Tuesday, August 02, 2011

Obama and Taxes: If the Truth is Too Complicated ...

President Obama's rhetoric in favor of tax increases is heavy on claims that the rich fail to pay their share, light on facts. Most of it is put in terms of claims about the federal income tax. Which is strange, since the federal income tax is paid almost entirely by high income taxpayers.

For details, see the figures provided by the Congressional Budget Office. For 2007, the latest year they cover, the bottom 60% of the income distribution paid about 1% of federal individual income taxes, the top 20% paid about 86% of the total and the top 1% almost 40%—the opposite of what Obama's rhetoric implies.

These figures are, however, misleading in two different ways. The federal individual tax is heavily weighted towards high income taxpayers, but it only produces about 40% of federal tax revenue. Payroll taxes produce about the same amount and, because they are paid only up to a maximum, the top 20% of the income distribution pays a lower share of its income in that form than the quintile below it, making the combined effect considerably less graduated than the figures on the income tax alone suggest.

The second problem should be obvious to an economist but seems to be invisible to almost everyone else. It's natural to think of the size of the check I write to the IRS on April 15th as the measure of the cost to me of the income tax—natural but wrong. 

To see why, suppose that the demand for high wage workers—top surgeons, lawyers, executives—is very inelastic. High taxes on such workers reduce the number of suitably talented people willing to enter the field, with the result that customers in need of their services bid up their wages. In the limiting case of perfectly inelastic demand, the result is to transfer all of the cost of taxation from those who hand over the money to the consumers of their services.

The same issue arises for other taxpayers as well. Payroll taxes take the form of a tax "paid by" the employee and another tax "paid by" the employer, but both are actually a tax on the same transaction—hiring labor. If an employer owes a thousand dollars in wages to an employee, it is of no economic significance whether the fraction that goes to payroll taxes is taken out by the employer before he hands over the money or by the employee after.

Who bears the actual burden of taxes depends on elasticity of supply and demand. If the labor supply is elastic, if the number of people willing to work is not very sensitive to wages, the burden ends up on the employees. If the only way of getting more workers is to pay them more and employers are willing to pay whatever it takes, on the other hand, wages rise by about the amount of the tax and the burden is born by the consumers of what the workers produce. 

Similar problems arise if one tries to estimate the real effect of other sources of revenue, such as the corporate income tax. Corporations are legal people but not actual people, so taxes they "pay" end up reducing the consumption of customers, employees, or stockholders. Who bears how much is again a hard question.

The CBO attempts to take account of such issues in its calculations; its conclusion, again for 2007, is that the bottom 40% of the income distribution bears about 5% of the burden of federal taxes, the top 20% almost 70%. It finds the lowest quintile  bearing a tax burden of about 4% of its income, with the rate rising quintile to quintile to about 25% for the highest and almost 30% for the top 1%.

Whether the CBO estimates are correct, I do not know, and I doubt they do. Whether they imply that high income tax payers bear more or less of the burden than they should  depends on how you believe the burden should be distributed. But the CBO estimates, at least, do not support rhetoric implying that executives pay taxes at a lower rate than their secretaries.

And I haven't even mentioned state and local taxes...  .

Obama presumably understands all of this; if not, he surely has people working for him who can explain it to him. Explaining it to the public in the form of sound bites designed to support the policies he favors is a harder problem, but not an insoluble one. 

If the truth is too complicated ...


Hernan Coronel said...

I am not rich but in the country I live (Argentina) I am probably in the top 10 percentile related to income (related to salary). I always feel I am paying too much taxes and on the other hand I KNOW that salaries would be lower if no tax was imposed so I definitely agree that taxes are in the end paid by consumers as transferred by the firms.

Anonymous said...

The super rich pay hardly any income tax, since their income is mostly in the form of capital gains. The only tax that bothers them is the estate tax. The merely rich, who get their income from labor, pay a higher percentage than both the poor and the super rich.

Andrew said...

Anonymous: The rich rarely pay estate tax; simple estate planning will avoid it for the most part.

David: What Obama says in your quote is irrelevant. He speaks that way because the truth is too complicated for the average American to comprehend.

The part which is easy to comprehend is that ever since the Bush tax cut for the rich, the economy has sucked balls, and it has led to bad times for rich and poor alike (in absolute dollars hurting the rich far more). The Bush tax cut for the rich has lead to nothing good for anyone except a few wall street gamblers who managed to bet correctly on the economy.

If we simply restore tax rates to where they were during the glorious Ronald Reagan years, the government deficit will be gone and everyone will benefit.

The rich will pay more taxes but they'll more than make up for it when the market booms.

The stupid part of this whole debate is that it's framed as a zero-sum game. It's not. The best solution is the one that is best for all, and that is bringing back the REAGAN ERA!!

P.S. Your stats are deliberately misleading, including people such as children and the poor retired as people who don't pay income tax

Anonymous said...

@andrew, are you not confusing correlation with causation?

Les Cargill said...

Can't speak for surgeons, but the demand for lawyers and executives is down, whether it's inelastic or not.

Anonymous said...

I don't know exactly what Obama said that you're referring to, but I don't see a contradiction between "the rich pay most of our tax revenue" and "the rich should pay more", for someone who believes (as Obama does) in highly progressive taxation.

DerekL said...

Anon, capital gains are taxed when you cash them out. So no, they don't pay income tax but they *do* pay capital gains taxes. This kind of obfuscation on your part is very annoying (as well as mendacious) because it implies that since they don't pay income tax, they don't pay "their fair share".

But to address David's point - President Obama (like all politicians) doesn't care for the truth. He's playing to packed populist house to score points for the upcoming election cycle. Facts need not apply, because blaming the ills on the rich has been a popular scapegoat for years now.

dWj said...

The quintiles, also, are based on a tendentious measure of "income". If you formed your quintiles based on some kind of long-term smoothed economic income, and perhaps long-term average taxes, it would come out more progressive.

$9,000,000,000 Write Off said...

Why are income quintiles used? Why not just number of households, say the top 10,000 households, the next 10,000 etc? That seems like a more natural grouping.

Why use income at all, when most households move up and then down during the course of their members' lives. Why not just compare household balance sheets?

Jeff Semel said...

Wonderful post! I think "elastic" should read "inelastic" in the sentence, "If the labor supply is elastic, if the number of people willing to work is not very sensitive to wages, the burden ends up on the employees."

Here David is referring to a nearly vertical supply curve, right? (I only know about the concept from blogs and popular books like Hidden Order, which I read for fun.)

Can the CBO estimates as to who bears the actual burden of taxes can be extrapolated to prospective tax increases? That is, do they apply at the margin? I would think so, but I'm not sure.

Anonymous said...

I'd be happy to bring back Reagan. The top marginal income tax rate under TRA86 was 28%.

Anonymous said...

Why are people praising Reagan?

Reagan boosted import tariffs and trade restrictions.
Reagan cut marginal income tax rates, but he also raised Social Security taxes.
Reagan increased farm subsidies.
Reagan sent the federal debt through the roof.
Federal spending under Reagan grew from $678 billion to $1.14 trillion.
Reagan set the record for the highest average spending as a percent of GDP over his administration. (Obama may beat him.)

Mark Horning said...

I've said this many times: I've worked many jobs in my life, but I never once had a "Poor" person hire me to do anything.

Higher taxes on the "rich" whomever they are simply eliminates jobs from the market.

Anonymous said...

As David Friedman points out, taxes alter the state of the entire economy. However, linguistically, it's easiest to attribute tax rates to those who pay them in the first instance. (The wage earner pays his income tax, etc.) In this sense, shareholders pay the 35% federal corporate tax, and then pay in addition, a 15% tax on their dividends or capital gains, for a grand total federal tax rate of 1-(1-.35)*(1-.15) = 44.75%.

So, when Warren Buffet talks about his secretary paying a higher tax rate than himself, he's omitting the effect of the 35% federal corporate tax. Yet, if the federal corporate tax is irrelevant to Warren Buffet, then the federal government might as well make it 100% -- get more revenue without hurting Warren. I'll bet Warren would start screaming about that.

Ironically, Obama, himself, pays a very low tax rate. Of course, he pays the normal tax rate for "earned income" on his $400k salary. But his "fringe benefits" dwarf that salary. Obama gets free employer-provided housing in a palace with an army of personal servants. He and his wife fly around in government jets. Sumptuous parties provided by the government. Etc. Much of that is not needed for Obama to do his job. Just take Michelle's holiday to Spain in a fleet of government jets, for which she paid only one first-class fare. All these benefits are untaxed, meaning that Obama is, himself, very lightly taxed.

Anonymous said...

To see why, suppose that the demand for high wage workers—top surgeons, lawyers, executives—is very inelastic. High taxes on such workers reduce the number of suitably talented people willing to enter the field...

Hahaha. They sure would prefer to stay poor and pay no taxes rather than be rich and pay them. You are so funny, can you wiggle your ears too?

SheetWise said...

Anon, a discussion of capital gains tax rates is really out of place in an economics blog -- capital gains are a fiction, and we all (should) know it. A discussion of what qualifies as a "capital gain" may be insightful. but real capital gains don't exist.

Anonymous said...

Jeff, I am pretty sure David used the terms correctly: supply is said to be elastic if people will keep working no matter what they are paid. (hence why "the [tax] burden ends up on the employees" and not consumers, in such a case. the curve is horizontal, not vertical.)

About the capital gains tax thread, you guys might want to check out this thought provoking post by Steven Landsburg claiming a capital gains tax is a double tax.

Eric Rasmusen said...

Great point, that the incidence of the income tax depends on the long-run elasticity of demand! As you note, it is quite believable that the demand for doctors is inelastic, so taxing them more raises their fees. I wonder if demand for executives is inelastic? That would depends on spans of control.

What is neat about the point is that it's commonplace in looking at the burden of the corporate income tax (onconsumers, workers, and investors). But in thinking about the big picture--- the progressivity of the tax system--- it makes sense to apply the idea to skilled labor too. And to human capital.