Taxation and class war
Hunting the rich
The wealthy will have to pay more tax. But there are good and bad ways to make
them do so
Sep 24th 2011 | from the print edition
THE horns have sounded and the hounds are baying. Across the developed world
the hunt for more taxes from the wealthy is on. Recent austerity budgets in
France and Italy slapped 3% surcharges on those with incomes above 500,000
($680,000) and 300,000 respectively. Britain s Tories are under attack for
even considering getting rid of Labour s temporary 50% top rate of income tax
on earnings of over 150,000 ($235,000). Now Barack Obama has produced a new
deficit-reduction plan that aims its tax increases squarely at the rich,
including a Buffett rule to ensure that no household making more than $1m a
year pays a lower average tax rate than middle-class families do (Warren
Buffett has pointed out that, despite being a billionaire, he pays a lower
average tax rate than his secretary). Tapping the rich to close the deficit is
not class warfare , argues Mr Obama. It s math.
Actually, it s not simply math (or indeed maths). The question of whether to
tax the wealthy more depends on political judgments about the right size of the
state and the appropriate role for redistribution. The maths says deficits
could technically be tamed by spending cuts alone as Mr Obama s Republican
opponents advocate. Class warfare may be a loaded term, but it captures a
fundamental debate in Western societies: who should suffer for righting public
finances?
Leviathan should bear the brunt
In general, this newspaper s instincts lie with small government and against
ever higher taxation to pay for an unsustainable welfare state. We reject the
notion, implicit in much of today s debate, that higher tax rates on the
wealthy are justified because of the finance industry s role in the crunch:
retribution is a poor rationale for taxation. Nor is the current pattern of
contribution to the public purse obviously unfair : the richest 1% of
Americans pay more than a quarter of all federal taxes (and fully 40% of income
taxes), while taking less than 20% of pre-tax income. And knee-jerk
rich-bashing, like Labour s tax hike, seldom makes for good policy. High
marginal tax rates discourage entrepreneurship, and no matter how much Mr Obama
mentions millionaires and billionaires , higher taxes on them alone cannot
close America s deficit.
So the debate is poisonously skewed. But there are three good reasons why the
wealthy should pay more tax though not, by and large, in the ways that the rich
world s governments currently propose.
First, the West s deficits should not be closed by spending cuts alone. Public
spending should certainly take the brunt: there is plenty of scope to slim
inefficient Leviathan, and studies of past deficit-cutting programmes suggest
they work best when cuts predominate. Britain s four-to-one ratio is about
right. But, as that ratio implies, experience also argues that higher taxes
should be part of the mix. In America the tax take is historically low after
years of rate reductions. There, and elsewhere, tax rises need to bear some of
the burden.
Second, there is a political argument for raising this new revenue from the
rich. Spending cuts fall disproportionately on the less well-off; and, even
before the crunch, median incomes were stagnating. Meanwhile, globalisation has
been rewarding winners ever more generously. Voters support for ongoing
austerity depends on a disproportionate share of any new revenue coming from
the wealthy.
But how? So far most governments have focused on raising marginal income-tax
rates, something most rich people respond to quickly (see article). Capitalists
shift their income into less-taxed forms, such as capital gains; they move;
they work less; they take fewer entrepreneurial risks. Even if it is hard to be
sure how big these effects are, the size of the very top level seems to matter,
so Britain s 50% rate is more dangerous than Mr Obama s proposal to raise
America s top federal income-tax rate from 35% to 39.6%. Somebody earning $1m
pays more tax in London than any other financial capital madness for a place
with so many mobile rich people. The excuse that it was worse in the 1970s
hardly inspires confidence.
Simpler, bolder, better
Given the rich world s need for faster growth, governments should be wary of
sharp tax increases especially since they are unnecessary. Indeed, the third
argument for raising more money from the rich is that it can be done not by
increasing marginal tax rates, but by making the tax code more efficient.
The scope for doing so is most obvious in America, which relies far more than
other countries on income taxes and has a mass of deductions on everything from
interest payments on mortgages to employer-provided health care, so taxes are
levied on a very narrow base. Getting rid of the deductions would simplify the
code and raise as much as $1 trillion a year. Since the main beneficiaries of
the deductions are the wealthy, richer folk would pay most of that. And since
marginal rates would be untouched (or reduced), such a reform would do less to
discourage them from creating wealth.
In Europe, where tax systems are more efficient, one option would be to shift
more of the burden from income to property, which would collect more from the
rich but have less impact on their willingness to take risks. The mansion tax
proposed by Britain s Liberal Democrats would thus do less damage than the 50%
rate. And on both sides of the Atlantic there is room to narrow the gap between
tax rates on salaries and bonuses and those on dividends and capital gains.
That gap explains why Mr Buffett, most of whose income comes from capital gains
and dividends, has a lower average tax rate than his secretary. It is also the
one hedge funders and private-equity people have exploited to keep the billions
they rake in.
There is a basic bargain to be had. Imagine a tax system which made the top
rates on wages and capital more equal, and which eliminated virtually all
deductions. To avoid taxing investments twice, such a system would get rid of
corporate taxes. It would also allow for a much lower top rate of income tax.
The result? A larger overall tax take from the rich, without hurting the
dynamism of the economy. Now that would be worth blowing your horn about.
from the print edition | Leaders
Taxing the wealthy
Diving into the rich pool
Imposing higher tax rates on the wealthy can have unintended consequences
Sep 24th 2011 | WASHINGTON, DC | from the print edition
ASKED why he robbed banks, Willie Sutton, a hold-up artist of some
accomplishment during America s Depression, answered simply: Because that s
where the money is. Advanced economies that have piled up debts are eyeing
their rich for similar reasons. The way to begin filling holes in the budget,
many suggest, is by extracting more from those who have done best. This week
Barack Obama proposed paying for new stimulus measures and deficit cuts by
reforming the tax system to ensure that millionaires do not pay a lower tax
rate than middle-class families.
Mr Obama s reform is based on the Buffett rule , so named after Warren
Buffett, a folksy billionaire who publicly scorns a system that allows him to
enjoy an effective tax rate that is less than his secretary s. A growing number
of the rich appear to agree. Wealthy Germans and French have signed petitions
in favour of higher taxes. Luca di Montezemolo, who sells Ferraris to many of
them as chairman of the Italian sports-car company, told La Repubblica it was
right for the rich to pay more. The broader public agrees. Even in tax-hating
America, some two-thirds of voters support deficit-reduction plans that include
higher tax rates for top earners.
New austerity plans are bowing in this direction. Italy s latest includes a
special levy on those earning more than 300,000 ($410,000). France will ask
for a similar exceptional contribution from those making over 500,000. A
sense of fairness and political reality is driving the trend. The rich can
shoulder a larger share of the burden of fixing government finances, it is
argued, and can be asked to do so without doing much harm to growth.
A dangerous soaking
But there is an alternative view: that a soak-the-rich strategy is misguided.
History suggests that low taxes on the rich encourage investment and growth.
With many economies weak, now is not the time to saddle capitalists with
greater taxes, particularly since the rich are among society s most mobile: the
footloose wealthy will simply move, taking their taxes with them. This debate
is particularly fiery in Britain, always fearful for its London financial
centre, and a 50% top marginal tax rate which came into effect in 2010. A
number of economists believe it is doing lasting damage to the British economy.
Others dispute the charge.
With debt burdens so high, spending cuts are inevitable. But these can only do
part of the job. Reduced spending can hit lower-income households hard.
Political resistance to spending-only austerity is high and rising. Voters will
push for tax increases on the rich. So, it is important to understand what the
effects of that would be. The debate is passionate and often ideologically
driven. Three questions are crucial: What share of tax do the rich actually
pay? What has happened to this tax burden over recent decades? And what does
the evidence suggest about how the rich respond to changes in taxation?
The rich pay a substantial share of taxes across the developed world, and this
share has risen in recent decades. According to the OECD, a think-tank, the top
10% of earners contribute about a third of total tax revenues 28% in France,
31% in Germany and 42% in Italy. Rich Britons pay about 39% of total taxes
while America s wealthiest households contribute a larger share to government
than in any other OECD country, at 45%. Looking just at income tax, the share
paid by the top 1% of earners in America rose from 28% in 1988 to 40% in 2006,
in Britain it rose from 21% in 1999 to 28% this year. America s greater
dependence on its rich is due in part to their good fortune. As of 2007, the
total earnings of the top 1% equalled 74% of all taxes paid, up from 24% in
1976. The rich are a juicy target because their taxes could conceivably cover
far more of the budget than before.
Very little of the rising share of tax payments from the rich can be traced to
changes in rates. On the contrary, tax systems are far easier on top earners
than was true a few decades ago. Working out the tax burden, to answer the
second question, is no simple matter. Top earners often pay tax on personal and
capital income, as well as social insurance and excise taxes. Corporate tax
changes largely affect owners of capital, but are also borne to some extent by
workers. General trends for labour and capital-income rates are clear, however.
The rich face lower rates than they used to.
In the late 1970s top marginal income-tax rates of 60-90% were not uncommon
across advanced economies. But with the dawn of stagnation, academic economists
favoured reduced government intervention, and lower, flatter tax systems gained
ground. Tax burdens on the rich have fallen (see chart 1). Across the OECD the
average top marginal rate fell by nearly 11 percentage points.
The trend was particularly pronounced in America and Britain. Ronald Reagan
campaigned by touting tax cuts as a means to rescue the American economy from
stagnation. During his administration, top marginal tax rates dropped in steps
from 70% to 28%. In Britain Margaret Thatcher slashed the top marginal income
tax rate from 83% to 40% between 1979 and 1988. These tax systems remain
progressive, but much less so than they used to be. Marginal and average tax
rates still rise with income, but overall tax structures are much flatter than
they were a generation ago.
Other economies followed suit, if slightly less ambitiously. In 1988 Canada
reformed its tax system, flattening the rate structure and cutting top rates.
Germany passed a tax reform that same year, reducing marginal rates. Norway
dramatically cut top rates on both labour and capital income in 1992, from a
58% top income-tax rate to 28%. In the 1990s and 2000s many central and eastern
European economies embraced tax reform, adopting simpler and often flat tax
systems designed to reduce tax rates and evasion. Russia overhauled its
progressive tax system in 2001, dropping the top rate from 45% in 1999 to a
flat 13%. Rates were occasionally pushed up after the broad declines of the
1980s. In the 1990s America raised its top marginal income rate to 39.6% in an
effort to rein in deficits. Over the past 30 years as a whole, however,
governments have taken less of each dollar or pound pocketed by the rich.
Rates on corporate and capital income followed suit. Across the OECD the
average corporate-tax rate was 28% in 2007, down from over 40% in the 1980s.
Declines on tax rates for capital income have been smaller than those for
labour income, not least because tax rates were lower before the 1980s. Greater
mobility of capital relative to labour ensured the trend towards reduced
capital taxation was broadly shared. Economies reduced corporate-tax rates to
stay competitive with their neighbours. Ireland s 12.5% rate continues to irk
fellow euro-zone members.
Despite falling rates, advanced economies remain as dependent on top earners as
ever. In most rich countries, but especially Nordic and English-speaking
economies, the rich have done very well while incomes for other earners have
lagged. In America the income share of the rich has grown faster than the share
of taxes paid. Across the OECD, income inequality as measured by Gini
coefficients (which calculate how far an economy is from perfect income
equality) rose by roughly 7% from the 1980s to the 2000s.
More of the pie
In Britain the share of pre-tax income flowing to the top 1% of earners more
than doubled from 1976 to 2007, from 5.9% to 14.6%, and it has risen in other
countries too (see chart 2). America s rich have done better still. The top 1%
of earners in America (roughly, those earning more than $400,000 a year)
captured 58% of real economic growth from 1976 to 2007, and now take home
roughly 18% of all pre-tax income earned, up from less than 10% in the 1970s.
The share of the top 0.1% alone quadrupled over that period. The rich have done
very well in recent decades and the richest have done best of all.
The present debate hinges on whether these changes have been for the good,
which addresses the third question about how the rich have responded. The ideal
tax system strikes a balance between efficiency and equity. Voters set
priorities, among them defence, infrastructure and a social safety net.
Different societies make different choices, but a government cannot avoid a
basic trade-off. The more it wishes to spend, the more it must extract from the
economy via taxation. When governments tax more, workers react and take steps
to avoid higher tax burdens. These responses distort the functioning of the
economy, often reducing potential growth and the economy s ability to provide a
high standard of living to all.
The supply-side tax revolutions of earlier eras prompted a wave of studies
looking at the effect of lower taxes. Did people behave as expected? And were
tax changes good for growth? Early results were instructive. The rich do not
often respond to tax increases by working less, for instance, as was widely
assumed. But taxable income is very responsive to tax changes. The rich adjust
by tweaking the manner and timing of their compensation.
Studying America s 1986 Tax Reform Act, which lowered the top marginal rate
from 50% to 28%, Martin Feldstein, a Harvard economist, found that taxable
income among high earners adjusted, dollar-for-dollar, with tax rates. Mr
Feldstein argued that higher tax rates on the rich, such as the 1993 tax
increase that laid the groundwork for the balanced budgets of the Clinton
presidency, were likely to distort economic activity without raising much
money. Similar work analysing Mrs Thatcher s tax cuts in Britain found a
comparably sharp response to changing rates; the taxable income of the rich
swung from falling to rising in 1979.
Later studies challenged these findings. Austan Goolsbee, a Chicago University
economist and recent head of President Obama s Council of Economic Advisers,
said that estimates from the 1980s and 1990s overstated the effect of tax cuts.
Top incomes were rising as part of a long-term economic trend, leading
economists to overestimate the beneficial impact of tax cuts. Other historical
episodes painted a different picture, Mr Goolsbee argued. From the 1920s to the
1970s responses were more modest. A tax increase in 1935 corresponded with an
increase in the taxable incomes of the rich at a time when William Randolph
Hearst ordered his newspaper editors to christen the New Deal the Raw Deal
and harangue Franklin Roosevelt for his attempts to soak the successful .
Mr Goolsbee also questioned whether the behaviour of the rich hurt growth over
the long run. A tax increase might prompt a one-time shift in the timing of
compensation without meaningfully altering long-term choices. A big measured
fall in income after the tax rise of 1993, for instance, mainly reflected a
one-off pre-reform cash-out of stock options by a relatively small group of
rich taxpayers. Thereafter, the change in behaviour was smaller.
In general and across time periods and countries, tax changes affect the
choices of the rich, though the big responses of the 1980s and 1990s may have
been unusually large. Studies generally show that a 1% increase in the marginal
tax rate reduced taxable income by 0.1-0.4%, though sometimes and in some
places it may be higher. The rich, though, are more sensitive, responding two
to three times more than poor households, according to a Danish study. Changes
in taxes on capital income also generate bigger responses than changes on
labour income.
The rich may move more than their incomes when taxes rise; they might move
house. On a rough calculation for The Economist by KPMG, getting out of London
would be lucrative (see chart 3). New technologies benefit highly talented
workers, who market themselves globally and reap large returns. These
superstars are more mobile than ever before. After Britain s Thatcher-era tax
reforms, the share of foreigners among top earners grew much faster than did
the share in the middle and bottom of the income distribution, reflecting the
mobility of international talent. A similar pattern appears in studies of tax
responses in New Zealand. Indeed, the threat of migration appears to be
strongest within Europe and across the English-speaking world.
High scorers
A recent paper by Henrik Jacobsen Kleven of the London School of Economics,
Camille Landais of Stanford University and Emmanuel Saez of Berkeley examined
responses to tax variation among top football players. They found that after
the European football market was liberalised in 1995 countries with higher tax
rates attracted fewer foreign stars and their domestic leagues performance was
poorer. Spain adopted the so-called Beckham law in 2005 (named after Britain
s David Beckham who had joined Real Madrid), which gave preferential tax status
to foreigners living in Spain. Thereafter, Spain s share of top foreign players
rose sharply and diverged from that in Italy, which had followed a similar
trend. Footballers may be more mobile than most, but there is likely to be some
effect from tax rates on where the most talented individuals locate.
Neither is income the only thing governments tax. The rich commonly earn money
from corporate profits and capital investments. Economists usually recommend
against taxing capital, for several reasons. Corporate taxation distorts
patterns of production, and although governments may wish to fiddle with the
final distribution of goods and services they need production to be as
efficient as possible. Since capital is an input to future growth, taxation of
capital income can reduce investment and distort production over time.
Berkeley s Mr Saez and Peter Diamond, a Nobel laureate at the Massachusetts
Institute of Technology, nonetheless say that taxing investment income is
justifiable. It is often hard to draw a clear distinction between investment
and labour income, especially for top earners. A low or zero rate of tax on
corporate and capital income may simply encourage top earners to change how
they take their compensation.
The case of carried interest in private equity and hedge funds provides an
example. Fund managers earn a share of profits as compensation, which is
treated as capital income for tax purposes. This suits managers just fine given
the lower rate of capital taxation. There is a compelling argument that such
compensation is simply labour income, however, and that the current pattern is
basic tax-avoidance. Indeed, they suggest that a reform which closes loopholes
like the carried-interest exception and reduces the difference between tax
rates on capital and labour income may prove more efficient while also boosting
revenues. Many economists consider this an attractive alternative to higher top
marginal income-tax rates.
When the rich change their behaviour it can distort economic activity; top
earners may alter their sources of income, adjust their business strategies or
simply pack up and move. The impact varies, with smaller rate changes producing
fewer distortions. By closing loopholes governments can reduce avoidance, and
fewer loopholes also mean a broader tax base and more revenue for a given rate
of tax.
A surprisingly difficult question to answer is how tax changes affect long-run
economic growth. Economies are constantly buffeted by changes booms and busts,
random shocks and demographic trends among them. These complications obscure
the effect of lone tax changes. The simplest of analyses might note that the
high-tax years of the early post-war period were associated with rapid growth
while the low-tax years following the 1970s were not. Yet it is wrong to
conclude that high taxes cause rapid growth. In central and eastern Europe tax
reform coincided with a period of scorching growth. It is very difficult to
separate the effects of tax changes from broader economic liberalisation and
closer integration with western Europe.
To overcome such complicating distractions, Christina and David Romer, two
economists at Berkeley, use a narrative approach. They pore over historical
documents to work out why tax shifts were made. When they find reforms adopted
primarily to boost long-run growth, and not to fix a flagging or overheating
economy, they add them to their sample. Studying those changes alone gives a
cleaner picture of the effect of tax reform.
In the short to medium term, tax changes have large effects. An isolated tax
increase of 1% reduces real GDP by almost 3%, mostly because tax rises have a
significant effect on investment. (The negative impact of tax increases is
smaller when the explicit goal is deficit-reduction, but still present.) The
impact on growth is relatively persistent; the greatest effect is felt more
than two years after the change. A similar narrative study of British tax
changes produces comparable results. Beyond the first few years, it is hard to
draw conclusions.
Higher rates on the rich are not, then, a free lunch. At low levels rate
increases will lift revenue, but not without a cost in efficiency and
short-term growth. If the budget is a government s primary concern, then the
evidence is that reforms which close loopholes and broaden the tax base are a
more efficient way to bring in more money than higher taxes for the rich.
from the print edition | Briefing