Sunday, October 10, 2004

How a Progressive Income Tax Operates

The Federal Income tax (and the Arizona income tax since it is tied to the federal tax) is a PROGRESSIVE tax in that as you progress upward on the income scale the tax rate increases.

This is in contrast to a FLAT tax in which the rate is the same regardless of income. Under either system the higher the income the higher the tax.

A flat tax of 10% in which every worker pays 10% of his/her income in taxes would result in a person earning $10,000 per year paying $1,000 in taxes and a person earning $100,000 per year paying $10,000 in taxes. The higher income individual in this case pays ten times as much as the lower income individual but both pay the same rate of 10% of their income.

Under a progressive system (like that of the U.S.) as income goes up the rate increases for each additional increment of income. A progressive income tax schedule might look like this:

$0 - $5,0000%
$5,001 - $20,00015%
$20,001 - $35,00025%
$35,001 - $50,00035%
$50,001 and up45%

In the example above every wage earner from the lowest paid to the highest paid pays no tax on the first $5,000 of income. Those who make more than $5,000 pay 15% on all earnings between $5,001 and $20,000. Those earning over $20,001 pay 25% on all earnings between $20,001 and $35,000 and so on.

A person earning $33,000 per year would pay $5,499.75 in taxes calculated as follows:
First $5,000 in income:$0.00 taxes
Next $15,000 in income:$2,250.00 taxes (15% of $15,000)
Last $12,999 in income:$3,249.75 taxes (25% of $12,999)
Total Taxes:$5,499.75

Note that the individual above does NOT pay 25% of his/her income in taxes (25% of $33,000 = $8,250) but rather pays 16.67% ($3,249.75/$33,000 = 16.67%) in taxes.
When a person says he/she is in the "25% tax bracket" they mean that the last dollars of income they earn are taxed at a rate of 25%.

Prior to the Reagan (U.S.) and Thatcher (Great Britain) tax cuts in the 1970s & 1980s the U.S. top rate reached 96% and the top rate in England was something like 110%.

In both cases the bracket for these very high rates started at an amount that was less than $100,000. For simplicity, let's say that the 110% rate in England started at $90,000. Thus, a person making $89,999 whose income increased by $10,001 (to $100,000) would see their tax bill increase by $11,001 or $1,000 more than their raise.

You can see that, with very high rates, people would take steps to reduce their incomes - either by finding tax shelters (which basically are businesses designed to generate losses on paper which are then subtracted from income to reduce taxable income to an amount below the very high tax brackets) or, if they could, stop working for the year once their income reached the point where additional amounts would put them in the very high tax bracket.

A doctor earning $10,000 per month in England might decide to work only 9 months (thereby keeping annual income at $90,000 and avoid the 110% tax bracket) and close for June, July and August. This would be fine for the doctor but the doctor's nurse, receptionist, bookkeeper, lab technician, janitor, etc., all of whom made considerably less than $10,000 per month would also be forced to stop working for these three months.

Thus, a tax designed to "soak the rich" ended up providing the rich with a nice vacation and costing the "average worker" one-quarter of their income.

The social/economic reason for progressive taxes is two fold.

First, marginal utility theory states that as consumption of a product increases the marginal utility of each succeeding unit steadily decreases - i.e., the satisfaction of the first piece of Godiva chocolate is great, the second good but not as good as the first, the third is still good but adds very little additional satisfaction, etc.

The same with income, with the first units being great because they provide necessities for life. But as income increases the amount of additional satisfaction from each additional unit becomes less and less. Thus, according to Marginal Utility theory, the pain from paying higher taxes will be less for the rich than for lower income people so we should tax the rich at a higher rate.

The second reason has to do with the fact that as income increases people tend to save more and, in the case of the rich, this means that a huge fortune can be amassed over a lifetime.

Assuming a relatively static economy and heirs who are equally aggressive at making money (history has shown that neither of these assumptions are correct) it won't take too many generations until all the wealth in a nation is controlled by a few wealthy families.

Neither of the reasons put forth for progressive taxation stands up to serious scrutiny. But the concept of a progressive income tax has proven popular with politicians and those in favor of big government.

The myth that the rich, as a class, bear a bigger portion of the tax burden sells well among middle and lower income voters (class warfare and envy are good tools to galvanize a voting bloc and hold it together).

But for this myth to be true, government spending must be kept low and the tax rate on the rich must not be so high as to destroy the incentive of the rich to invest.

In practice government spending has steadily increased and is far more than the rich, as a class, can afford to support regardless of the tax rate. In order to raise sufficient funds to pay for all the government's programs, politicians talk about large tax increases being borne by the "super rich" and then quietly enact tax legislation that starts the high rates somewhere in the $30,000 income range (which most people do not consider to be "super rich").

Further, in order to avoid the danger of people not investing and creating the capital needed to enable the economy to grow, government allows people to deduct certain types of investment spending from taxation. Since the higher a person's income the better one is able to afford to invest, this provides a way for the truly rich to reduce their tax burden.

In addition to helping to preserve investment, it also allows the politicians to directly influence investment decisions. Thus, instead of spending tax dollars on public housing for the poor, they can provide a tax deduction for investments in low cost housing. However, by providing the wealthier segment of society a means to reduce their tax burden, the government is faced with a greater need to increase rates at lower income levels.

A final irony is that the super rich actually benefit from the present progressive income tax. By taxing current income and not wealth (which is income earned in the past and saved) the existing super rich are able to retain their wealth and position in society while lower income people are prevented from moving into the ranks of the wealthy by being denied the opportunity to accumulate wealth through saving because of the high taxes they are forced to pay.