America’s Two Tax Systems

Alexandria Ocasio-Cortez, the charismatic new Congressmember from New York, recently floated the idea of a 70% top marginal tax rate on those earning over $10 million. Her proposal was met with criticism from the center and the right, but was also publicly supported by numerous Nobel Prize-winning economists, with some studies even suggesting that 70% was not shooting high enough. In much of the discussion that followed, news outlets issued explainers clarifying how a marginal tax rate works, but few commented on whether America’s tax system is even progressive anymore.

A progressive tax system is one in which the higher up on the income spectrum one gets, the higher their percent of tax paid on that income. In the United States, the first progressive tax was signed into law by Abraham Lincoln in 1862. By the middle of the 20th century almost all developed nations had their own form of progressive taxation. America’s top marginal tax rate peaked at 94% during the Second World War and remained high until the Reagan years when it began to come down to the current rate of 37% on any dollar earned over $500,000 for single filers.

The idea behind progressive taxation originated in the United Kingdom as a means of collecting more tax revenue during the French Revolution. The economic theory that supports this idea is that of marginal utility; that as people earn more money, each dollar earned is less valuable. Give $1,000 to a household making $25,000 a year and it will significantly improve their financial livelihood. Give the same amount of money to someone making tens of millions a year, and they may not even notice the change in their checking account balance.

Marginal utility theory allows for the collection of a greater percent from higher earners before it begins to disincentive work. Think of this as part of the famous Laffer Curve theory; that higher tax rates will raise revenue until eventually they disincentive labor. Though the peak of the curve is somewhat disputed, the New Palgrave Dictionary of Economics states that the range in academic studies centers around 70%. All this extra money raised through tax revenue could fund key government programs like the worker training and infrastructure jobs programs championed by Ocasio-Cortez and others.

Beyond raising additional revenue, a progressive tax system helps address income inequality. This is both through funding more programs for the lower earners, but also it takes more from the top and thus aids in the equity of the tax system. Economist Emmanuel Saez notes that pre-tax income inequality is also higher in countries with lower top marginal rates, which he suggests comes from CEOs working harder to maximize their own pay in systems like ours.

All this is to say that a progressive tax system has many benefits when administered correctly. In a world where we want to make filing taxes easier rather than harder, we create tax brackets to group income into so as to simplify what rates people pay. The U.S. currently has seven tax brackets, as stated above, the highest beginning at the $500,001st dollar earned.

This means that someone earning $6 million is paying the same top rate as someone who earns 1/10thof what they do. Considering $6 million would still place you below average amongst the 1% in places like New York City, this tax system begins to look less progressive as you go up the income scale. In fact, once you pass $500,000 a year, the change in how much of your income goes to taxes actually decreases. This is to say that the rate of increase in your tax burden falls ever lower as your income rises. This happens at each level in the tranche, not just for the highest earners, but when we cap the progressive marginal tax system at only $500,000 what we have left is effectively a flat tax rate for those earning over that amount.

A flat tax system is one in which every dollar earned is taxed at the same amount, which as stated is effectively what we have for the absolute richest in our society. This is wildly inefficient, as the marginal utility of those extra dollars is very low for the ultra-wealthy. This skewed tax code also shifts more of the tax burden down on to middle- and lower-class households.

Under America’s two income tax systems, the ultrarich effectively buy-in to a tax system that is less equitable. Once you start earning over $1 million a year, most of that income is being taxed at the same flat rate. If we were to expand the number and size of tax brackets to better reflect Diamond and Saez’s recommendations including scaling up to a top rate of 73%, the government would collect a projected $72 billion more in tax revenue each year. This would increase equity and align our tax system with how it was during some of America’s best years of economic growth. Far from extreme, Ocasio-Cortez’s proposal is starting to look like a great place to start.

It’s the wealth, stupid

However, even though the structure of income taxes is important and Ocasio-Cortez’s plan is far from outlandish, a much larger contributor to American inequality is how wealth is taxed and distributed. Over the last quarter of a century, only the richest 10% of American households have seen their net wealth grow, while the bottom 50% of households have seen their net wealth shrink in real terms. This disparity exacerbates other cleavages of inequality, such as the large racial wealth gap between the median white household ($171,000) and the median black household ($17,600).

This growing wealth inequality is largely fueled by the regressive tax mechanism regulating money earned from investment income. Long-term capital gains are taxed at 0%, 15%, and 20% depending on what income bracket you fall into, but they never exceed 20%. These numbers are substantially lower than tax rates on earned income for the same individuals. The 2017 GOP tax bill only fueled this redistribution towards the wealthiest individuals; by slashing the corporate tax rate permanently, doubling the estate tax exemption, and lowering the top marginal income tax rate.

For the very wealthy, the lion’s share of their annual earnings comes from capital gains. For the lower 99% of American households, more than three-quarters of their annual income comes from salaries and wages, whereas for anyone making over $10 million per year their salary accounts for only 15% or less of their income. Reports from the non-partisan Tax Policy Center have shown that wealthy individuals “report an effective taxable return on their wealth of less than 2% on their individual income tax returns.” This means that for every $1 million of wealth those individuals have, less than $20,000 is taxable when aggregated across interest, dividends, and capital gains.

The Tax Policy Center states as the primary reasons for such low taxable returns the tax system’s preference for retirement saving, non-taxing of unrealized gains, and arbitrage allowed by loss offsetting in the tax code. Often, this results in the richest people in the country paying lower effective tax rates on their total income each year than those in the middle class (recall Warren Buffett’s secretary). Most wealthy investors do not realize their capital gains on an annual basis (i.e. liquidating their investments) and therefore are not subject to the lower tax rate anyway.

All of this means that the very wealthy are not only subject to an effective flat tax on their salaried income but more importantly, they are able to make most of their income from gains and returns taxed at a much lower rate. This is something unattainable for the vast majority of Americans because of the up-front capital required to adequately invest in stocks or property. Therefore, though the capital gains tax may have been envisioned as a way to spur investment and shore up capital for business ventures, it has become a massive windfall for the ultrarich.

Recent reporting from the Washington Post confirmed that Saez, along with his UC Berkeley colleague Gabriel Zucman, is now working with Senator Elizabeth Warren to develop her proposal for a wealth tax on those worth over $50 million. The basic proposal includes a 2% tax on wealth over $50 million, rising to 3% on that over $1 billion. Saez and Zucman project that a wealth tax could increase tax revenue some $2.75 trillion over a decade.

Unlike Ocasio-Cortez’s proposal to raise rates on flows of money, Warren’s plan would hit an individual’s stock of cash. This would incentivize the ultra-rich to spend their fortunes, either on charitable giving or on lavish living expenses. If a wealth tax is passed, a sizeable cottage industry would arise overnight to aid tax evaders. Therefore, Warren’s wealth tax relies in part on greater enforcement that includes increasing mandatory audits.

Whether it is by raising taxes on flows of income or on stocks of wealth, there is a lot of energy building amongst Democrats for progressive tax reform. The share of pre-tax income going to the top 1% of earners has been rising steadily for over 40 years, and America’s continual tax cuts for the wealthy have helped fueled that redistribution of wealth away from the Middle Class and towards the mega-rich. Though it continues to be worth debating what exactly a truly progressive tax system would look like, the question of when we need to start has been settled.

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