DISPUTATIONS: Something’s Gotta Give

by William Galston | May 16, 2011

Because my previous column on taxes stirred up some controversy, I thought it would be useful to put all the evidence on the table for everyone to consider. But before engaging the details, let me make my priors clear.

First, I opposed the Bush tax cuts—all of them. As a good Clintonian, I thought we should use the surplus to make long-deferred social investment and to address the challenges of an aging population.

Second, I favor significant income tax increases for the best-off Americans. And if someone could figure out how to design a wealth tax that wouldn’t generate massive capital flight, I’d be for that as well.

Third, along with most Americans, I think that while we must address our long-term fiscal imbalance, it would be wrong to do so with spending cuts only. According to a recent survey by the Pew Research Center, only 20 percent of Americans favor a spending-only approach, while 65 percent favor some combination of spending reductions and tax increases.

That brings us to my previous column, in which I argued that Obama’s campaign pledge not to increase taxes for families making less than $250,000 was unwise and will have to be scrapped eventually. As study after study has shown, the bulk of the Bush-era tax cuts went to households that aren’t wealthy, and ending the cuts for the top tier would recoup only one quarter to one third of the lost revenues. That explains why serious liberal fiscal policy analysts, such as the Center on Budget and Policy Priorities, advocate letting all the Bush cuts expire, not just those Obama wants to terminate. 

It is absolutely true, as Jonathan Chait has argued, that the average tax rate for the wealthy declined as the Bush cuts kicked in, and there’s both reason and opportunity to push it back up. (I never suggested otherwise.) But as the tables below show, the larger truth (and problem) is that everyone’s average rate has declined since 2000, rates at the bottom and in the middle fell more (in percentage terms) than did those at the top, and the share of taxes paid by the wealthy has actually increased.

We can’t regain the lost revenue just by restoring the status quo ante for the top 2 percent of households who would be affected by Obama’s plan. On the other hand, we wouldn’t want to raise income taxes for those stuck at or near the bottom or even in the middle. They’re already living at the margin, and their payroll taxes are regressive. That leaves the upper-middle class—say, the top 5 percent of households, those with incomes of $150,000 or more. According to the CBO, these households command about 30 percent of total household income, and they reaped substantial benefits—in dollars as well as percentages—from the Bush tax cuts. If we want to regain our fiscal balance and invest in our future, they’ll have to contribute something along with the wealthy.

But there’s an obstacle—a perceptual problem with deep political consequences. Most people in the top 10 percent, or even 5 percent, of U.S. households don’t think of themselves as well-to-do. A Third Way survey found that 9 percent of respondents regarded themselves as low income, while nearly 9 in 10 placed themselves in some segment of the middle class. Only 1 percent said they were “wealthy.” When Americans are asked how they feel about increasing taxes on the wealthy, almost all of them think the hike will fall on someone else. No wonder this option polls so well. Someone will have to break the news to the self-described “upper-middle class” (about 16 percent of the Third Way survey) that they’ll have to be part of the solution.

That doesn’t mean, however, that we should restore the tax rates to what they were before. The case for fundamental reform of our tax system—individual as well as corporate—is as strong as it has been since the 1980s. But closing the loopholes that honeycomb our current code will affect millions of people who aren’t wealthy. And we should be looking to diversify our tax base: The top one-fifth of households are already paying more than four-fifths of all individual income taxes. A serious case can be made for a consumption tax, a carbon tax, or both. But these alternatives, too, would have the effect of raising taxes for the households Obama promised to hold harmless. In the long run, something will have to give way. I hope it’s the president’s promise and not our future.

                 Average federal tax rates, by income quintile and top percentage

                Lowest    Second    Third    Fourth    Fifth    Top 10%    Top 5%    Top 1%

2000           6.4          13.0         16.6      20.5       28.0        29.6          31.0          33.0

2007           4.0          10.6         14.3      17.4       25.1        26.7          27.9          29.5

Change       2.4            2.4           2.1        3.1        2.9           2.9            3.1            3.5

(% points)

Change       38             18            13         15         10            10             10            10

(%)      

                Share of federal tax liabilities, by income quintile and top percentage

                  Lowest    Second    Third    Fourth    Fifth    Top 10%    Top 5%    Top 1%

2000           1.1            4.8          9.8       17.5       66.6        52.2            41.4        25.5

2007           0.8            4.4          9.2       16.5       68.9        55.0            44.3        28.1

Increase      (0.3)          (0.4)       (0.6)      (1.0)        2.3           2.8              2.9         2.6       

(decrease) 

        Share of individual income tax liabilities, by income quintile and top percentage

                   Lowest    Second    Third    Fourth    Fifth    Top 10%    Top 5%    Top 1%

2000            -1.6           1.1         5.7         13.5      81.2         67.7           56.2         36.5

2007            -3.0          -0.3         4.6         12.7      86.0         72.7           61.0         39.5

Increase       (1.4)         (1.4)       (1.1)        (0.8)       4.8           5.0             4.8           3.0

(decrease)

(Source: Congressional Budget Office, Special Collection: Average Tax Rates by Income Group, June 2010)

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William Galston is a senior fellow at the Brookings Institution and a contributing editor for The New Republic.

 

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