You know, gentlemen, that I do not owe any personal income tax. But nevertheless, I send a small check, now and then, to the Internal Revenue Service out of the kindness of my heart. [351]
David Rockefeller[352]
Egotistic immorality, a negative externality, is the primary driver behind regressive taxation. The overall tax system or a single tax is regressive when it falls lightly or not at all on those best able to pay and heavily on those less able to do so. Taxes can be regressive because of the choice of tax base, like taxing labor while exempting capital. Moreover, frequently taxes only seem progressive with higher tax rates for higher incomes, whereas in reality tax loopholes, shelters, exemptions, and alternative rates create gaps between the stated and effective rates. Hence, the effective personal income tax rate of the wealthy is lower than that of the middle class. Worsening economic inequality and regressive taxation are symptoms of deteriorating morality and sinking democratic standards.
Principles of Personal Taxation
A tax is personal if it is borne by an individual or a family rather than a corporation, institution, or foundation. Direct personal taxation includes personal income, capital gains, social security, wealth (in some jurisdictions), inheritance (estate), and gifts (asset transfers).[353]
In theory, one can escape an indirect sales tax by not consuming, but not a direct tax; in reality, one can escape a direct personal tax by using tax loopholes and tax shelters or not realizing a profit on an asset. Hence, the details of the tax code can subvert its declared purpose.
There are four widely accepted tax principles for upholding the efficiency and fairness of personal taxation:
1. Simplicity: This is the easiest principle to apply but the most frequently violated because complexity is necessary to obscure the low effective tax rates borne by the extremely wealthy. To ensure fair taxation, elected assemblies should avoid passing complex and incomprehensible tax legislation that is only understood by a microscopic minority of tax experts. Thus, in Switzerland, perhaps the world’s most democratic state, laws need to pass a comprehension test by a suitable sample of Swiss citizens.
2. The ability to pay: This principle requires those with a greater ability to pay to bear a larger share of the tax burden than those who are less able to do so; it is the impetus behind a progressive income tax, whereby higher tax rates apply to higher incomes.
3. Equity: This principle requires persons in similar economic circumstances to have similar tax burdens.
4. Neutrality: This principle seeks to maintain economic efficiency by avoiding or minimizing tax interference with economic choice and distortion of resource allocation.
Arguably, there ought to be two additional tax principles, as follows:
5. The Laffer principle: The Laffer curve, popularized by Arthur Laffer (b. 1940), illustrates a marginal tax rate that maximizes tax revenue such that a higher or a lower rate would reduce tax revenue.[354] In 1963, President Kennedy proposed reducing personal and corporate income tax rates.[355] The legislation passed in 1964, after his assassination, reducing the top personal income tax rate from 90 percent to 70 percent and the lowest rate from 20 percent to 14 percent. It also lowered the corporate income tax rate from 52 percent to 48 percent.[356] The tax cuts sustained a fast economic growth rate at 5.5 percent until 1969, while inflation remained restrained at 1 percent. Most remarkably, the tax cuts increased tax revenue materially, suggesting that excessively high tax rates had resulted in chronic underconsumption, holding back the economy below its production possibility frontier. The increase in tax revenue also suggests that the tax cut moved the fiscal policy from a restrictive posture to a more neutral one and diminished the tax-disincentive for work.[357]
6. Justifiable tax burden: The benefits derived from public goods must correspond to their cost, the overall tax burden. In a failing democratic system, these benefits typically fail this test because public goods are not supplied in a sufficiently competitive manner and they represent a wrong mix of public goods by including, for example, wars of aggression.
A Regressive Personal Income Tax
Taxation of wealth, land, and produce is steeped in history, while personal income tax is a relatively recent innovation, only becoming moderately significant in the second half of the 19th century. In the United States, such taxation began with the Civil War at 3 percent. A major reason for not adopting it earlier was its considerable complexity; that aspect continues to this day as one of its many drawbacks, although it presently generates more revenue than any other personal tax.
There is a prevailing impression that the US personal income tax is fair, with progressive tax rates, and those with higher incomes pay higher tax rates; in reality, it is highly regressive. This unfair distribution of the income tax burden has prompted Warren Buffet, one of the very richest in the world, to complain that his secretary’s personal income tax rate was double his own, although, clearly, he should be subject to a higher tax rate than she. The words of David Rockefeller—one of the wealthiest people in America—at the start of this chapter are further evidence that the personal tax regime is terribly regressive.
The marketing of the personal income tax has brainwashed the public mind into believing it is progressive, whereas it is regressive, inequitable, undemocratic, and violates all the fundamental principles of taxation.
In part, the unfairness of the personal income tax is rooted in its base, personal income. In addition, over the years, numerous tax loopholes, shelters, and fiddling have rendered it still more biased against earned incomes while sheltering income from capital sources. It is a testament to the unfairness and absurdity of personal income tax that a person on a modest salary must pay his share of income tax while a billionaire earning tens of millions in interest from municipal bonds is exempt.
To the extent that the tax code treats capital gains more favorably than yield on investments, it encourages risky investments over safer ones, resulting in speculative bubbles followed by huge losses, as demonstrated by the bursting of the dot-com and other bubbles. Similarly, continuation of the oil-depletion tax allowances accelerates oil depletion at a time of ample international oil supplies, thereby squandering a strategic reserve instead of preserving it for future emergencies. It also makes the development of clean energy sources, such as solar energy, less attractive than otherwise, thereby contributing to environmental pollution and global warming. The personal income tax also interferes with free choice and efficient resource allocation by favoring debt-financed property ownership over rental through allowing a tax deduction of mortgage interest without comparable treatment for rent. Its favorable treatment of the interest expense of business partnerships and proprietorships encourages debt financing, with major negative economic consequences.
In a Senate debate, Ted Kennedy famously complained about the Republican refusal to raise the minimum wage while giving considerable tax breaks to billionaires by saying, “Where does the greed stop?”[358] To the extent that personal taxes of all forms, including social security taxes, diminish the incomes of wage earners who have a high propensity to consume, it dampens economic activity. In contrast, taxes that distribute the tax burden more fairly would be economically beneficial to all segments of society: lower income groups would have more after-tax dollars to spend and the rich would benefit because their corporations would have more sales and profits and the value of their stock holdings would appreciate.[359]
Moreover, the personal income tax falls mainly on the savings of salaried people. Consider someone who consumes 80 percent of his (her) pretax income and is subject to total direct personal taxes at 20 percent (social security tax at 7.65 percent plus income tax at 12.35 percent). The tax is tantamount to a 100 percent tax on his (her) savings. As such, it is a precipitous barrier to building a nest egg through savings, falling heavily on marginal changes in wealth instead of on wealth itself. Thus, the personal income tax is a formidable impediment to vertical social mobility, frustrating the American dream for the majority of citizens. Perhaps, students of sociology may have more to say about the role of taxation in stifling American vertical social mobility.
Personal income tax also has subtle negative effects on demographics. To the extent that it cuts the resources available to low- and middle-income families, it discriminates against child bearing, given the high cost of bringing up children and seeing them through college. This is a critical problem in several European countries and Japan, where reproduction rates have fallen below the levels necessary for maintaining their populations. Thus, personal income tax has increased the risk of the progressive extinction of some nations and races.
The following identifies how the present personal income tax code violates the six tax principles cited earlier:
1. Instead of a simple code, it is highly complex; its opaqueness facilitates its regressive nature. It is accessible to only a few prohibitively expensive tax advisers who have dedicated their lives to deciphering its mysteries.
2. The tax base, taxable income, is only a partial indicator of ability to pay. It also violates the taxable income yardstick because the loopholes permit those with very high incomes to have lower effective tax rates than those with middle incomes.
3. It violates the equity principle because it treats income from capital sources more favorably than income from labor. For example, someone earning $500,000 in salary would pay a higher tax rate than someone making a similar amount in capital gains, and worse still the latter could simply pay nothing by not realizing any capital gain.
4. It violates the tax-neutrality principle because it discriminates against labor by its non-uniform treatment of different sources of income. It also has a strong bias in favor of debt financing.
5. It violates the Laffer principle because closing the tax loopholes would yield substantially higher tax revenue, making it feasible to lower tax rates.
6. It violates the principle of fair pricing of public goods by charging rich taxpayers significantly less than the benefits they derive from public goods.
In conclusion, the personal income tax code is complex and unfair, it violates tax neutrality, it causes economic dislocations, and it’s detrimental to economic efficiency.
Capital gains tax is the other significant personal tax as measured by the revenue it generates. It is payable pursuant to the realization of net capital gains in a given financial year. In practice, this is an elective tax for the wealthy, because it is avoidable by not realizing capital gains, just as a sales tax is avoidable by not making a purchase. Indeed, the investment strategy of many successful investors is to continue holding assets with huge unrealized capital gains for years or even decades. In a debate on Bloomberg on November 6, 2010, the distinguished economics professor Nouriel Roubini aptly summarized the capital gains tax in an illuminating comment, “… for Warren Buffet, and others, unrealized capital gains are taxed at zero percent.”
In the absence of a personal capital tax, unrealized capital gains should be taxable annually instead of leaving it to the discretion of the individual to postpone it indefinitely by not selling appreciated assets. Unrealized capital gains are a central tax loophole for the rich.
Capital gains tax is also regressive because its rate is lower than the top rates on earned income for no justifiable economic reason. It is more regressive still because the tax rate on long-term capital gains is lower than that on short-term gains, and since the wealthy can hold their investments longest, its higher rate targets those with limited resources.
The excuse for taxing those with limited means at a higher rate than the rich is that short-term gains are speculative and should be discouraged, overlooking that those with limited means cannot hold on to their investments for as long as the wealthy. This argument is without merit because institutions conduct the bulk of the speculation and they are subject to corporate taxes, not personal capital gains tax.
Finally, a capital gains tax seriously violates Pareto optimality because it prompts a lock-in effect on appreciating assets; hence, it diminishes capital market liquidity and capital mobility, distorts securities prices, and interferes with the efficient allocation of capital.
Employees’ Social Security Tax Contribution
US social security tax targets the poor in particular; it is 7.65 percent as a percentage of the income of working people.[360] In 2014, the largest component of the social security tax, the 6.2 percent FICA tax, only applied to the first $117,000 of the gross compensation, whereas a smaller flat rate without an income ceiling would have been less regressive.[361] Most unfairly, the social security tax is without regard to the official poverty threshold.[362]
In Chapter 17, the section titled “Employers’ Social Security Tax Contribution” discussed the social security tax as it applies to corporations and proposed merging it with the general tax on corporations to eliminate its discrimination against labor. Similarly, employees’ share of the social security tax is regressive, which requires incorporating it within a single tax on labor income to permit exempting low incomes, as discussed in the next chapter. [363]
An expenditure tax, sometimes referred to as a consumption tax, is a tax on the total annual consumption of an individual. At present, it is not applied anywhere and has rarely been used in the past. Nevertheless, from time to time, some recognized economists have proposed it; hence, it is useful to put it in perspective. Like all taxes on consumption, except perhaps those on super-luxuries, it is regressive because those with low income consume a much higher percentage of their incomes than those with high incomes. Thus, in principle, it would fall most heavily on lower- and middle-income groups and lightest on high-income groups. Hence, along with the poll tax, it is one of the most regressive taxes ever devised, although generous exemptions for low consumption levels would make it less so. Still, it would always be light on the rich because they consume least as a percent of their income.
It is also economically inefficient and irrational. To the extent that the rich consume a small percentage of their income and to the extent that an expenditure tax would discourage their consumption further, it would accentuate the problems of economies suffering from chronic underconsumption, causing them to operate well below their production possibility frontier, precipitating higher unemployment, lower profits, and slower economic growth.