The administration has “backed a tax plan that analysts say would greatly benefit the wealthy.” I want to unpack that and take a closer look at what it might mean.
“The Trump tax plan drops the top bracket from 39.6 to 35 percent, and allows for the possibility of a 25 percent top rate through a pass-through entity.” The Washington Post Fact Checker
I want to explore two questions. Would the proposed income tax changes reduce the taxes paid by the average wealthy tax payer (say the top ten percent, who in 2016 paid 80% of all income taxes)? Would that be a good thing or a bad thing and in what ways should we judge that question?
To evaluate the impact on taxes paid by dropping the marginal tax rate from 39.5 to 35 percent we must also take into account the increase in taxable income resulting from broadening the tax base (eliminating some of the existing deductions from taxable income such as State and Local Taxes and interest paid on other than mortgage debt, etc). The conventional wisdom of tax reform is to lower the rates and broaden the base. This can be done in amounts that leave tax revenue unchanged (revenue neutral). Whether the wealthy pay more or less from the proposed modest drop in the tax rate will depend on how successful congress is in fighting off the special interest groups that will try to preserve their special interest deductions.
There are two other important considerations when evaluating the revenue impact of a rate cut. To the extent that lower marginal tax rates encourage greater investment, the economy will grow more than otherwise. This is an additional way in which the tax base is increased and with it the tax revenue generated from whatever the tax rate might be. While there is no case in which the economy grew fast enough to recover all of the revenue lost from cutting the rate, faster growth generally recovered some of it. But a bigger revenue boost can also come from the wealthy repatriating more of their income held abroad to be taxed in the U.S.
But let’s assume, all things considered, that lowering the marginal tax rate for the wealthy reduces the taxes they pay. Is that a good or a bad thing? Leaving aside the point above about increasing economic activity in the U.S., what should the standard of judgment be of what is fair? Obviously people with more income should pay more taxes but how much more? If current tax rates (and deductions) are unfairly high for the wealthy, then lowering them is a good thing. If they are unfairly low, they should be raised. In short, it is not necessarily appropriate to say that something that lowers the taxes paid by the wealthy is a bad thing. The core question is thus: what is our standard of fairness?
Tax burdens are generally discussed in relation to the share of ones income paid in taxes. Rather than comparing the fairness of a millionaire with an income of $5,000,000 paying $1,000,000 in taxes with the average American family income of $50,000 paying $10,000, we look at the tax burden in relation to the share of ones income paid in taxes. In the preceding example, both the millionaire and the average family are paying 20% of their incomes in taxes. In fact, the average share of income paid in taxes of the top 10% of income earners was almost 20% in 2012 while the bottom 50% (most of whom paid no federal income taxes) was 3.3%. A flat tax rate (same marginal rate for everyone), which means that a person with twice the income pays twice the tax, is my standard of fairness. Many others believe that it is fair for the rates to be progressive (higher marginal rate for higher incomes).
My point is that it is wrong to conclude that any reduction in the taxes paid by the wealthy is good or bad unless we have first agreed on the standard of fairness and whether existing tax payments exceed or fall below that standard.
It is important to note also that there are many other taxes that people pay. While most America families pay no federal income taxes, they do generally pay wage (social security) taxes, sales taxes, property taxes and other taxes. “The Principles of Tax Reform”