As conservatives think about how to deal with the aftermath of the seemingly-likely Republican Armageddon in November, there appears to be a lot of cognitive dissonance on taxes. Some (e.g., me) argue that a focus on marginal income tax rates has somewhat run out of political steam, both because we have been successful in reducing marginal rates so dramatically over the past 30 years, and because the economy has changed so much. Others (e.g., also me) argue that a pro-growth, low-tax agenda is central to a conservative movement that can command majority support and serve the best interests of the nation.
To an extent, these groups are talking past each other because so many conservatives casually conflate taxes with the federal income tax. This may have useful in 1978, but deeply misrepresents the world of 2008. Thinking about total tax burden (including all federal, state and local taxes) can lead to some different conclusions.
Many pro-growth, low-tax conservatives observe that an increasingly large share of total income tax is being paid by a smaller and smaller fraction of the population. It is striking that the top 20% of households by income pay about 2/3 of all federal income taxes, and most of this is paid by the top 1% of earners. This raises the eternal fear that the populace is voting to expropriate wealth through legal means.
Now, one driver of this is that increases in wage inequality since about 1980 mean that the highest-income households make a ton of money these days. Here is the effective federal income tax rate by income quintile:
Highest income quintile: 12%
Second-highest income quintile: 7%
Middle income quintile: 5%
Second-lowest income quintile: 3%
Lowest income quintile: 1%
This picture is somewhat less dramatic, though the federal income tax certainly remains highly progressive. Of course, the top marginal rate is an important as a driver of incentives for wealth creation. Most people would accept a somewhat less progressive tax schedule, even though it would lead them to pay more taxes this year, if they believed that it would drive enough incremental economic growth by incenting more work and risk-taking that their after-tax income in future years would be much higher because the nation as a whole would become wealthier. One of the central achievements of the conservative movement was to make this case successfully to the American electorate. This was quite convincing in the world of 70% marginal income tax rates that obtained in 1980. How much benefit further reductions in the current top marginal tax rate of 35% would create for the nation as a whole is a lot less clear.
But there are lots of other taxes that people pay. In fact, the federal income tax represents only a little more than ¼ of total tax receipts. The federal income tax rate is highly progressive, but the total tax rate (including all federal, state and local taxes) is much less so. According to the Tax Foundation, here is the effective total tax rate in the U.S. by income quintile:
Highest income quintile: 35%
Second-highest income quintile: 31%
Middle-income quintile: 28%
Second-lowest income quintile: 23%
Lowest income quintile: 13%
What can be so eye-opening about this is how flat the rate distribution is from the second-lowest income quintile all the way up to the highest income quintile. In extremely round numbers, a household right around the middle might make $50,000 per year, have a tax burden of $14,000 and therefore has $36,000 left to spend. An upper-income family might make $150,000, have a tax burden of $55,000 and have $95,000 left to spend. You can see why somebody sitting in the middle might not be so sympathetic to the argument that America’s key tax priority is to lower the taxes on the guy making $150,000 per year.
Where do all of these not-so-progressive taxes that are hitting those in the middle come from? According to the Tax Foundation, here was the distribution of total tax burden for the middle income quintile of households in 2004:
Payroll taxes: 32%
Federal income tax: 18%
Property tax: 12%
General sales tax: 10%
All other: 28%
Total: 100%
By far the biggest tax burden (and especially federal tax burden) for the typical household in the U.S. is the payroll tax. Only for the top income quintile is income tax larger than payroll tax. So, tax credits against the payroll tax seem like they would be a logical part of what it means to cut taxes (and especially federal taxes) for the middle class. The proposal to provide a child tax credit against payroll taxes strikes me a reasonable way to do this. It is “social engineering” in the strictest sense, but like the mortgage tax credit against income taxes designed for an earlier era, it seems like a minor compromise with principle to serve the ends of providing middle-class tax relief and encouraging fairly broad-based behavior that is in the interests of society (i.e., raising kids), rather than being some truly special interest tax break.
It will be important to balance many competing objectives as we think about the best tax policy for America. We need to use taxes to grow the pie, not just to divide up the pie. Holding the line on a return to much higher marginal income tax rates will be hard enough. Unfortunately, international competition is likely to become much more severe over the next several decades, and increasing economic efficiency will be a required to maintain American growth and the resulting standard of living. So, growing, not just maintaining, the incentives for work, risk and entrepreneurship need to remain central to the conservative project. As somebody who has been an entrepreneur for some time, it’s not clear to me that further reducing the top marginal income tax rate is nearly as important for encouraging this as is the capital gains tax rate plus tax simplification more generally. An advantage of focusing on capital gains is that it encourages an ever-broader slice of the electorate to become entrepreneurs, who tend to be natural conservatives, or at least become so as they manage a business. The information revolution, in ways we don’t yet fully understand, appears to be lowering efficient firm size. Focusing on gains to entrepreneurship as opposed to salary is one part of getting in front of the wave of a changing economy. One of the advantages of being out of power is that it becomes easier to champion reform proposals that hurt incumbents but help the country. Legislators like an excessively-complicated tax code because it allows them to sell tax breaks in return for campaign contributions. It is shocking how much deadweight cost this creates, and what a deterrent this is to small entrepreneurs, for whom tax compliance it is not just a cost of doing business, but a barrier to entry.
Being for lower taxes ought to be a core part of what it means to be a conservative for the conceivable future. As food-for-thought, it might be more useful to do this by (i) going after the total tax burden, for example through a child tax credit against payroll taxes, (ii) placing more relative emphasis on reducing marginal rates for capital gains than income, and (iii) tax simplification.