How redistributive is America’s tax system? For some observers there’s no doubt, taxes in the United States are highly progressive—you owe more, as a fraction of your income, as you earn more. European countries rely a lot on value-added taxes—a levy on consumption which, since the rich save more, disproportionately hits the poor. But there is no value-added tax in America: low-earners, as the argument goes, thus must pay relatively little. At the top of the pyramid, the federal government has no qualms about making the rich pay the country’s bills through its progressive income tax, according to this view.
For many on the other side of the debate about tax progressivity, the truth is the opposite. The wealthy get off almost scot-free, by way of myriad loopholes in the tax laws and other legislated, special-interest breaks.
Who’s right? Before we can have a serene debate about policy, we must establish some basic facts about who really pays what. Unfortunately, government agencies such as the Congressional Budget Office—in charge of informing Congress about budget and economic issues—do not provide the answer to that question, at least not fully. They publish information about the distribution of federal taxes, but disregard state and local taxes, which account for a third of all taxes paid by Americans and are much less progressive than federal levies. Their statistics do not provide specific information on the ultra-wealthy, so it’s not possible to tell whether Donald Trump is an exception or an instance of a broader phenomenon among billionaires.
Let’s try to lift the fog.
THE AVERAGE INCOME OF AMERICANS: $75,000
Our investigation begins with a simple question: What is the average income of Americans today? To answer it, we must introduce a concept that will play a critical role in this book: national income. By definition, national income measures all the income that accrues to the residents of a given country in a given year, whatever legal form this income takes. It’s the broadest possible concept of income. It’s a figure larger, in particular, than the income reported on tax returns or recorded in household surveys. For instance, it includes all the profits made by corporations, whether or not those profits are distributed to shareholders. Like dividends, undistributed profits are a form of income for shareholders—the only difference being that this income is fully saved the year it is earned and reinvested in the firm. National income also includes all the fringe benefits—such as contributions to private health insurance—that workers get through their employers.
National income is closely related to the more familiar concept of “gross domestic product” avidly scrutinized in the media. GDP, as it is called, measures the value of all the goods and services that are produced in a given year. It’s a concept that first emerged in the aftermath of the Great Depression and became popular in the 1950s and 1960s. Before that, the notion of national income prevailed. Today, however, the growth statistics that presidents and pundits like to comment upon always refer to the growth of GDP. In the United States, GDP per adult reached close to $90,000 in 2019.1 That is, the average adult produced goods and services worth $90,000.
To get from GDP to national income requires two adjustments. First, you subtract capital depreciation—the loss in the value of the buildings, machines, and equipment used during production—that is an integral component of GDP (the reason why domestic product is “gross”). Depreciation does not correspond to any income for anybody: Before paying their workers, distributing dividends, and investing in new machines, businesses must first replace their worn-out equipment and other capital assets. Tractors get old and break down, windows must be fixed, and so on. Depreciation as measured in the national accounts is large, about 16% of GDP. In fact, depreciation is even larger than the national accounts measurement because production often is accompanied by the depletion of natural resources and the degradation of ecosystems. These forms of depreciation logically should be subtracted from GDP but currently aren’t, although there are ongoing efforts to fix this flaw in economic statistics.2
The second adjustment to move from GDP to national income involves adding the income that the United States receives from abroad and subtracting what it pays to the rest of the world. In the 1950s and 1960s, when international capital markets were shut down, these international flows were negligible. Today, cross-border payments of interest and dividends are sizable. The United States pays 3.5% of its GDP to foreign countries—in the form of interest and dividends—and receives the equivalent of 5% of it from the rest of the world. On net it receives more than it pays.
After removing depreciation and adding the net flows of foreign income, US national income reaches about $18.5 trillion in 2019, or $75,000 on average among the 245 million adults (aged twenty and above) who live in the United States. This $75,000 is the same whether one looks at income before taxes and before government transfers—such as Social Security benefits and publicly funded health care spending—or at income after taxes and transfers. Whatever the government takes in taxes, it ultimately redistributes to flesh-and-blood individuals, whether in cash (such as in the case of Social Security benefits), in kind (such as when it pays for your health care), or by paying the wages of police officers, soldiers, and other public-sector employees. The government, quite fortunately, does not destroy any income. Nor does it create any, for that matter.
THE AVERAGE INCOME OF WORKING-CLASS AMERICANS: $18,500
Most Americans earn less than $75,000; some earn much more. To study income distribution in more detail, it is useful to divide the population into four groups: the working class (people in the lower half of the distribution), the middle class (the next 40%), the upper middle class (the next 9%), and the rich (the top 1%). While these groups are not homogenous, this simple act of division already reveals stark inequalities.
Let’s start with the working class, the 122 million adults in the lower half of the income pyramid. For them, the average income is $18,500 before taxes and transfers in 2019. Yes, you are reading this correctly: half of the US adult population lives on an annual income of $18,500. Pause for a second and consider the top line of your paycheck, before any income tax deduction. We expect many readers will immediately realize the gulf that separates them from half of their fellow Americans. For 122 million adults, what the market brings is a grand total of $18,500 a year, about a quarter of the average income of $75,000 in the entire population. This figure is the most comprehensive estimate possible; it is obtained by starting with the broadest possible measure of income—national income—and distributing this total across the entire adult population, leaving nothing out. That $18,500 includes, for instance, dollars immediately paid by workers to the government (in the form of payroll taxes, to take one example) or by their employers to private insurance companies.
Further up the income pyramid, the next 40% (the “middle class”) earns $75,000 on average before taxes and transfers, coincidentally also the average income in the entire population. This group, comprising almost 100 million adults, in that sense can be seen as representative of the country. Though we’ve all heard doomsday stories about the demise of the American middle class, the reality is more nuanced. With an average income of $75,000, the US middle class is still among the most prosperous on earth. Moreover, middle-class income has grown 1.1% a year since 1980, which, although nothing spectacular, is not negligible. At a rate of 1.1%, income doubles every seventy years: newer generations earn twice as much as their grandparents. The striking fact about the American economy is not that the middle class is vanishing. It’s how little income the working class makes.
What about the people making more than the middle class? When one looks at the top of the income pyramid, it’s important to distinguish the upper middle class (the top 10% excluding the top 1%) from the rich (the top 1%), because these two groups are in entirely different leagues. The upper middle class (22 million adults) are certainly not to be pitied. With an average income of $220,000 and everything that goes with it—spacious suburban houses, expensive private schools for their children, well-funded pensions, and good health insurance—they are not struggling. But as a group they do not have much in common with the 1% (the 2.4 million richest Americans), whose members make $1.5 million in income a year on average.
THE GAINS OF THE 1%: AS LARGE AS THE LOSSES OF THE BOTTOM 50%
Since the emergence of the slogan “We are the 99%,” the public has become familiar with the divergence between the fortunes of the rich and those of the rest of society. But the idea bears repeating, because it reflects a fundamental truth about the American economy: over the last few decades, income has skyrocketed for those at the very top of the income distribution, and nowhere else. Some believe that successful, well-off professionals (the top 20%, say) have pulled away from the rest of the country.3 In reality, what the data show is that the main fault line in the American society is higher up the pyramid: it is between the 1% and everybody else.
Perhaps nothing summarizes more succinctly the metamorphosis of the US economy than this simple illustration. In 1980, the top 1% earned a bit more than 10% of the nation’s income, before government taxes and transfers, while the bottom 50% share was around 20%. Today, it’s almost the opposite: the top 1% captures more than 20% of national income and the working class barely 12%. In other words, the 1% earns almost twice as much income as the entire working-class population, a group fifty times larger demographically. And the increase in the share of the pie going to 2.4 million adults has been similar in magnitude to the loss suffered by more than 100 million Americans.
The United States is unique, among advanced economies, to have witnessed such a radical change in fortunes. Rising income inequality is undoubtedly a global phenomenon, but the speed at which income concentration has been rising over the last four decades depends markedly on which countries you are looking at. Compare, for instance, the United States with Western Europe. In 1980, the top 1% share of national income was the same across the Atlantic, around 10%. In the ensuing years, however, the dynamic of inequality has looked very different. In Western Europe the top 1% income share has increased by two percentage points (instead of ten points as in America), to reach 12% today. The bottom 50% income share has declined two percentage points, from 24% to 22%.4 Looking more broadly, there is no country among high-income democracies where inequality has increased as much as in America.
1.1 THE RISE OF INEQUALITY IN THE UNITED STATES, 1978—2018
(Share of national income earned by the top 1% vs. bottom 50%)
Notes: The figure depicts the share of pre-tax national income earned by the bottom 50% income earners and the top 1% earners since 1978. The unit is the individual adult with income equally split within married couples. The figure shows that the top 1% income share almost doubled from about 10% in 1980 to about 20% today. Conversely, the bottom 50% income share collapsed from around 20% in 1980 to about 12% today. Complete details at taxjusticenow.org.
EVERYBODY PAYS TAXES
Now that we have a good view of how income is distributed in the United States, we can turn to taxes. In 2019, US residents paid the equivalent of a bit more than 28% of US national income in taxes to local, state, and federal governments combined. This corresponds on average to around $20,000 per adult. Of course, some pay more than $20,000 and others less. But nobody pays zero. Popular though it may be, the notion that 47% of the population does not contribute to the public coffers—the so-called “takers” lambasted by presidential candidate Mitt Romney in 2012—makes no sense. As a country, the United States has chosen to pool close to a third of its resources through its various forms of government. Every adult contributes to this effort. Romney was alluding only to the federal income tax, but there are many other taxes to consider when we ask, “Who pays?”
Broadly speaking, taxes in the United States—like in most other developed countries—can be grouped into four buckets: individual income taxes, payroll taxes, capital taxes, and consumption taxes. Each of these has a fascinating history and plays an important economic role.
The federal individual income tax, created in 1913, is the most well-known and largest tax in the United States, collecting about a third of all revenues (around 9% of national income out of 28%). Although the federal income tax is supposed to draw on all income, whether it derives from working (wages) or from owning capital (interest, dividends, capital gains, etc.), the income subject to taxation is less than the total amount of national income. Tax evasion contributes to this gap: since statisticians try to approximate the true income of Americans, they include estimates of the sums hidden from the taxman (based on random audits conducted by the IRS) to form an estimate of national income. But the main reason why income subject to taxation is less than national income is that many forms of income—especially of capital income—are legally tax-free.
Dividends and interest earned on retirement accounts? Tax-free. Undistributed corporate profits? Tax-free. Health insurance premiums paid through employers? Tax-free. The implicit rents that homeowners pay to themselves? The same. Today, income subject to the individual income tax (gross of any deduction) amounts to only 63% of US national income. Most of the rest of national income is legally exempted. Although politicians on both Left and Right generally insist that it’s better to have a broad base—that is, the largest possible pool of money to draw taxes from—the base of the individual income tax has shrunk over the last decades. In 1980, 71% of national income was included in income subject to tax. The unceasing invocations of “base broadening” notwithstanding, Uncle Sam is taxing a smaller and smaller fraction of the pie.
The rates applied to this base ranged from 0% for the first $12,200 of income to 37% for incomes above $510,300 ($612,350 for married couples) in 2019. This makes the federal income tax a progressive tax. The opposite of a progressive tax is a regressive tax—one where the more you earn, the lower the fraction of your income you must pay. (And in between is the flat tax: a tax where everybody pays the same rate no matter his or her income.) Though it is progressive, today’s income tax is much less so than it has been historically. Since the creation of the federal income tax in 1913, the top marginal income tax rate (the rate that applies to dollars earned in the top tax bracket, above $510,300 in 2019) has averaged 57%, twenty points more than the current top rate of 37%.
Besides the federal income tax, all states except seven* impose their own income taxes. States generally use the same definition of what constitutes taxable income as the federal government; they then apply their own rate schedule, with top marginal tax rates of up to 13% in California. A few cities (including New York) have their own income tax, too. Altogether, these state and local income taxes collect about 2.5% of national income in revenues, making total individual income tax revenues add up to 11.5% of US national income. With the corresponding tax base, as we have seen, at 63% of national income, the average income tax rate in the United States is a bit more than 18% (11.5% divided by 63%).
The second largest source of tax revenue is Social Security payroll taxes (8% of national income). These taxes are levied on labor earnings and come out of wage earners’ paychecks—from the very first dollar earned—at a rate of 12.4%. They are capped at $132,900 a year in 2019, a figure that roughly corresponds to the threshold for being among the top 5% highest wage earners. Any earnings above that cap are exempt from taxation, making Social Security taxes deeply regressive. A separate tax is collected to fund Medicare—the government health insurance program for the elderly—at a rate of 2.9% on all earnings. Altogether these payroll taxes, which were small fifty years ago, have grown to become almost as large as the federal income tax itself. As we will see, this development has significantly contributed to eroding the progressivity of the American tax system.
The third largest source of tax revenue is consumption taxes: sales taxes levied by states and local governments, and excises (on gasoline, diesel fuel, alcohol, tobacco, etc.) levied by both the federal and sub-federal governments. License taxes (such as motor vehicle licenses and levies on the extraction of natural resources) also fall into this category, as well as trade tariffs—which are nothing other than sales taxes on imported goods. Altogether, consumption taxes total $3,500 per adult on average. That’s equivalent to an average tax of 6% on personal consumption expenditure. Sales taxes represent about half of this total and excises and licenses the other half. In spite of a sharp increase under President Trump, import duties still represent small sums, about a tenth of total consumption taxes in 2019.5
The last—and smallest—source of tax revenue is capital taxes. We include under this category the corporate income tax, residential and business property taxes, and the estate tax. Some tax capital income flows (the corporate income tax, which taxes corporate profits); others tax capital assets (either annually, as in the case of property taxes, or at the time of death or when gifts are made, as in the case of the estate and gift tax). Capital taxes add up to a bit more than 4% of national income. Since the total flow of capital income represents about 30% of national income in the United States, capital taxes are equivalent to an average tax of about 13% (4% divided by 30%) on capital income.
ONLY PEOPLE PAY TAXES
Regardless of which bucket they fall into, all taxes are paid by people. It would be great if “big corporations” or “robots” could pay taxes for us, but alas this is impossible. Just as all national income ultimately accrues to flesh-and-blood individuals, so too are all taxes ultimately borne by real persons. For example, in the same way that undistributed profits of corporations constitute income for shareholders (income that’s saved and immediately reinvested by companies), corporate taxes are also taxes paid by shareholders: they reduce the profits of companies, which reduces how much dividends shareholders can receive or how much profits they can reinvest.
Although only people pay taxes, some of the people who pay them may live elsewhere. In that sense, it’s possible to make foreign countries pay, or at least try to make them pay. However, except for some very specific situations—such as small oil-producing nations—no country has ever succeeded in making foreigners contribute a large fraction of its tax revenues. In the case of the United States, some of its property and corporate taxes are paid by foreigners; for instance, Chinese residents who own real estate in Los Angeles pay property taxes to the state of California. Similarly, close to 20% of the shares of US corporations are owned by foreigners,6 so the US corporate income tax is, to some extent, a tax on foreign owners. But the overall amount of US taxes paid by non-US persons is small, of the order of 1% of national income. And it works both ways. Americans own shares of foreign corporations and real estate in London and in Spain, so they pay corporate and property taxes abroad too—about as much as foreigners pay to the United States. In the end, US governments collect 28% of national income in taxes, and Americans pay 28% of their income in taxes.
Figuring out how tax payments are distributed among individuals—that is, which social group pays what—involves a bit of detective work. In the 1970s and 1980s, Joseph Pechman at the Brookings Institution produced pioneering estimates of the distribution of all taxes in the United States, but oddly enough nobody attempted to emulate him, and the last estimates that exist are for the year 1985, when inequality was much lower than today and the structure of taxation quite different too.7
The main hurdle to figuring out who pays what is that although in the end only people pay taxes, the entity that legally remits the check to the IRS is not necessarily the person who pays the tax. For instance, employers remit half of federal payroll taxes and employees pay the other half. But the distinction is meaningless: in the end, all payroll taxes are based on the labor income of workers. That these taxes are administratively split into two parts—one remitted by employers, the other by employees—is a legal fiction that has no economic implications. As a general rule, taxes on labor (such as payroll taxes) are paid by workers, taxes on capital (such as corporate taxes and property taxes) are paid by the owners of the corresponding capital assets, and taxes on consumption are paid by consumers. Once one realizes this, allocating taxes to who actually pays them, although it requires marshaling a lot of information, is in concept a simple task.
The question of who pays the taxes collected by governments today is different from the question of how the economy would look if specific taxes were lower or higher tomorrow—what economists call, quite confusingly, “tax incidence.” For example, what would happen if the corporate tax rate were cut? In principle, many things could change: firms could boost shareholder income with higher dividend payments or share buybacks; they could increase the wages of their employees; they could slash the price of the products they sell; they could expand investment in factories or in research and development.
We will discuss questions of tax incidence later in the book, in the context of potential reforms. In the meantime, the critical thing to understand is that determining who pays existing taxes is a different project from imagining how the world would look if those taxes were changed. Regardless of what firms might do if the corporate tax rate were cut tomorrow, today’s corporate taxes are paid by shareholders and nobody else.8
IS THE US TAX SYSTEM PROGRESSIVE?
We can now attempt an answer to the key question: Once we account for all taxes and all forms of income that contribute to national income, does America really make the rich contribute more than the poor?
To address this question, we compute how effective tax rates varied across the income distribution in 2018, the year following President Trump’s tax reform. We divide the population into fifteen groups: the bottom 10% (that is, the 24 million adults with the lowest pre-tax income), the next 10%, and so on, until we reach the top 10%, which we decompose into smaller and smaller groups, until we reach the 400 wealthiest Americans. (This focus on the top of the pyramid is necessary because the rich, although few in number, earn a large fraction of total income and thus account for a large share of potential tax revenue.) We compute the amount of taxes paid by each group and divide that figure by each group’s pre-tax income.9 By construction, all the groups combined pay on average 28% of their income in taxes—the macroeconomic rate of taxation in the United States in 2018. The interesting question is how the effective tax rate varies across the distribution. Do the ultra-rich, for example, contribute more—relative to their ability to pay—than minimum wage workers?
The short answer is: “No.” Today, each social group funnels between 25% and 30% of its income in taxes into the public coffers, except the ultra-wealthy who barely pay 20%. The US tax system is a giant flat tax—except at the top, where it’s regressive. The view that America, even if it may not collect as much taxes as European countries, at least does so in a progressive way, is wrong.
More precisely, the working class—the five bottom deciles of the income distribution, who earn on average $18,500 a year—pays around 25% of its income in taxes. This rate slightly increases for the middle class—the next four deciles—and stabilizes at around 28% for the upper middle class. Taxes then rise a bit for the rich but never substantially exceed the average rate of 28%. Finally, they fall to 23% for the 400 richest Americans. As a group, and although their individual situations are not all the same, the Trumps, the Zuckerbergs, and the Buffetts of this world pay lower tax rates than teachers and secretaries. How can a tax system that many view as progressive be, in fact, so regressive?
1.2 THE US TAX SYSTEM: A GIANT FLAT TAX THAT BECOMES REGRESSIVE AT THE TOP
(Average tax rates by income group, 2018)
Notes: The figure depicts the average tax rate by income groups in 2018. All federal, state, and local taxes are included. Taxes are expressed as a fraction of pre-tax income. P0–10 denotes the bottom 10% of the income distribution, P10–20 the next 10%, etc. Taking all taxes together, the US tax system looks like a giant flat tax with similar tax rates across income groups but with lower tax rates at the very top. Complete details at taxjusticenow.org.
WHY THE POOR PAY A LOT
Let’s start with the bottom of the income ladder. The heavy tax burden imposed on the least fortunate Americans has two culprits.
The first is payroll taxes. Every worker in the bottom deciles, no matter how small her wage, sees her paycheck immediately reduced by 15.3%: 12.4% for Social Security contributions and 2.9% for Medicare. Meanwhile, the minimum wage has collapsed: a worker employed full time at the federal minimum wage makes barely $15,000 a year in 2019, only a fifth of the average national income per adult. In 1950, that same minimum-wage worker earned the equivalent of more than half of the average income.10 Alongside this dramatic reduction in their pre-tax income, minimum-wage workers have seen their payroll taxes rise, from 3% of income in 1950 to more than 15% today.
Other countries have followed the opposite route: increasing the minimum wage while cutting payroll taxes at the bottom of the wage distribution. In France, the minimum wage has grown faster than inflation, to reach 10 euros in 2019, the equivalent of $11.50 (against $7.25 in America). Meanwhile, payroll taxes for minimum-wage workers—which fund an extensive welfare state, including universal health insurance—have been cut from more than 50% in the 1990s to less than 20% today.11
The second and primary culprit for the high tax rates paid by working-class Americans is consumption taxes. The United States may not have a value-added tax, but it has a proliferation of sales and excise taxes that, like a VAT, make prices higher. And there’s a twist: in contrast to regular value-added taxes, US levies exempt most services, which the affluent consume at high rates as a percentage of their overall spending. This twist means that the consumption of the poor (goods) is taxed, while that of the rich (services) is largely exempted. The United States does not have a VAT; it has a poor man’s VAT.
Do you enjoy going to the opera? No sales tax. Have a country club membership? No sales tax. Need a lawyer? No sales tax. But if you drive, dress, or buy appliances, sales taxes apply all the way. Admittedly, most states have reduced rates for grocery purchases, which account for about 15% of consumption for the poorest people. But this generosity is largely offset by the extreme regressivity of excise taxes on fuel, alcohol, and tobacco. Excise taxes—in contrast to sales taxes—do not depend on the price of the product purchased but only on the quantities consumed (liters of wine or ounces of beer). High-end wines and beers thus end up being taxed more lightly relative to their price than common beverages.
1.3 THE US FLAT TAX: COMPOSITION BY TYPE OF TAX
(Average tax rates by income group, 2018)
Notes: The figure depicts the average tax rate by income group and its composition by type of tax in 2018. All federal, state, and local taxes are included. Tax rates are expressed as a fraction of pre-tax income. The working class pays almost as much as the middle class and the rich because of regressive consumption taxes and payroll taxes. The super-rich pay less than other groups because most of their income is not subject to taxation. Complete details at taxjusticenow.org.
The best available estimates show that sales and excise taxes, when combined, are extremely regressive in the United States. They absorb more than 10% of income in the bottom deciles compared to barely 1% or 2% at the top.12 Much of this regressivity flows from the fact that the poor consume all their income, while the rich save part of theirs (and the ultra-rich almost all of theirs: try spending a billion dollars a year). But the exemption of services also plays a major role. Conservative critics of a European-style VAT contend that if implemented in the United States, the tax would become an uncontrollable money machine that would transform America into a “socialist” nation. But there’s a less well known reason for their displeasure: unlike current archaic consumption taxes, an American VAT would hit the wallets of the wealthy.
Although sales taxes are local—not federal—there’s no tax haven for the poor: their burdens do not change much from one state to the other. Some states have lower consumption taxes or larger reductions for groceries, but overall they have overwhelmingly regressive tax systems. It’s indeed a general rule that taxation at the sub-federal level tends to be regressive. It’s much easier to implement progressive taxes at the federal level, both for practical reasons (federal agencies have access to more information and more resources) and because of tax competition (the wealthy can more easily move across state lines than across national borders). Ignoring state and local taxes in the analysis of the distribution of tax burdens, as most commentators do, gives a misleading picture.
WHY THE RICH PAY LESS
Since their inception, progressive taxes have had a core purpose: to offset the regressivity of consumption taxes, thereby making taxation socially acceptable. In the United States, as we’ll see in the next chapter, the first justification for the federal income tax introduced in 1913 was to offset the regressive impact of tariffs that, at the time, had been the only source of federal tax revenue. The other justification was to dampen the upsurge of inequality observed during the Gilded Age.
Unfortunately, today’s income tax largely fails to achieve these goals, for three key reasons.
The first problem, and the essential reason why billionaires pay low rates, is that most of their income is not subject to the personal income tax. As we have seen, only 63% of national income is included in the base of the income tax—many forms of income are legally exempt. A significant portion of taxpayers benefit from these exemptions, but the truly wealthy benefit even more. For many of them, virtually all of their income is exempt. Think about it: what’s the true economic income of Mark Zuckerberg? He owns about 20% of Facebook, a company that made $20 billion in profits in 2018. So his income that year was 20% of 20 billion, $4 billion. However, Facebook did not pay any dividend, so none of these $4 billion were subject to individual income taxation. Like many other billionaires, Zuckerberg’s effective individual income tax rate is close to 0% today, and it will remain close to 0% for as long as he does not sell his stocks.
The only sizable tax Zuckerberg pays is his share of Facebook’s corporate tax. But now the second problem comes into view: the corporate tax has almost disappeared. Facebook has never excelled at paying its dues: by shifting its profits to the Cayman Islands, it has dodged billions in corporate taxes over the years, and as we will see in more detail in Chapter 4, Facebook is far from the only multinational to do so. On top of that tax avoidance, in 2018, the US corporate tax rate was slashed from 35% to 21%. The consequence? Federal corporate tax revenues have fallen by almost half from 2017 to 2018.13 We’ll return at length to this development, but it’s worth recording here its most direct implication: low corporate taxes mean the ultra-rich, whose income mostly derives from owning shares in corporations, now really can get off almost scot-free.
The third reason why the wealthy pay low taxes is the recent transformation of the federal individual income tax. In less than two decades, the federal income tax has morphed from a comprehensive tax—taxing labor and capital equally—to one that favors capital over labor income explicitly. Since 2003, dividends have benefited from reduced rates of 20% at the maximum. This change means that even when corporations—like Microsoft—pay dividends, their owners—like Bill Gates—pay at most 20% in income taxes on those dividends. Since 2018 business income—income earned by doctors, lawyers, consultants, venture capitalists, etc.—has enjoyed a 20% deduction, so that the top marginal tax rate for business income is 29.6% instead of 37% as for wages. This is one of the key changes introduced by the Trump tax reform, and one of its most controversial aspects (indeed, all economists seem to oppose it, a rare feat). The deduction is limited for the self-employed, for instance for a successful consultant working solo. But it is unlimited for income generated by businesses that employ many employees or own a large enough capital stock. For instance, quite conveniently, someone in the business of owning and renting skyscrapers in New York City.14
The only category of income that does not benefit from any exemption, deduction, reduced rate, or any other favor is wages. At any income level, wage earners are thus more heavily taxed than people who derive income from property. More broadly, people with identical incomes can have wildly different tax bills depending on the legal (and often arbitrary) classification of their income. The tax changes of the last twenty years have done away with a core principle of tax justice: the notion that people with the same income ought to pay the same amount of tax. It’s no longer the case.
The explosive cocktail that is undermining America’s system of taxation is simple: capital income, in varying degrees, is becoming tax-free. This process is not uniform: some capital taxes are disappearing faster than others. The profits of big multinational companies bear less tax than those of domestic businesses. Dividends bear less tax than interest income. Depending on the nature of their wealth, rich people thus benefit in varying degrees. The ultra- wealthy, whose income mostly derives from owning shares in big companies, have so far been the primary winners.
PLUTOCRACY
Is it really a problem if the tax system is a giant flat tax with preferential treatment for the ultra-wealthy? Why should we care? There are several ways to answer this question.
Let’s first mention that we’ve done nothing to exaggerate our numbers, quite the contrary. If anything, our estimate of the extent to which American taxation has become regressive at the top is likely to be conservative. We’ve assigned the same effective corporate tax rate to every firm, although it’s possible, perhaps even likely, that those controlled by the rich avoid more taxes—for instance by shifting a higher fraction of their profits to offshore tax havens. Should this be true, we would overestimate the taxes paid by billionaires.
We should also make clear that the United States is not the only democracy where the overall tax system is much less progressive than it may appear at first sight. Conducting rigorous international comparisons is difficult, for reasons we’ll return to in Chapter 5, but the best evidence suggests that the United States is in good company: the tax system of France, for example, appears to be no more progressive than America’s.15
In our view, the lack of progressivity in US taxation is a problem for three reasons.
First, for basic budgetary considerations. Even if one only looks at the very top end of the income ladder, where taxes become regressive, the stakes are large. The top 0.001% currently pay 25% of their income in taxes. Doubling their rate to 50% would generate more than $100 billion in revenue each year, everything else being equal. That’s enough money to increase the after-tax income of each working-class adult by $800 a year, for instance by reducing their payroll taxes. The extreme concentration of income on the top end means that, for the United States, the tax bills paid by the super-rich matter a lot for the government’s overall finances.
The second reason is, quite simply, fairness. The taxes the wealthy don’t pay, the rest of us must cover. It’s always possible to argue that everybody receives the market income they deserve; that the rich, who were unfairly treated in the 1960s and 1970s, are now getting their just deserts from ever more unfettered and global markets. We don’t agree with this ideology—sometimes known as market fundamentalism—but at least it’s a consistent world view. However, what argument can justify that billionaires should pay less than each of us, and pay less and less as they get wealthier and wealthier? What principle could justify such an obviously perverse situation?
But probably the most fundamental reason to oppose America’s current tax regime is the inequality spiral that it feeds. As we’ve seen, the income share of the top 1% has ballooned while that of the working class has collapsed. And yet, instead of tamping it down, the tax system has reinforced this trend. The wealthy used to pay a lot; they now pay less. The poor used to pay relatively little; their duties have increased. In 2018, for the first time in the last hundred years, the top 400 richest Americans have paid lower tax rates than the working class.
This looks like the tax system of a plutocracy. With tax rates of barely 20% at the top, wealth will keep accumulating with hardly any barrier. And with that, so too will the power of the wealthy accumulate, including their ability to shape policymaking and government for their own benefit.
It’s always possible to shrug off the risk of an entrenched plutocracy. To believe that whether a few super-rich own a large fraction of the country’s wealth is irrelevant. That America’s institutions are so strong that they cannot be captured by special interests. That from Boston to Los Angeles, democracy will always and forever beat plutocracy. And certainly, democracy has overcome plutocracy in the past. It triumphed over the slaveholding plutocracy of the South. It beat back the nascent industrialist plutocracy of the Gilded Age.
1.4 US BILLIONAIRES NOW PAY LOWER TAX RATES THAN THE WORKING CLASS
(Average tax rates: bottom 50% income earners vs. 400 richest Americans)
Notes: The figure depicts the average tax rate for the 50% of adults with the lowest incomes and for the top 400 highest earners since 1960. Tax rates are expressed as a fraction of pre-tax income. Before the 1980s, the very top paid much more than the bottom 50%. In 2018, for the first time, the bottom 50% has paid more than the top 400. Complete details at taxjusticenow.org.
In one case it took a war; in the other a tax revolution.