Income Tax Structures of an Economy - Essay Example

The hardest thing in the world to understand is the income tax." -Albert Einstein Income tax structures of an economy can theoretically belong to any of the following three classes – progressive, regressive or proportional. A progressive income tax structure is characterised by rising tax rates with income while a regressive tax structure observes the opposite in essence. A proportional tax structure implies the same tax rate for all income groups (Stiglitz, 2000). However it is not seldom that one fails to comprehend the tax structure of an economy to entirely belong to either of these and often those aiming to perfectly classify the US income tax structure as either of these have faced the same problem, for albeit it has followed an essentially progressive taxation framework since its inception in that the rich have had to bear larger tax rates compared to the poor, often there have been certain tax cuts or impositions that allegedly go against the principle of progression itself (Folsom, 1999). Apart from this aspect, the assumptions that justify progressive taxation have also been challenged leading to considerable debate that has not limited itself to only politicians or economists. Considerable amounts have been written and spoken about regarding the tax system that should be followed and the structure taxation should assume in the USA. The common layman like the erudite scholar has developed his particular opinion regarding the pattern in which taxes should be levied and the incidences the different economic classes should bear. This lack of consensus is at least partially a result of under-comprehension of the socio-economic aspects that govern the system and this lack of comprehension is evident in the large furore that is the inevitable result of any tax cuts for the upper or the upper-middle class. This non-substantial general comprehension stems from among other things, the fact that the degree of progression has observed remarkable instability and variation in the US economy. For instance, while in 1954, federal income tax was imposed at different rates ranging from 20% to 91% for 24 different income bracket layers (Internal Revenue Code, 1954) brackets with the tax rates varying from 10% to 35% in 20061. Thus although both these structures were progressive in nature, the changes brought about that reduced the number of brackets as well as the magnitude of the tax rates can be argued to have been regressive, as the maximum tax rate has been reduced from 91 to 35 percentage points and the minimum has been reduced to 10% from 20%. The IRS reports that for the year 2006, the top 0.1% income earners bear 17.4% of the total federal tax burden while they earn 9.1% of the total income while the bottom 50%, who earn 13.4% pay 3.3% of the total federal tax bill. Further, it has also been derived that the top !% who earn 19% of the total national income bear 36.9%, the top 5% while earning 33.4% of the income are accountable for 57.1% of the total federal tax burden. This pattern of a low tax burden for the bottom half of the economy with the rich being accountable for a disproportionately higher share implies a progressive tax pattern. In what follows, we shall attempt to evaluate the progressive tax structure in terms of manifest functions2, latent functions3 and social dysfunctions4 of the resultant social structure and then attempt to assess upon the desirability of the system relating it to the alternatives based upon our derived understanding. A progressive income tax structure is primarily prescribed to treat income inequalities present in an economy. The idea was to levy disproportionately high taxes on the upper income groups and redistribute the revenue through state regulated reallocation schemes (Hartman, 2002). This idea can be traced back to the writings of Adam Smith. Adam Smith (1776), taking note of the fact that acquiring the only necessities of life imposed relatively greater expenses on the poor, posited that it was not at all unreasonable that the rich should contribute to public expenses more than in proportion to their respective revenues. So, the essential premise that proposes that the tax structure should be progressive is apparently one of social equity and justice. This can be called the manifest function of the social structure that observes a progressive tax structure. However it is also noted that this structure empowers the government to redistribute the income. According to Hartman (2002), the second and least publicly acknowledged objective of progressive taxation is to provide government with the power to redistribute income from the “wealthy” to the “poor”. This is certainly one of the latent functions of the progressive social structure. Another argument favouring the progressive tax structure stems from the notion that different income groups have different consumption propensities. It is generally agreed upon that poor people consume most of their income while the rich save most of theirs. So, if the poor and the rich have their incomes taxed at the same rates, implying a relatively greater tax brunt on the poorer section it may well lead to a reduced demand for consumption thereby leading to a situation of excess supply which unless treated may well aggravate into a depression (Mankiw, 2000). An objective which played an important role in gathering the original public support for progressive taxation was the consideration that the economic and political power of wealth required curtailment (Hartman, 2002). But this very fact also serves in generating certain disincentives that can be viewed as a major social dysfunction of the progressive tax enabled society. The highest earners also contribute maximally in raising the national income of an economy and adoption of a strong progressive taxation structure implies a large part of their revenues which essentially act as the primary incentives for these people are taken away as taxes. So, this process of curtailing economic power on the flip side of the coin also curtails the magnitude of the incentive to strive for more earnings through further productive participation in the economy. And this in turn, adversely affects the pace of growth. Another aspect of the economy that taxes higher incomes at disproportionately higher rates is that it curtails the amount of loanable and investible funds. It is an observed fact that the individuals belonging to the wealthier bracket save larger amounts of their incomes. Therefore a larger tax burden on them implies a reduced amount of savings for the society as a whole and this in turn implies reduced supply of investible funds (Mankiw, 2000). This is another social dysfunction of the economy in which progressive income taxes are levied. A stunning aspect of the American progressive tax structure as Hartman (2002) shows is that over the course of 40 years from 1957 to 1997, it has failed to redistribute income in favour of the poor. His study derives that in these four decades, while the share of income taxes levied on the top 10% of incomes rose 15 percentage points, the after tax income share of the remainder of incomes declined 13 percentage points implying that progressive taxation has failed to deliver on its primary premise of reducing the disparity of real incomes. Theoretically, although increasing the tax share on the wealthy should raise the post-tax share of income of the rest of the taxpayers, a detailed and meticulous study of the share of taxes versus share of income for the afore mentioned decades has proved this apparently obvious cause-and-effect to be a wrong assumption. Rather a negative relationship between the tax share paid by the upper tenth share of incomes and the income share of the remaining 90 percent after-tax has been found implying that when tax share of the top 10 percent rises, for the remaining 90 percent the post-tax income share of falls (Hartman, 2002). So, the progressive structure has in essence had an entirely opposite distribution effect compared to what its proponents predict. And given the diminishing marginal utility of income, redistribution in favour of the less affluent raises welfare of the society (Bankman and Griffith, 1987) which then implies this failure to redistribute if we admit it to be so, has had adverse impacts on welfare. And this is certainly an undesirable event for the society as a whole. The idea that progressive taxes empower governments to redistribute incomes in favour of the poor has been in essence interpreted by critics as allowance for politicians to protect friends, punish enemies, and to tax certain groups to give benefits to other groups (Folsom, 1999). So, our problem restated assumes the form of the statement that the magnitude and convoluted nature of progressive income taxation and its pervasiveness coupled with its susceptibility to politically motivated manipulations have led to it becoming very dramatic in the political and economic changes that have occurred in the last century. Congressman Justin Morrill of Vermont noted In 1864, the time when the progressive income taxation first became a political issue in America, that “in this country we neither create nor tolerate any distinction of rank, race or colour, and should not tolerate anything else than entire equality in our taxes” (Folsom, 1999). This idea of unequal treatment to bring about equality is actually an argument that critics use to refute the idea of progressiveness in taxation. So, what surfaces is that progressive taxation although based upon the premises of ensuring social justice via regulated redistribution of wealth (the stipulated manifest function) does have certain undesirable latent effects and certain associated social dysfunctions that appear to have defeated the celebrated manifest function of redistributing the income in favour of the poor itself. Also certain tax cuts favouring income earned from investments, brought about in recent times by the Bush government have led to questions and allegations about them being regressive by having adverse effects on the people situated between the extremely wealthy and the low income section. It has been shown that if the tax cuts brought about by president Bush are made permanent then by 2015, individuals earning between $80,000 and $400,000 shall have to pay 13.9 percentage points more of federal taxes compared to those earning above $400,000 while those earning below $80,000 shall find their tax rates remaining the same or they might have to bear minute increases in tax payments (Johnston, 2005). A New York Times editorial (2005) argues this to be socially unacceptable because although the families belonging in the annual income bracket of $100,000 to $200,000 are not as worse of as street dwellers, the concerns regarding college for the children, care for aging parents and saving for retirement do make their lives considerably difficult and being hit by heavy tax burdens does not help. The article posits that a system that hinders comfortable retirement or a top-notch education for families that have made it into the upper twenty percent of income earners is significantly faulty. Coupled with this when one considers that families within this income bracket will be paying 5 to 9 percentage points more of their incomes as taxes compared to those earning more than one million provided the Bush tax cuts are accepted to permanency, it certainly appears to be unacceptable (NYT editorial, 2005). This system although progressive in that the rich pay more taxes at an increasing rate, the recent tax cuts, although do not affect the utmost poor, do certainly affect those moderately affluent families not belonging in the extremely affluent brackets. Therefore, the present tax structure of America is unacceptable in its present form from two particular angles. Firstly, it has evidently failed to deliver on the redistribution aspect. And secondly, the recent tax cuts go against the very principles of progression by making life difficult for those relatively worse of compared to the super rich sections. To arrive at a sound and practically adoptable solution we have to first look into why progressive taxation failed to achieve distributive equity and from thereon attempt to extract the foundations upon which to build upon our prescriptions. The primary cause behind the documented failure of the progressive tax lies in its objective of curtailing economic and political power of the wealthy. In this pursuit, the economy observed high marginal tax rates on financial and intellectual capital and this in turn resulted in reduced efficiency and productivity for the economy as a whole that again caused the reduction in the income shares of the majority. So, in essence, the real income effect of very high marginal tax rates that have been levied citing the arguments for progressive taxation has been reduced real income for the masses in the after tax context. It seems therefore the high costs of bearing disproportionate tax rates for the high income groups in terms of reduced income shares, a gradually slowing pace of growth and capital formation are not being offset by the promised social benefits and therefore the evident prescription would be a strong and deep rooted tax reform (Hartman, 2002). Again, if we consider the Bush tax cuts as a reforming step, the effects are also not promising. Although the problem of capital being taxed very highly and thereby losing its motivation to perform has been done away with here, the families belonging to the immediately lower brackets than the very wealthy class have been hit very hard and unacceptably. So, these changes in the form of capital favouring tax cuts have only served to create a new type of inequality and income disparity that bears signs of serious aggravation in the near future. So, the prescription emerging from the discussion above is a reform of the tax structure based upon principles of proportionality. Although that may raise questions of distributive injustice, one can easily prove the critics wrong by reminding them about the failure of the progressive system in ensuring that as well and then exhibiting that the primary causes of failure of that system or the one brought about by the Bush tax cuts exist no longer in a proportional tax structure. However, the part of the tax revenue should be allocated to ensure subsidised prices of necessities to alleviate the poor from potential hardships that may be otherwise brought about due to this reformed taxation structure. A proportional tax structure will once more restore the erstwhile lost incentives to the most productive classes thereby ensuring greater efficient participation in the economy. Hopefully, Americans will find poverty to be best dispelled by growth-oriented public policies that promote “a growing economic tide that raises all boats, not the unproductive misallocations of government largesse from confiscation of the efforts of our most productive citizens and productive capital” (Hartman, 2002). And this is to be likely as given the advanced economic structure of America where all types of markets are efficient enough to ensure rewards for productive participation which themselves act as incentives for all classes. References: Bankman, J. & Griffith, T., (1987) Social Welfare and the Rate Structure: A New Look at Progressive Taxation, 75 Cal. L. Rev. 1905 Folsom., B., (1999) What’s Wrong with the Progressive Income Tax?, Viewpoint on Public Issues, Mackinac Center for Public Policy, May 3, 1999, No. 99-18 ISSN1093-2240 Hartman.,D.A.,(2002) Does Progressive Taxation Redistribute Income? , The Road Map to Tax Reform Series, IPI Center for Tax Analysis, Policy Report No.162 February 2002 Internal Revenue Code of 1954, Pub.L. 83-591, 68A Stat. 5, enacted 1954-08-16 IRS data on tax breakdown for USA http://www.irs.gov/taxstats/indtaxstats/article/0,,id=129270,00.html Johnston, D.C., Richest Are Leaving Even the Rich Far Behind, NYT, June 5, 2005 http://www.nytimes.com/2005/06/05/national/class/HYPER-FINAL.html Mankiw, N.G., (2000) “macroeconomics” 4th ed, Worth publishers, New York Merton, R.K., (1949) Social theory and social structure, New York: Free Press, [Columbia University, New York, NY] New York Times, The Bush Economy, Editorial, June 7, 2005 Smith, A., (1776) An Inquiry into the Nature And Causes of the Wealth of Nations, Book Five: Of the Revenue of the Sovereign or Commonwealth. Available online at www.econlib.org/LIBRARY/Smith/smWN.htm Stiglitz, J.E., (2000) Economics of the Public Sector, 3rd Ed, Norton Wall Street Journal, Incomes and Politics, September 02, 2006 Read More