NRPLUS MEMBER ARTICLE T he United States has a progressive income-tax system. What this means is that the tax rate paid on a dollar of income depends on how much income is earned. As income reaches higher thresholds, each dollar above those thresholds is taxed at a higher rate. As a result, those earning higher incomes pay a higher average tax rate.
Or at least that’s how the system is supposed to work. In their provocative new book, The Triumph of Injustice: How the Rich Dodge Taxes and How to Make Them Pay, Emmanuel Saez and Gabriel Zucman argue that in effect, the U.S. operates under a flat-tax model in which the average tax rate is about the same for all Americans regardless of income. (This is the “injustice” of their title). According to the book, despite the fact that the tax code is designed to be progressive, high-income earners are not paying higher rates. Saez and Zucman argue that the solution to this problem is to make the tax code more progressive, close its loopholes, work with international partners to make corporate tax rates consistent throughout the world, and introduce a wealth tax. This, they say, would help the system function as it was designed to and reduce income inequality.
The book is aimed at a popular audience and is certainly likely to garner a lot of attention in the upcoming election season. This is especially true given its advocacy of a wealth tax, which dovetails with the proposals of progressive presidential candidates such as Senator Elizabeth Warren. But unfortunately, there is not much to recommend in its authors’ arguments. The book does not adhere to standard practices within economics for determining who pays a particular tax and, in fact, isn’t always consistent even within the methodology Saez and Zucman chose. Their overview of the history of U.S. tax policy is overly simplistic and ignores broader issues of fiscal capacity. And they sometimes contradict themselves in the service of their narrative.
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Since the policy conclusions of the book are predicated on the assertion that the U.S. effectively has a flat-tax system, I will begin with an assessment of that claim. In principle, it sounds easy to figure out average tax rates: You take the amount of taxes paid and divide it by the amount of income earned. But in practice, it is much more complicated than that. For example, some income that people receive is in the form of wages and salaries, and some is in the form of government transfer payments. Should these transfers be included as income or not? In addition, economists have long emphasized that the statutory incidence of the tax is not the same as its economic incidence (i.e., who actually pays its cost). It is therefore important to dig into the assumptions underlying the book’s central assertion to see where, empirically, it comes from and why it is so different from other estimates in the relevant literature.
Let’s start with government transfers. Saez and Zucman do not include such transfers (with the exception of Social Security) in income. In addition, they do not include refundable tax credits in their calculation of total taxes paid. These are very important when it comes to computing the sales-taxes component of a person’s total tax liability. To understand why, consider an individual who earned $10,000 in income and received $10,000 in transfers from the government. Their total post-transfer income is $20,000. Suppose that they consumed this entire amount and paid a sales tax rate of 5 percent. They would pay sales taxes totaling $1,000, which is 5 percent of their consumption and 5 percent of their post-transfer income. However, according to Saez and Zucman’s methodology, this individual’s tax rate would be 10 percent (1,000/10,000), because transfer income would be eliminated from the denominator. In other words, what Saez and Zucman are doing is using post-transfer consumption data and pre-transfer income to calculate the share of income paid in consumption taxes. This methodological choice is hard to justify. Without the transfer, the individual in my example would not have been able to consume as much as they did. The transfer clearly plays a role in terms of how much they pay in taxes, but is not included in the income used to calculate their tax rate by Saez and Zucman. What’s more, not counting transfers in the income figure used to calculate a person’s tax rate systematically raises the rates of those receiving government transfers. In fact, as earned income gets closer and closer to zero, an individual’s tax rate would approach infinity in the methodology used by Saez and Zucman. To the authors’ credit, they are aware of this problem. But to resolve it, they simply remove any individual earning less than $7,250 from their sample, which weakens their claim.
Another controversial assumption that the authors make is in determining who pays a tax. A central tenet of economics is that statutory tax liability is not the same as who actually bears the cost of a tax. To understand what I mean, consider the example of a sales tax. Suppose that a particular good sells for $5 and the government levies a tax of $2 per unit on that good. What this does is drive a wedge between the price that consumers pay and the price that sellers receive. If sellers paid the entire tax, the price of the good wouldn’t change. Consumers would still be able to buy the good for $5, but the sellers would only receive $3 after the tax was paid to the government. If consumers paid the entire tax, the price would rise to $7, with the company receiving their $5. In reality, neither of these scenarios is likely. What generally occurs is that the price that buyers pay rises and the price sellers receive declines. If the burden is shared equally, the buyer would pay $6, the seller would receive $4, and the government would receive the $2 tax. In this scenario, both buyers and sellers would effectively pay $1 of the $2 tax regardless of who is legally responsible for paying it.
This sort of argument has important implications for many types of taxes. As my example illustrates, sales taxes are paid partially by firms and partially by consumers. Correspondingly, the corporate-income tax could be paid by shareholders in the form of lower after-tax profits and by workers in the form of lower wages. The same is true for payroll taxes.
Saez and Zucman claim to circumvent this issue entirely. They argue that they assign taxes based on statutory incidence. In other words, they assign taxes based on who is legally obligated to pay the tax. Since the corporate-income tax is a tax on the firm and the firm is owned by its shareholders, they argue that the shareholders pay the tax. Unfortunately, they don’t apply the same methodology to sales taxes or payroll taxes. They assume that sales taxes are paid entirely by consumers, when such taxes are legally paid by firms. And they assume that payroll taxes are entirely paid for by workers when their costs are actually split between firms and individuals. They also claim that tariffs are a tax on consumers, which is inconsistent with their statutory assumption.
The reason that these assumptions matter is that they systematically increase the estimated amount of taxes paid by lower-earning Americans while, given the recent decline in the corporate-income tax, reducing the estimated amount of taxes paid by top-earning Americans. This gives a significant boost to the book’s argument that the U.S. effectively has a flat-tax system, but it also represents a stark departure from other academic studies on the matter. Economists Gerald Auten and David Splinter, for example, find that average tax rates are actually quite progressive, with the average tax rate for income earners in the bottom half of the distribution at around 13 percent and the average rate for the top 0.01 percent of income earners at around 50 percent. In a recent note, Splinter pointed out the way in which Saez and Zucman arrived at their starkly different conclusion by using the different, peculiar definition of income explained above. Splinter also noted that Saez and Zucman had applied ad hoc rules to allocate unreported income (this is income not found in tax returns, but evident in national-income estimates) in a way that systematically lowered their estimates of tax rates at the top, whereas he and Auten had relied on data from IRS audits in arriving at their estimates. (Saez and Zucman are dismissive of the IRS audits in the book.)
The book’s misuse of statistics is also quite telling. For example, in setting the stage for their argument, Saez and Zucman write, “Let’s start with the working class, the 122 million adults in the lower half of the income pyramid. For them, the average income is $18,500 before taxes and transfers in 2019. Yes, you are reading this correctly: half of the U.S. adult population lives on an annual income of $18,500.” That’s quite the statistical trick. Median income in the U.S. is approximately $33,000 per year. What Saez and Zucman are doing is taking the average of the people below this median and declaring that every one of those people lives on that level of income — an obvious falsehood.
One can be forgiven for cynicism about the fact that each of the inconsistencies in the book’s treatment of tax incidence works in favor of its flat-tax thesis and the resulting narrative that the rich are not paying their fair share. In fact, this cynicism is only heightened by the fact that the book is often self-contradictory in service to its narrative. For example, the authors claim that the reduction in the top marginal tax rates of the 1980s was based on the false idea that people were avoiding paying these high rates, only to claim a few pages later that tax shelters were the “iconic product of the Reagan era.” So, which is it? Were people dodging top marginal rates or not?
Saez and Zucman also tell the reader that there is no correlation between capital accumulation and taxes on capital, only to later claim that the government’s encouragement of the 30-year mortgage increased capital accumulation. (Apparently, capital accumulation responds to subsidies, but not taxes.) And they claim that the purpose of taxation is to maximize revenue, only to then argue that high taxes on the rich “are not aimed at funding government programs in the long run. They are aimed at reducing the income of the ultra-wealthy.”
The authors’ willingness to shape their methodology to fit their conclusion and to lapse into self-contradiction when necessary is never more apparent than in their attempt to spin the history of U.S. tax policy as one of class struggle. They proudly declare, for example, that “the first justification for the federal income tax introduced in 1913 was to offset the regressive impact of tariffs that, at the time, had been the only source of federal tax revenue.” In doing so, they completely ignore much more valid reasons for the lack of a federal income tax prior to 1913.
The biggest such reason is fiscal capacity. For an income tax to work, the state needs to have an infrastructure in place for keeping track of income and monitoring taxpayers to ensure that they pay the appropriate amount of tax. When fiscal capacity is low, countries must rely on mercantilist policies such as tariffs to raise revenue because an income tax would be too costly to administer. There is general academic agreement that investment in administrative capacity is necessary before a state can replace mercantilist policies with income taxes. Niall Ferguson, for example, has argued that the need for states to finance war explains a great deal of the development of fiscal capacity and financial development, more broadly. Charles Tilly provides a class-based argument along the same lines. Tilly argues that the state developed in response to the need to provide defense, and that as military technology improved, war became more expensive and states had to develop the fiscal capacity to wage it. The differences in the evolution of different states, he says, depended on the role of capital-owners within them. Economist Earl Thompson even argued that the U.S. tax system was consistent with one in which the state had evolved primarily to finance its national defense. And indeed, early attempts to collect income taxes in the U.S. always coincided with war. When they did not, as in the late 1800s, they were subject to challenges on constitutional grounds. This point is merely glossed over in the book.
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Inequality is clearly an important issue. There has been a fierce backlash across the world in recent years against the wealthy and the so-called elite. Populism is more prominent in both major American political parties today than it has been in decades. To some extent, this is easily understandable. There is a rather compelling argument that the social hierarchy determines the institutional structure of society. When people become upset with the institutional structure, they naturally seek to disrupt the social hierarchy. But there is more to social hierarchy than income or wealth, and Saez and Zucman, in their polemic zeal, have produced an oversimplified, misleading book.
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