Troubling Tax Trope

I wrote a few days ago about tax policy. One of the things I wrote was:

I cannot believe that 600,000 people paid 40% of the Federal government's $2.15 trillion in tax revenues in 2005; that would work out to an average tax bill of $3.6 million for each of these allegedly ultra-rich taxpayers. Any rich person who intended to remain so would look at the prospect of paying $3.6 million in taxes with something akin to the look a prom queen would have at a fresh turd floating in the punchbowl -- and hire a small army of accountants and lawyers to reduce that tax obligation in any way possible.

I still can't believe it. But I hear a harmonizing note today sounded at Donkelphant, where the normally-insightful Justin Gardner writes to advocate raising the capital gains tax rate as opposed to income taxes, and pessimistically hints that a new economic plan to be offered by Senator John McCain will do the opposite. Gardner quotes from the Gray Lady, dialing his Wayback Machine all the way to 2003:

The 400 wealthiest taxpayers accounted for more than 1 percent of all the income in the United States in the year 2000, more than double their share just eight years earlier, according to new data from the Internal Revenue Service. But their tax burden plummeted over the period. [¶] The data, in a report that the I.R.S. released last night, shows that the average income of the 400 wealthiest taxpayers was almost $174 million in 2000.

Now, this is a more subtle form of the trope -- 400 taxpayers had an average income of $174 million in 2000. But it still gets at the idea that very well-off pay a hugely disproportionate share of the money that funds our government.

Here's my value-added: the Gray Lady and Gardner refer to "income." Wealth is not income. Wealth is capital that has already been accumulated. Income is cash flow. My employer pays me X dollars a year in exchange for my labor; that is income. From there, I do various things with that money, motivated in no small part by the incentives and disincentives built in to the Internal Revenue Code, so as to reduce my taxable income to some fraction of X.

But Bill Gates does not get a W-2 form. We are discussing income tax, not a wealth tax. Wealth is untaxed in this country. Even the capital gains tax does not tax wealth -- it taxes the growth of wealth. He's made his money already and now, as a philanthropist, he is spending the rest of his life giving it away. Consequently, it would be hardly surprising if Bill Gates, the richest man in America, paid effectively no income tax at all. In all likelihood, my middle-class income was higher than his last year.

Gardner's point, and it is similar to mine, is that a "capital gain" is not the same thing as "income" and therefore this is where we should be looking if we are going to increase governmental revenues. Okay, I understand the point and it's not a point that goes to income at all since by law, we've defined this sort of money as something other than "income."

My point, though, is that there are simply not enough of these very-wealthy taxpayers out there, and they are very sophisticated, from whom meaningful numbers can be extracted. Those 400 highest income-earners in 2000 were not the Bill Gateses of the world. They were hedge fund managers, CEOs of blue-chip and tech companies, and other people who were gaining their wealth in that period of time. They may have gained their wealth in the form of capital gains rather than incomes, and let's not forget what economic times looked like back then -- tech was still hot, recovering after a late-90's "correction" and a monkey could throw a dart at a copy of the Wall Street Journal that had been tacked on to the wall of his cubicle and pick a winner. It was in this environment that the Gray Lady reported:

While the sharp growth in incomes over that period coincided with the stock market bubble, other factors appear to account for much of the increase. A cut in capital gains tax rates in 1997 to 20 percent from 28 percent encouraged long-term holders of assets, like privately owned businesses, to sell them, and big increases in executive compensation thrust corporate chiefs into the ranks of the nation's aristocracy.

Again, this is not taxing wealth, it is taxing income -- or, as the Gray Lady grouses, taxing the growth of previously-accumulated wealth at a lower rate than had been done in previous years.

Now, let's consider the theory that the top 400 taxpayers are a very small fraction of the already-elite top 1% of taxpayers. 600,000 people are .2% of all Americans, and we're told to believe that they provide 40% of the revenues for the government. If true, their average tax would be $3.6 million.

Add to that the theory that 400 individual people, .00013% of all Americans, pay 1% of the total revenues for the government. We are further told that, their average tax bill in 2000 was $174 million apiece, which would be $213.35 million apiece in today's dollars.

But the government's total revenues are on the order of about two trillion dollars a year. If 400 people are paying $213.35 million apiece, that would generate $85.3 billion. That's 4%, not 1%, of total revenues. Those numbers underestimate the impact of these very high-income taxpayers by a factor of four. So the Gray Lady's numbers indicate that these taxpayers are paying only a quarter of the taxes that they "should" be paying. "Should" is in quotation marks in that last sentence, because that word begs the question we've been dancing around.

Specifically, how ought Americans be taxed so as to make them pay their "fair" share of the burden? In answering that question, it is possible, as Gardner and the President and many others have been doing, to quietly agitate in a populist direction, towards the idea that the rich should pay a lot more than everyone else.

It is also possible to be realistic about the question. Taxing the ultra-rich is an exercise in diminishing returns. As I saw in my study of historical tax rates, one way the government got around that in the past was to impose very high marginal tax rates for high levels of income. But 90% marginal tax rates for anyone is simply not going to fly in today's political environment.

The idea that we can solve our economic problems by "soaking the rich" is simply not accurate. By definition, 1% of all income earners are going to be in the top 1% of all income earners. Those top 1%, as I hope I've demonstrated above, do what I and nearly every middle-class taxpayer across the country already do, only on a much larger and more effective scale -- they use their money in such a fashion as to define their taxable income down, and avoid paying huge percentages of the taxes that they potentially could be paying. I bought a house, and I got a huge mortgage interest deduction on my taxes. I gave some of my money to charity, I put some of my money away in an IRA. I didn't even need a lawyer or an accountant to tell me to do those things. (Alright, yes, I am already a lawyer myself, but I'm not a tax lawyer.)

How much more of this can a really rich person do? Lots, as it turns out. As a little bit of math shows above, they can do enough to reduce their tax obligations by a factor of 75% at even the very highest levels of income and capital gains. The very rich can afford to hire lawyers and accountants and do things with their money so as to defer or avoid paying the taxes altogether. Trying to soak these people with income-based or even capital gains-based taxation schemes is going to be an exercise in futility.

That is true if the goal of these tax schemes is to extract money from the very wealthy. It is not, of course; that's just the political rhetoric circulated around it.

Income taxes and even capital gains taxes are aimed at the middle class, not at the wealthy.

The real goal of these tax schemes is to extract money from the middle class. Which makes sense from a number of perspectives. The middle class can afford to pay; there's a pinch felt, but most middle-class taxpayers can certainly do it. They are made to pay as they go in the form of withholding from income, effectively converting every employer in America into a tax collector, ensuring that middle-class tax revenues do indeed flow into the government. (Notice how the wealthy do not have to withhold and can self-report their income; they do not have employers with reporting and withholding obligations.) Middle-class taxpayers lack large masses of accumulated wealth, but they earn reasonable streams of income in return for their labor, income which is not readily-concealable from government inspection. There are a lot more of them than there are rich people. They are, in short, ideally-positioned under the current scheme of revenue generation to pay taxes.

Bear that in mind as discussion of tax increases is underway. And bear in mind, as we've discussed before, that the real action in taxes is not found in the tax rates. It is found in the process of defining what is taxable in the first place. The rich are always going to be better than the middle class at gaming that aspect of the system. And the poor? They have no income to tax in the first place, or at least very little of it. They simply aren't worth the time it takes to do more than review withholdings.

When discussion of tax policy is underway, it is always taxes on the middle class that are really at issue because no significant revenues come from the extreme ends of the curve. It is always much more in the definition of taxable income than the tax rates that matter. Both parties, people from both ends of the political spectrum and from all points in between, act in harmony with this fashion no matter what kind of rhetoric they use, because they have no other realistic options.