taxing the rich

From Arthur Laffer (of Laffer Curve fame) in the WSJ (hat tip: Linda Christiansen)...

Over the past 30 years, the U.S. has seen large changes in income tax rates as well as other tax rates. And, as would be expected, the budgetary implications of these tax changes have once again become a hotly debated partisan issue.

But missing from the discussion are the huge differences in how the top 1% of income earners respond to changes in tax rates versus, say, the bottom 75% or 80% of taxpayers -- the so-called middle class and lowest income groups. The "rich" quite simply are not like the rest of us.

From the standpoint of logic, the supply of their taxable income should be far more sensitive to changes in tax rates than the supply of taxable income of the middle class and poor. In the highest tax bracket, 100% of all taxpayers have the highest tax rate as their marginal tax rate. And it's the marginal tax rate that elicits supply-side responses....

That's why JFK's change from 91% marginal tax rates for the wealthiest to 70%-- and then Reagan's change to 28% in 1981-- made such a big difference.

And now a key point about "elasticity"-- in this context, flexibility in getting around taxes, by income class...

In addition, low-income earners have a lot less flexibility to change the form, timing and location of their income -- and the avenues open to them to reduce their tax liabilities are far fewer. The avenues open to higher-income and highest-income earners include 401(k)s, IRAs, Keogh plans, itemized deductions, lifetime gifts, charitable gifts, all sorts of deferred income compensation plans, trusts, tax free bonds, etc.

Moreover, the culture surrounding low income earners is not nearly as focused on tax avoidance as it is in higher income earners; fewer lower-income earners, therefore, even avail themselves of the limited programs, laws and other opportunities to reduce their tax liabilities. This means that the supply of taxable income in the highest tax bracket should be far more responsive to incentives than it is in the lower tax brackets, all other things being equal.

Many tax-avoidance methods require expert advice and counsel from people such as tax accountants, lawyers, deferred compensation experts and, yes, even economists. Higher-income people find tax accountants and lawyers and other financial professionals far more cost-effective than do people with lower incomes, not only because the costs are spread over larger sums, but because the pursuit of tax avoidance is, dollar of income for dollar of income, more profitable at higher tax rates. This makes the taxable incomes of those who earn more, more variable, and the taxable incomes of those who earn less, less variable.

And now for some data on the question at hand...

But what actually happens to tax receipts by income tax bracket when tax rates change?

Since 1980, statutory marginal tax rates have fallen dramatically. The highest marginal income tax rate in 1980 was 70%. Today it is 35%. In the year Ronald Reagan took office (1981) the top 1% of income earners paid 17.58% of all federal income taxes. Twenty-five years later, in 2005, the top 1% paid 39.38% of all income taxes.

There are other ways of looking at tax receipts by income bracket. From 1981 to 2005, the income taxes paid by the top 1% rose to 2.96% of GDP, from 1.59% of GDP. There was also a huge absolute increase in real tax dollars paid by this group. In 1981, the total taxes paid in 2005 dollars by the top 1% of income earners was $94.84 billion. In 2005 it was $368.13 billion.

In 2000 this teeny, tiny group -- 1% of all taxpayers -- actually paid income taxes equal to 3.75% of GDP, which is why President Clinton had a budget surplus. Much of this huge surge in tax payments by the top 1% of tax filers resulted from the huge increase in realized capital gains resulting from President Clinton's capital gains tax rate cut to 20% from 28% in 1997.

Let's take a look at the bottom 75% of taxpayers over this same time period -- the group current Democrats refer to as middle- and lower-income earners. From 1981 through 2005, the share of all income taxes paid by the bottom 75% of all income earners (as reported on the individual income tax returns) declined to 14.01% from 27.71%. As a share of GDP, total taxes paid by the bottom 75% fell to 1.05% from 2.50%. The bottom 75% of all taxpayers today pay less than 35% of all the taxes paid by the top 1% of all income earners.

Over the last 25 years, the bottom 75% of all taxpayers' tax payments fell and their tax rates fell. This is the group the Democrats are targeting for tax cuts.

The important point here is that, over the last 25-plus years, the only group that experienced an increase in income taxes paid as a share of GDP was the top 1% of income earners. Even the top 2%-5% of income earners saw a decline in the GDP share of their income taxes paid.

But now we get to the secret sauce, and the essence of what really happens in the realm of tax rates, incomes and tax payments by the rich.

We have accurate data on both the total taxes paid by the top 1% of income earners, and on their comprehensive household income as measured by the Congressional Budget Office. From these two data series we can calculate the effective average tax rate for the top 1% of all income earners.

Surprise, surprise: The effective average tax rate for the top 1% of income earners barely wiggles as Congress changes tax codes after tax codes, and as the economy goes from boom to bust and back again (see chart).

The question is, how can that effective average tax rate be so stable? The answer is simply that the very highest income earners are and have always been able to vary their reported income and thus control the amount of taxes they pay. Whether through tax shelters, deferrals, gifts, write-offs, cross income mobility or any of a number of other measures, the effective average tax rate barely budges. But this group's total tax payments are incredibly volatile.