TaxProf Blog

Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Tuesday, February 21, 2012

Bartlett: Current Tax Code Violates Horizontal and Vertical Equity

New York Times, Tax Code Not Aligned With Basic Principles, by Bruce Bartlett:

It is clear that the rising inequality of wealth and income and how the wealthy should be taxed will be major issues in the political campaign. ... One problem that undoubtedly will arise is how to generalize about any particular income class’s tax burden. ...

[A] tax system that lightly taxes capital and heavily taxes labor is necessarily going to benefit the wealthy. As this chart illustrates, federal tax rates on the wealthy have been falling since 1978, when Congress cut the maximum capital gains rate to 28% from 35%.

The average federal (income plus Federal Insurance Contributions Act) tax rates for a sample of 2005 taxpayers after adjusting for growth in the National Average Wage Index.
We rationalize this mainly on the grounds that increasing the stock of capital is good for everyone. For example, it will raise productivity, which in the long run will raise wages for all workers.

The empirical question of whether sharply lower taxes on capital, and hence the wealthy, has actually raised saving, investment and productivity is one I will revisit. Suffice it to say that since 2003, when the current tax rates on capital gains and dividends were instituted, the economy offers little, if any, evidence on this score. (Before 2003, capital gains were taxed at a maximum rate of 20% and dividends were taxed like wages and salaries.)

The point I want to make here is that differential tax rates on different forms of income mean that tax burdens will vary not only between income classes but within them as well. The latest Economic Report of the President has an interesting table that illustrates this point.

Rates shown include income, corporate and payroll taxes.    

For the wealthy, we can see effective tax rates vary between 12% for those at the lower end of the top quintile and 29% for those at the upper end. Among the top 1%, effective rates vary between 9% and 35%. Those paying the highest effective rates are, no doubt, those such as doctors and lawyers with large incomes consisting mostly of salaries.

Thus we see that the bottom tenth of those in the top 1% pay well less in federal taxes as a share of their income than at least 25% of those in the bottom income quintile. And 25% of those in the top 1% pay less than substantial numbers of households in the upper three quintiles. ...

We can see, then, that the tax system in the United States violates the fundamental principles of income taxation. Those are “vertical equity,” which says that those with upper incomes should pay a higher effective tax rate than those with modest incomes — as far back as Adam Smith, ability to pay has always been a core principle of taxation — and “horizontal equity,” which says that those with roughly the same income ought to pay roughly the same taxes.

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In some ways Bartlett's op-ed reads like Orwell's 1984. The table he cites, reflecting the 2012 distribution of average tax rates for various income classes and subgroups within, reflects some awfully robust vertical equity at work. Bartlett's claim that the table demonstrates a lack of horizontal equity is unfounded. By breaking each income class down into substrata based on different income levels, the table sets up comparisons of taxpayers who do NOT have "roughly the same income," and tell us nothing about horizontal equity. As Bartlett surely is smart enough to know better than to distort statistics this way, readers may fairly ask what he is up to.

Posted by: Jake | Feb 21, 2012 1:13:26 PM

These charts ignore elasticity of reported taxable income. That elasticity is very high for capital gains from rich people.

The income inequality scolds give the impression that they will not be satisfied until the top tax rates are 90% are higher. Pre-1960 when that was the case virtually nobody reported taxable income in the top bracket. Rich people found legal ways to avoid paying the tax. It can be as simple as Warren Buffett's tactic of never selling his hugely appreciated company stock.

If we have a 90% top bracket there will be virtually no revenue collected at that rate. Yet some people would prefer that outcome. I wouldn't. Why impose extra cost on the economy and on government revenue just to punish the rich? That's stupid.

When the combined Federal and state marginal tax rate on capital gains surpasses 40%, you are probably in revenue-losing territory on the wrong side of the Laffer curve. It may calm your feelings of envy, but it's not doing the country any good.

Note that California taxes capital gains for the rich at 10.3%, and that due to the AMT this is non-deductible against federal taxes. We can probably push the federal capital gains rate only up to about 30%, including the effect of all proposed phase-outs of tax breaks, before revenue is at risk. Most AMT taxpayers already face a 22% federal rate on capital gains because phase-out of the AMT exemption creates a 7% rate increase.

Posted by: AMTbuff | Feb 21, 2012 2:33:13 PM

Alas, we see that the top 1% are paying more or less the same effective rate they were paying in 1960...and 1970...and 1980...and 1990...

There are so many that believe the wealthy used to pay 70+% in taxes. Great to see this data

Posted by: alan dean | Feb 22, 2012 6:42:05 PM