Large Tax Increases Are Not a Semantic Question

Yesterday I argued that simply covering our medium-term fiscal problems with tax hikes was not going to be easy or relatively painless; we'd have to go back to the Clinton-era tax rates, and then hike rates again by at least a third, possibly more.  Today Kevin Drum responds that this doesn't seem so bad:

Page 65 of this CBO document provides estimates for how much income tax various people pay. The median family gets dinged for 3% of its income. A one-third increase means their income taxes would go up by....1% of their income. That's not so much.

How about a family with twice the median income? That is, someone who's pretty well off. They pay 13% of their income. A one-third increase means their taxes would go by 4% of their income. Again, this is far from catastrophic, especially since we're talking about an increase phasing in over the course of many years.

Are these numbers the right ones? I don't know. It all depends on what happens to spending and on how we decide to allocate the burden of higher taxes. If payroll taxes go up, it might hit the middle class a little harder. If we choose to increase capital gains taxes or institute a financial transaction tax, it would hurt them less. Or maybe we'll choose a consumption tax or a carbon tax instead. Who knows? Still, it's likely that more than three-quarters of all taxpayers would end up paying no more than an additional 5% of their income in taxes. That's not painless, and no one will enjoy it. But over the course of a decade or two it's just not a "huge change."

Of course it depends on how we implement such a hike.  But looking just at the federal income tax makes no sense.  In order to raise taxes to the 25% of GDP that Kevin wants, all taxes need to rise by at least a third, not just income taxes: excise taxes, corporate income taxes, payroll taxes.  And we're talking about rising from the Clinton level, not from the current effective tax rate level.  That's going to be a lot more than 5%.

Here's a chart showing effective tax rates on the various quintiles over the past thirty years, using data from the invaluable Tax Policy Center:

This data imputes all taxes (including corporate and excise taxes) to various income cohorts, which I think is sensible; ultimately, all taxes are borne by some person, and in the case of corporations, that person is mostly a shareholder.  If you take out corporate income taxes, the gap between the top two quintiles would narrow slightly, but it would not go away.  As you can see from the dotted red line, the share of taxes as a percentage of GDP does not correspond neatly with changes in the tax code, especially on the upside.

So our baseline would be returning effective tax rates on the top quintile to around 28%; effective tax rates on the middle quintile to 17%; and effective tax rates on the bottom quintile to 6%.  Then we raise each tax rate by a third to 37%, 23%, and 8%, respectively.  The current tax rates?  We don't know exactly (the data only go up to 2007), but a rough estimate is 25%, 14%, and 4%.  

In other words, for the poorest 20% of Americans (who make less than $20,000 a year, with an average income of $11,500), taxes go from about $460 to about $920.  For the middle quintile (making an average of $50,000 a year), taxes go from around $7,000 to over $12,000.  For those in the top quintile, with an average income of $167,000, taxes jump from a $41,000 to $62,000.  

Turn it around and look at the effect on incomes: after tax incomes drop from $11,040 to $10,580**, in the lowest quintile; from $43,000 to $38,500 in the middle quintile; and from$125,000 to $105,000.  And the higher you go, the stronger the effect is; for the top 1% (which starts at AGI of $400,000), you reduce their minimum income from a bottom of roughly $275,000 to perhaps $210,000, either through taxes, or through lower capital income as a result of higher corporate income taxes*.  

Can this be done?  Maybe.  Probably, at least on the lower tiers, who don't respond to tax rates the way the wealthy can.  But it won't be easy or moderate.  I'm sure there are a number of people in my readership where two spouses take home $125,000 between them.  How easily can you guys chop $20,000 out of your budget?  And though the percentages are lower, in practical effect it's even worse for the bottom: if you're making minimum wage, $460 is several weeks worth of paychecks.

Now, if you don't want to take more money from the lower quintiles, you have to take even more from the top quintiles.  But the effective tax rate on the top 1% is already almost 50% if we raise all taxes by the same amount.  Those people also pay other taxes: property taxes, state income taxes, sales taxes.  How much of their income do we think the state can claim?  How much do we think it should claim?

Kevin and I probably differ on that question, but I don't think that most Americans would peg the answer at 60% or more, which is easily what it could be in the high-tax states where high-earners tend to cluster.

Does this mean we shouldn't raise taxes?  Not at all; I was a pretty staunch advocate of letting the Bush tax cuts expire last year, and I certainly hope we'll do so in 2012, though I very much fear we won't.  But raising taxes by another third beyond that?  I think that's too stiff a bite.  Politically, reducing paychecks by that much would be extraordinarily painful, even if done slowly.  The size of the burden on the rich would probably slow investment and economic growth. And beyond that, I don't think it's just that someone should have to work longer for the government than they do for themselves.  

* This is a bit approximate because I'm using comprehensive household income for the five quintiles, and AGI, which is all I can find, for the top 1%.  The effect might be smaller--but it would still be very substantial.

** Fixed math error