Progressivize Everything

Introduction:

It’s been a hard thirty years for those who believe in progressive taxation. Since the advent of President Reagan (oh yes, it’s the 30 year anniversary, expect to see a lot of annoying Republican nostalgia-trips this year), it became the conventional wisdom that taxes should always be cut, and that calling for tax increases was political suicide. Moreover, when taxes are reluctantly increased to raise revenues, they are much more likely to be regressive taxes (such as sales taxes, sin taxes, gasoline taxes, and the like) rather than progressive taxes like the income tax, on the grounds that voters approve of taxing the spendthrift and the morally suspect but not themselves.

In the wake of Obama’s election, this has begun to change somewhat – Obama’s first budget proposal included an increase in the top income tax bracket from 35% to 39.6% (the rate established in the Clinton Omnibus Budget Reconciliation Act of 1993), and an increase in the second-highest income tax bracket from 33% to 36%. Likewise in the House health care bill, the major source of financing is a 5.4% income tax surcharge on individuals making $500k a year and couples making a million plus, and even the Senate health care bill at least genuflects in the direction of progressive taxation by increasing the Medicare payroll tax on those making more than $200k a year.

What’s interesting about this small resurgence of progressive taxation is how limited it is – Obama’s pledge to only raise taxes on those making $250,000 a year or more is quite startling when we realize that only the top 1.5% of the country’s households earn that much money. There’s something odd about a definition of taxing the rich that excludes 85% of the top 10%.

This suggests that, if progressives are interested in really transforming our tax system which we will need to do do accomplish the progressive social and economic policy agenda, we need to start thinking more systematically about what progressive taxation should look like.

A Word on VAT:

By way of a counter-example, let’s start with discussing the value-added tax. For those not familiar with the term, a value-added tax is a consumption tax levied on a given product at each stage of its production, with the tax being assessed on the value added by each participant in the process. Hence, the producer of the raw materials pays a percentage, the manufacturer pays a percentage, the wholesaler pays a percentage,  the retailer pays a percentage, and the customer ultimately foots the bill as the previous participants pass the tax onto them.

It’s essentially a fancier sales tax, and it is quite regressive – all customers are being charged the same rate, regardless of their ability to pay, and since the poorer consume a much higher proportion of their income than the richer (in Keynesian terms, they have a higher marginal propensity to consume), they end up paying a much larger proportion of their income in VAT taxes.

And yet American progressives have a strange, and I would argue unhealthy, fascination with the VAT tax. Matt Yglesias likes them, Ezra Klein likes them, self-identified progressive institutions like the Center for American Progress like them, and even prominent progressive politicians like Nancy Pelosi have at least indicated openness to the idea. To the extent that there is a single argument for a VAT among progressives, it goes something like this: in order to accomplish progressive policy goals (to say nothing of the budget deficit and national debt), we will need a lot more revenue than we have now; a VAT tax is the best option for new revenue (for reasons that often have to do with economists’ arguments that it’s not distortive); a VAT tax is used in Europe to produce revenues that fund a highly redistributive welfare state; therefore, we should adopt a VAT tax and use the revenue for progressive ends.

As arguments go, I find this one less than compelling. Granted, we need additional tax revenue, both for progressive purposes and to shore up our public sector’s financial standings. However, this still means that there is a question as to which form of revenue would be best for this task. The VAT tax is not the best vehicle for that. Economists may argue that the VAT tax would be best because it is non-distortionary; however, the empirical evidence for income and other progressive taxes being distortionary is incredibly weak to the point of non-existence – and arguably, economists have been repeatedly guilty of substituting a theoretical argument that humans will respond to income tax (increases) by working less for an empirical argument that humans actually do this. Empirical evidence tends to show that either there is no distortionary effect or even a small positive effect – people who make lots of money like making lots of money and tend to like making money more than not working, and when top income tax brackets rise work harder to maintain their position.

Secondly, simply because European states have VAT taxes does not mean that such a tax is acceptable to progressives. This argument takes a really reductionist attitude to European politics, ignoring the fact that within the context of European politics, the VAT is the conservative preference, and progressive and social democratic parties call for shifting the state’s revenue stream away from regressive taxation. The Swedish Social Democrats, the French Socialists, the German SPD – look at any of their platforms, and you will see a consistent stance in favor of increasing income taxes and taxes on the wealthy in general, and opposing increases to regressive taxes like VAT or payroll taxes.

Finally, if the ultimate objective is to fund progressive social and economic policies, the question remains why it would not be preferable to do so with a progressive taxation? Doesn’t it make more sense to establish a tax system where our methods of financing lend a helping hand to our social policy objectives, rather than fighting against them?

Progressivize Everything:

If we are in need of additional tax revenue from progressive sources, what options are open to us?

• Payroll Taxes – In “In Proportion to Their Abilities,” I’ve already discussed how making the payroll tax a progressive tax would raise well in excess of $124 billion a year in new revenue. However, I think it’s also important to point out that progressive taxation has the added benefit of functioning as social policy – a progressive payroll tax would act as permanent economic stimulus by increasing the take-home pay of most workers, while making it cheaper for employers to employ all but the highest-paid workers.

• Income Taxes – one of the useful side-effect of the slight turn towards re-progressivization that we’ve seen in the last year has been to demonstrate that the potentials for fiscal expansion are much larger than have previously been thought. Consider that the House health care bill raises $460 billion over ten years through a 5.4% surcharge on the highest earners. Obama’s budget proposal to restore Clinton’s brackets for the highest earners (an increase of 4.6 percentage points) and the second-highest earners (3 percentage points) would raise $320 billion over ten years.

Yet this is only scratching the surface of the possible:

The top marginal rate is still more than 10 percentage points below where it was in the Reagan era.  That’s an additional $92 billion a year in revenue even only looking at the top marginal rate.  If we cast our eyes to the second and third-highest income tax brackets, which would include single individuals making more than $175k a year and joint households making more than $200k a year (all well within the top 5% of households), there’s a lot more that can be done.  Considering that the current income tax bracket stops at about $375k a year, establishing additional brackets at $500k, $1 million, $1.5 million, and $2+ million would make the income tax much more progressive and generate further revenue.

At the same time, increasing the progressivity of the income tax would help to reduce some of the inequality at the high end of the income distribution that’s occurred over the last thirty years, bringing down the share of take-home income held by the top quintile (who currently get 50% of the national income).

• Corporate Taxes – just as it is the case that the current top individual income tax rate lags far below what it was in the 1980s, it is also the case that the current top corporate rate of 35% is well below the 46% rate that held from 1979-1986. Given that the corporate income tax raises about $300 billion a year on an effective rate of 25.2%, increasing the effective rate would increase revenue by $12 billion per percentage point. If we were to return to the average 38% effective rate that corporations experienced in the 1980s, that would raise $156 billion a year; even a more modest increase, to say 30%, would still raise an additional $60 billion a year. This increase could be distributed in a progressive fashion by focusing on the top corporations (those making more than $18.33 million a year), leaving small businesses untouched.

• Capital Gains Taxes – capital gains taxes are another area where further progressivization follows from existing policy. Under Obama’s budget proposal, the long-term capital gains rate would revert to 20% (up from 15% under Bush). Again, even the increased rate is well below its historical peak; in the mid-90s, the long-term top rate was 29%. Even after the peak of the stock market, there is still an enormous amount of wealth held by a very few rich people, which can generate a substantial revenue flow. Obama’s proposal would raise $12 billion a year more with a 5 percentage point increase – returning to the Clinton era rates could raise an additional $21 billion a year.

At the same time, increasing the capital gains tax would have the progressive effect of helping to shift the relative rewards of labor versus capital. As I have argued before, one of the major structural weaknesses in the American economy had been an over-concentration of income at the top, leading to an imbalance of investment to consumption. As a result, we saw huge amounts of money chasing ever more dubious investment vehicles, leading to the real estate and financial bubbles that wrecked our economy. Pulling more money out of the capital markets and redistributing it to consumers would not only reduce inequality, but it would also reduce the vulnerability of our economy to sudden financial panics.

For those of you keeping score, these progressive changes work out to an additional $297 billion a year (taking the more conservative corporate tax change), or in other terms, about three times the annual cost of the current health care reform bills. Clearly, raising revenue in a progressive fashion is possible.

Conclusion:

As a philosophic stance, arguing that the ends are more important than the means is a perfectly supportable position. However, in public policy, we always have to remember that the means might materially affect the ends we seek. Trying to combat inequality with unequal taxes at best resembles trying to bail with a bucket with holes, so why not match means to ends?