Wednesday, April 27, 2011

Will President Obama Have to Soak the Middle Class?

Both men knew "where the money is."

An article last Monday in the Wall Street Journal "[w]here the tax money is" examined President Obama's purported claim that raising taxes on the wealthy will result in meaningful deficit reduction, thereby making the sort of spending reductions proposed by others, including Congressman Paul Ryan of Wisconsin, unnecessary. To this end, the article calculates the impact on federal revenue and thus the deficit of a 100 percent confiscatory tax on indivduals who earn $380,000 or more per year and finds that such a tax would raise $938 billion annually, far less than the current deficit of over $1.6 trillion. Moreover, a 100 percent tax on those individuals in the top five percent of the income distribution would yield $1.89 trillion, just enough to cover the deficit.

Note that these calculations certainly overstate the impact on the deficit of such confiscatory taxation. For one thing, the "wealthy" individuals in question already pay a sizeable portion of their income in taxes, with the result that the net increase in revenue resulting from a 100 percent tax rate would be less than the $938 billion and $1.6 trillion figures, respectively. Moreover, at least some individuals who must pay their entire salary to the government would work less, or not work at all, and thus create less income, if the government simply confiscated their income under the guise of "taxation." Such a reduction in work effort, of course, will also reduce the rate of economic growth and thus reduce the income of other citizens as well, thereby reducing tax payments from lower income groups. In short, even a 100 percent tax rate on high income earners, whether "high income" is defined as the top 1 percent or top 5 percent, defined, will still leave the United States with a very large deficit.

How, then, will the United States close its titanic budget deficit, if that is what she chooses to do? One way, of course, is to reduce spending, along the lines suggested by Congressman Ryan. If, however, the United States rejects meaningful spending reductions, the article predicts that Congress will, to quote bank robber Willie Sutton (pictured above), "go where the money is," that is, raise taxes (either directly, or by eliminating deductions) on indivduals in the middle and upper middle classes. For, as the article points out, individuals in the $50,000-$200,000 range produce more taxable income than individuals who earn over $200,000. Such an approach, it should be noted, would be consistent with the observation of nobel laureate Friedrich Hayek, also pictured above, to the effect that a chief function of high (progressive) tax rates on "the rich" is to induce individuals in the middle classes to accept rates that, while high in an absolute sense, are lower than those paid by the rich. (There is, of course, precedent for such an approach. In 1960, for instance, the top marginal federal income tax rate, levied on incomes of $400,000 and above, was 91 percent. Moreover, the marginal rate on income between $12,000 and $16,000 was 30 percent; the marginal rate on income between $24,000 and $28,000 was 43 percent, the marginal rate on incomes between $36,000 and $40,000 was 53 percent, the marginal rate on incomes between $88,000 and $100,000 was 72 percent, and so on. It short, while rates on the "rich" were quite high, so too were rates on individuals in the middle and upper-middle classes.) As Hayek put it:

"It would probably be true, on the other hand, to say that the illusion that by means of progressive taxation the burden can be shifted substantially onto the shoulders of the wealthy has been the chief reason why taxation has increased as fast as it has done and that, under the influence of this illusion, the masses have come to accept a much heavier load than they would have done otherwise. The only major result of the policy has been the severe limitation of the incomes that could be earned by the most successful and thereby gratification of the envy of the less-well-off."

See F.A. Hayek, "Taxation and Redistribution," in The Constitution of Liberty (1960).

Instead of simply redistributing income from rich to the middle class, such an approach would presumably also redistribute income within the middle class.

Hopefully the nation will opt for reduced spending instead of the Sutton approach.