Let's Talk About Taxes

This article was originally published to singularitypolitics.com November 16th, 2014.

The Progressive Taxation System

The philosophical underpinnings of the modern system of progressive taxation is one of the most ill understood elements by many laypeople. At first glance it seems to make littles sense and indeed does appear to “punish success” in some respects. One can only then conclude that some form of jealousy or contempt must be the motivation for such a system. Why shouldn’t we all just pay the same tax rate? That would make the system fair.

This however, is not at all the case and falls apart rather quickly upon further analysis. Consider the two following hypothetical people: Jim who makes $30,000 a year and Bob who makes $1,000,000 a year. Let’s assume that they both live in a country with a flat 20% income tax. Jim pays $6,000 a year in taxes while Bob pays $200,000. Again it seems fair at fist glance but let’s consider what each of our characters might have bought with the money they instead paid to the government. With an extra $200,000 Bob most likely would have purchased some form of luxury good, or else would have increased his investments with that money. Jim on the other hand, would likely have purchased additional necessities like food, or clothing that he otherwise had to do without. It shouldn’t be difficult to understand that Jim needs that $6,000 a lot more than Bob needs the $200,000. This is an example of the concept of diminishing returns. Each additional dollar a person makes has less and less utility to that person. If you are saying to yourself: “Well maybe Jim should pay a lower tax rate than Bob.” You now understand one of the basic reasons behind the system of progressive taxation. It’s not about punishing the rich, it is about not punishing those who are not rich.

Taxing the Rich

taxchart.png

 

Source: taxfoundation.org

Above is the current (as of 2014) progressive income tax code for the United States Federal Government. I’d like to use this illustration to dispel another common misconception regarding progressive taxation. Namely, that we tax the rich at a higher rate than we do the middle class and the poor. While changes in the tax code can disproportionately benefit or harm people of different incomes, at the end of the day we are all subject to the very same tax code. Bill and Melinda Gates pay the same 10% tax on the first $17,850 of income they make in a year as any middle class family does. (Assuming for the sake of example that they file jointly.) It’s the different levels of income that are taxed progressively, not the earnings of an individual. If Bill and Melinda somehow only made $80,000 next year, they would pay a maximum of 25% for their federal income tax, with the majority of that income taxed at 15%. If a poor person were to win the lottery and take a lump sum payout, they would pay 39.6% in taxes for the amount of money over $400,000 (filing single, not head of household).

This leads us to another reason for this system, the velocity of money. I mentioned the concept of diminishing returns earlier, and it is similar to what we’ll discuss here. As you might expect, velocity of money refers to the rate at which money circulates through the economy. The higher the velocity, the less money there needs to be to account for the same number of transactions.

As a person earns more and more money, the velocity of each additional dollar slows down as you might expect. The early money is spent right away on things like rent, food, clothing, and other necessities. Eventually a person might purchase a car and so forth. After a certain point, when all needs are met the velocity slows down. Money is spent less on consumer goods, which drive the economy and create jobs, and instead moves into savings and investment where it mostly sits apart from the consumer economy. So therefore, our system applies a low tax to the early money a person makes and instead backloads the taxes onto the later money.

You may be saying to yourself: “But investments go to help companies grow and also create jobs.” However, the truth of that statement depends on what is meant by the word “investment.” What we traditionally think of as investments: stocks, bonds, and futures traded on an open exchange like the NYSE or NASDAQ, are mostly secondhand instruments bought from other people on the exchange and not the company itself. When you buy a share of Twitter on the NYSE, Twitter does not get any additional money. You are instead creating liquidity for someone who bought the stock from someone who bought the stock (and on and on) from Twitter. This money is most often used to purchase other instruments, but does sometimes get withdrawn and brought back to the consumer economy. However, it likely went through a number of non-consumer transactions beforehand and thus has a lower velocity. Companies are actually financed in the early stages through venture capital firms and eventually through their initial public offering. This is a small minority of the investment sector and is generally considered high risk. The rest of the investment sector would be better called the speculation sector, in that it is money moving around through various transactions with goal of making more money.

Consumer spending is a key driver of economic development. It is most quickly turned into wages, which then are largely used in consumer spending, and so on and so forth. This is the cycle that creates jobs and supports the middle class. Of course some of consumer spending is brought out of the cycle as profits and dividends, but the economic payoff for the middle class is much higher per dollar in the consumer sector than the investment sector. This idea of velocity of money and valuing the economic impact of consumer spending over speculation spending is another basis for our system of progressive taxation. It is based upon the principle that the economy needs to work for everyone and not just a privileged few.

Taxes and Economic Growth

The rhetoric that economic growth can be stimulated through cutting the taxes on higher incomes is thoroughly embedded in the consciousness of the United States and much of the developed world as well. It’s a major part of the idea of supply-side, or trickle-down economics. The idea here is that when taxes are cut people have more money to spend and that when high income individuals are given more money they invest it and create new companies and jobs. This argument relies on the idea that when the government levies taxes it in effect removes money from the economy. If we are talking about the United States between the years 1997 and 2001 this idea might hold some merit. That was the last time our country ran a budget surplus. It taxed more money than it spent. Since then, and for the majority of the years before then in post-war era, our country has run a budget deficit. It spent more money than it brought in through taxes. Most of that money is spent in what we have called the consumer sector, either directly (wages, purchasing goods) or indirectly (Social Security and Medicare payments).

taxgraph.png

 

Source: taxfoundation.org, multpl.com

Above is a graph of the top marginal tax rate and what I have termed the median tax rate against real GDP growth. GDP stands for Growth Domestic Product and it is the most common metric for the size of a nation’s economy. Real GDP simply means that those changes in GDP due to inflation are removed. The graph shows the growth rate not the actual growth. Meaning that a trend downward in the line doesn’t mean that the economy is shrinking, but rather that the economy was growing more slowly than the year before. When the line falls below 0%, that does signal a contraction of the economy. It’s also worth noting that more economic growth isn’t always better. Generally a healthy economy grows between 2.5-4% annually. Much higher than this may indicate an asset bubble. Median tax rate in this context means the highest tax rate an individual income of $50,000 in current dollars would have been subjected to.

There’s a few crazy things you’ve likely noticed on this graph. The first is that Real GDP growth is largely off the scale for the years from 1933 to 1945. 1933 and 1934 saw the economy contract by 26.34% and 10.81% respectively. Then, due in large part to the massive government spending of the New Deal and WWII, it grew by no less than 19.39% (1940) and as much as 78.21% (1943). This is very strong evidence that government spending does in fact stimulate economic growth. (More on that in articles to come) The second crazy thing is the top marginal tax rate during this same period, from 63% in 1933 to a max of 94% in 1945. It’s important to understand that the income level for the top marginal tax rate did not remain the same either. In 1936 it was $82.5 million in 2012 dollars. By 1943 it had fallen to $2.8 million. Between 1964 and 1965 the top bracket went from $1.48 million to $720,000. This trend largely continued. The third is for the years 1988 to 1990, where the top and median tax brackets are identical. All income over roughly $35,000 was taxed at the same 28% rate. 1990 is the year in which we had the lowest top marginal tax bracket of $34,167, again in 2012 dollars.

Now for the real questions. Do higher taxes on higher incomes prevent economic growth? Are tax cuts on high incomes an effective way to stimulate the economy? I think we can agree by now that the answer to these questions is no.

Patrick NelsonComment