy--those for whom the top tax rate was once reserved.

7. The Great Bull Market and our current Debt Boom saw rates drop but the tax widen out to include virtually the entire upper wage-earning / entrepreneural class. It's interesting to note that when President Reagan and Fed Chairman Paul Volker did the nation a great service by throttling inflation in 1981-82 by raising interest rates (a highly unpopular stance, believe me), tax rates were such that a great number of well-off folks were paying the top rate of 50%.

Was this painful? Yes. Did the nation prosper once the medicine (fiscal discipline) had been swallowed? Yes.

Once the market and economy took off again, tax rates settled into the high but quite confiscatory range of 35% - 40%--but the top tax rate remained low enough to cover any family with two top wage earners or a successful small business.

My conclusion: top tax rates were once reserved for the wealthy, except in time of war. Now they remain high for a much broader spectrum of wage earners and entrepreneurs.

In recent entries, I have noted how asset inflation is a "hidden tax" because even as assets skyrocket, pushing the hapless owner into high tax brackets, the "gains" were all illusory, the result not of increasing purchasing power but of inflation only. Inflation is thus a sneaky policy to grab more private assets without having to raise nominal tax rates.

I have commented on the pernicious incentives of our current tax structure: it punishes high wage earners and small businesses at the expense of those whose income flows from Schedule D and E income streams--long-term capital gains and rental income.

Lastly, I questioned why hedge fund managers screamed bloody murder and called their lobbyists when their $600 milllion-plus "earnings" were threatened with standard tax rates rather than the 15% long-term capital gains rate.

Astute reader Mark A. sent in these cogent comments on the complexities inherent in trying to "fix" these perverse disincentives:

Re: Capital gains, in your Sept 20 piece you remarked on the illusory quality of investment profits when adjusted for inflation. As you probably know, the capital gain rate has varied over the years and one of the principal arguments for the preferential rate has been that gains are largely products of inflation. (There are other more-bogus claims about incentives and jobs and crap, but this one is valid).

The two desirable tax mechanisms for correcting this - indexing gains for inflation (horribly complicated and subject to usual government bogosities), and substituting a net-consumption tax for the income tax (deemed highly desirable but impossible to transition to for reasons I've never understood) have been considered and rejected every time the tax comes up; the preferential rate has always, therefore, been a compromise to provide for some relief from the effect of inflation.

The radical Republican choice, of course, has always been to eliminate the tax altogether, which doesn't seem so nuts in this context, but remains politically ridiculous.

As an aside re: the lower rate on dividends, it is a horrible kludge to compensate for the lopsided treatment of interest vs. dividend payments at the corporate level; it would go away if dividends were fully deductible by companies (which might also reduce the huge waste of money that are stock buybacks...)

In any case, though your point remains valid that the differential treatment of earned income vs. rent income has created perverse incentives within the system, it's difficult to sustain your argument re: capital gain taxes specifically when you acknowledged earlier that a real tax on inflated values is bogus.

Finally, I'm no particular fan of the gross amounts of money made within the hedge-fund industry, but whenever the tax issue comes up the exact mechanisms of the "loophole" have always been elided with the note that it's too complicated to explain.

However, I saw a shill for the industry on the TV recently suggesting that the treatment has to do with an "earned-in" component of their compensation. I'm thinking it's something like this: in a 2+20 scheme, the 2% is guaranteed, paid in cash, and taxed as a fee. 20% is earned contingently, and maybe received as fractional interests in the investment portfolio, and taxed when it is sold at the cap gain rate.

I'm guessing the brouhaha is about the *gains on* the 20% (unless it's also about the initial 20% - what would its basis be?) , but I have no idea. In any case, it's not clear to me that there's a gross distortion of normal tax treatments going on here, just that the amounts are disgusting.

In fact, the political discussion of tax rates is hopelessly politicized and oversimplified. Talk about lower capital gains rates to adjust for inflation and Dems squawk about tax cuts for the rich. Numbers and proportions are shamelessly conflated.

In fact, 20% of upper-bracket taxpayers pay something like 60% of personal income taxes; Dems are now proposing to exempt larger amounts of middle incomes from income tax, such that a majority of households may not owe any income tax (so it then becomes sigificantly undemocratic); everyone complains about paying too much FICA tax but know that social security needs a rate tweak; everyone wants to tax higher incomes for the FICA tweak but not acknowledge that upper-income folks' benefits are capped so it's just a soak-the-rich ploy, etc.

I won't say that rich people can't pay more tax, but I will say that the political discussion about it is functionally illiterate. I hope you aren't falling into a similar trap.

It ocurred to me as an afterthought that the perverse incentive doesn't come from the tax scheme per se, but from the long-term depressive effect of the mobility of capital vs. labor. Though especially pronounced in recent years, I wonder if the stagnation of wages and people's responses since the 70s doesn't have more to do with migration of production to the sunbelt and mexico (then?) and china (now), the erosion of union power, etc. than with their consciousness of the tax code.

More succinctly, big capital has become progessively more concentrated (oligopolistic) and greedier (demanding higher rates of return) and meaner (less willing or required to share productivity gains with labor). We shouldn't be too surprised by this though - corporations are literally capital-concentrating machines - and capital itself has an inevitable tendency to concentrate - cf. how much richer a guy with $10,000 gets over ten years vs a guy with $1,000,000. Hedge funds are in this sense just capital on crack.

Until of course, something happens."

Thank you, James and Mark, for illuminating commentaries. James also recommended this site on government spending and policies:

Facing Up to the Nation's Finances

As long-time readers know, I believe fiscal discipline is a moral imperative; it is simply unforgivable to be adding $200 - $400 billion a year in deficit spending for our children and grandchildren to pay interest on over their entire lifetimes--in a period of supposed "growth" and "prosperity." Huge deficits were once considered a tool to be used only during recession to kick-start the economy, not "business as usual" during good times and record corporate profits.

Long-time readers know that I believe the spending side of the ledger must be controlled; we can't tax our way out of the hole we've dug. As I wrote two years ago: Baby Boomers, prepare to fall on your swords. There is no salvation but slashing out-of-control entitlement spending and reducing the interest paid on our ballooning national debt. But that's another entry.

New Readers Journal Essay: I highly recommend new contributor Crucial Taunt's thoughtful essay, Remembering the Mahatma, honoring Mahatma Gandhi's birthday (10/2/1869).

Thank you, Riley T., ($50) for your multiple generous donations to this humble site and your mordant wit. I am greatly honored by your contribution and readership. All contributors are listed below in acknowledgement of my gratitude.

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