Let's talk about tax, baby

Tax has got everybody talking. Warren Buffett famously declared that it was not right that he and other billionaires paid next to no tax. President Obama has since introduced changes to reduce taxes for the middle class and increase taxes for high earners. But not all of these have been successfully passed. So what is to be done with a system that appears to perpetuate, rather than ameliorate, inequality? Let's start with a little myth-busting.

Myth 1 – The richest Americans pay the most tax

Source: Citizens for Tax Justice, 2013.

False! It is true that the richest Americans, those in the top 10% of the income distribution, pay around 70% of all tax. But as a share of income, their tax burden is much lower. In fact, the share of tax paid by each income group is broadly similar to their share of income (Figure 1). In other words, the tax system does very little in closing the gap between the rich and the poor. It is only mildly progressive.

Some taxes explicitly benefit those on higher incomes. The most obvious is capital gains. The majority of US assets – houses, factories, stocks and shares – are held by the top half of the income distribution. Because of the level that capital gains tax is set, when these assets are sold at a profit, owners can end up paying a lower effective tax rate than low-income people who pay only wage and consumption taxes. So the rich move even further away from the poor.

Myth 2 – The US tax system unfairly penalises corporates

False! It is true that the US has the highest corporate tax rate across advanced economies - 39.1% compared to an average of 25.1%. However, corporate income tax raised is only 2% of GDP, much lower than in other countries. Why? Because corporations take advantage of tax loopholes to locate their headquarters overseas or attribute income to overseas sources, benefiting from lower tax rates. In allowing loopholes, the government penalises its own bottom line, not that of the corporates.

Myth 3 – The US tax system is supporting sustainable fiscal finances

False! Here’s where the debate gets interesting. The Congressional Budget Office says that US government finances now look in pretty decent shape over the next decade. They measure this by looking at the size of debt relative to national income, an affordability ratio. Once the economy has fully recovered and unemployment has fallen further, the deficit should be manageable, as long as the government sticks to agreed spending caps. 

Why should we be worried about this? Some highly-regarded economists, like Bob Gordon, are arguing that the US might be growing at a permanently slower rate. The economy won't recover in the way that we think. In part, this is because people are dropping out of the labour force (either because they cannot get a job or because they have reached retirement age).  It is also because the majority of income is tied up in the hands of the rich who save rather than spend (see previous blog). This means lower national income, lower tax revenues and a higher government debt ratio. Reforming the tax system today would allow the government to maximise its revenue, in preparation for a risky tomorrow. Part of this money could be spent on re-engaging those who have left the workforce, and who are more likely to be in poverty. 

More on that, next week.