Justin Fox has written a smart post on HENRYs (“high earners, not rich yet,” a term coined by Fox’s friend Shawn Tully). His concern is that HENRYs face a stiffer tax burden than the truly rich:
Everybody below them on the income distribution faces a lower effective tax rate. That’s to be expected in a progressive tax system, and we do generally have a progressive tax system, even when you count Social Security and state taxes. But here’s the weird part: Everybody above the HENRYs in the income distribution faces a lower effective tax rate too. Somewhere in the top 1% (those making more than $410,000 in adjusted gross income as of 2007) things start to turn regressive. So if you make $20 million a year, you probably pay out a smaller percentage of your income in taxes than if you make $500,000. For a full, if somewhat dated, rundown of effective federal tax rates at the top end of the income distribution, check out this December 2008 report from the Congressional Budget Office (pdf!) A less complete but more up-to-date accounting is available from the Tax Foundation. State and local taxes have the effect of shifting the inflection point somewhat lower down the income scale — right into the heart of HENRYland.
Like Annie Lowrey, Fox suggests that a millionaire’s tax bracket is one way around this problem. (Regular readers know that I’m not a fan of this idea.) And he offers a good and fair accounting of the virtues and the downsides of subjecting investment income to modest taxes:
There are some perfectly valid reasons for this: 1) dividend and capital gains taxes often amount to double taxation of the same income (taxed first as corporate income, then as shareholder income), 2) inflation erodes the real value of capital gains, 3) capital is mobile, so taxing it too much will send it scurrying abroad and 4) according to neoclassical economic theory (which is not infallible, but definitely worth paying some attention to), taxing capital retards economic growth.
The flip sides are that, 5) when capital tax rates are much lower than regular income tax rates, people in the highest tax brackets will find ways to transform their regular income into capital income (hi, all you private equity guys!) and 6) you get a tax system where people making $20 million a year shoulder less of the burden of financing government (relative to their incomes) than those making $500,000 a year.
I’m not as concerned as Justin Fox is about the fact that HENRYs face a higher tax burden than those private equity guys. Naturally, I want HENRYs to pay lower taxes, just as I’d like everyone to pay lower taxes. But it’s not obvious to me that we shouldn’t have a marginal tax schedule that declines at very high incomes. The truth is that we don’t have solid answers on the elasticity of taxable incomes. We do have some evidence, but nothing conclusive. In a paper on “Optimal Taxation in Theory and Practice,” Greg Mankiw, Matthew Weinzierl, and Danny Yagan survey the evidence:
If high-income workers are particularly elastic in how their taxable income decreases with higher tax rates, this would imply lower optimal marginal tax rates on high incomes, all else the same. But as with the distributionof abilities and the social welfare function, there is much debate over the true pattern ofelasticities by income.
Different underlying assumptions about the elasticity of taxable income and the shape of the distribution of ability yield very different conclusions, however, as Mankiw, Weinzierl, and Yagan explain.
In my ideal world. we’d have a flat consumption tax with a universal lump-sum transfer or demogrant. HENRYs would still shoulder more of the burden of financing government relative to their incomes, but the overall tax system would, if my intuitions are right, give us a bigger, richer economy that would benefit HENRYs and LENRYs and everyone else, one that would allow for generous transfers to the truly poor, provided we pare back entitlements aimed primarily at the nonpoor.
Are HENRYs more virtuous or deserving than the rich? Honestly, I have no way of answering that question, and I don’t think it makes sense to try. I’d rather focus on thinking about and advocating the tax system that grows the pie the most, consonant with meeting various spending obligations we decide are truly worthwhile.