Thinking Things Over March 4, 2012
Volume II, Number 9: Romney and Obama Agree on Progressive Taxation: Are They Correct?
By John L. Chapman, Ph.D. Washington, D.C.
Do we want to keep these tax cuts for the wealthiest Americans? Or do we want to keep our investments in everything else – like education and medical research, a strong military, and care for our veterans? Because if we’re serious about paying down our debt, we can’t do both. It’s time the nation’s wealthiest citizens pay their fair share to help lower our mounting debt. Now, you can call this class warfare all you want. But asking a billionaire to pay at least as much as his secretary in taxes? Most Americans would call that common sense. – Barack Obama, State of the Union Address, January 25
The problem with the Forbes flat tax is that it isn’t flat at all–it’s a zero tax on the wealthy and a 17 percent tax on working Americans. I’m hoping that voters will realize the Forbes flat tax is a gimmick, a phony, and not what it pretends to be….I want to make sure that we maintain the progressivity of the code. And I want to help people who I think have been most hurt by the Obama economy–and that’s middle income Americans….. We have a progressive tax code right now, and I’m not trying to change the progressivity of the code. I’m not trying to say that one group or another is going to get a better deal. But what I’m trying to do is to make sure that under no circumstances is the middle class going to end up with a larger share of the tax burden. – Mitt Romney
One of the ironies about this season of political discontent, with its high-intensity verbal combat and contentious policy debate, is the degree to which the likely Presidential opponents this fall, Barack Obama and Mitt Romney, actually agree on fairly major things. ObamaCare, for example, is explicitly modelled on RomneyCare, according to the President himself — both men see a rationale for the government having a significant role in the health care sector. Both have given implicit support to the current Federal Reserve and its Chairman, Ben Bernanke, and in related fashion, criticized the monetary and trade policies of China. Both support federal intervention in industries that “need help,” such as the auto sector; while Governor Romney has recently criticized the government’s oversight of Chrysler and GM bankruptcies, he was previously advocating a $20 billion ”rescue fund” to help revitalize Detroit with federal dollars.
And then there is the issue of taxation. On the corporate tax, both Messrs. Obama and Romney are in favor of aspects of the Bowles-Simpson approach to reform, in which lower rates and a flatter structure are traded off for closing of loopholes and deductions. While they differ on specifics, both men assert that this flatter structure and the lower rate levels would be more economically efficient. That is to say, flatter, lower rates would be less distortive of investment decisions (by making them dependent on the merits of the market opportunity rather than for any tax-advantaged rationales), and in theory a Bowles-Simpson scheme would incite greater work effort and productivity as a result of the flatter and lower rates. Additionally, both men realize that the United States currently has the second highest nominal corporate tax rates in the world, and will be the highest when Japan lowers its rates next month. The ability to attract foreign capital is of course impeded in a high-tax environment, and hence the U.S. is in an inferior position now in terms of global competition for investment. And when no less than the Chairman of Coca Cola complains that in many ways it is now easier to do business in China than here, including because of the uncompetitive taxation that diminishes returns on capital in the U.S., even the Obama Administration — not known for being very investor-friendly — takes notice.
The Obama-Romney axis of agreement extends in part to personal taxation as well. While the two men differ substantially on the rate structure and levels that should be in place, both are in favor of a progressive scheme. For both of them, higher marginal rates should apply to higher incomes. This begs two questions, one positive, the other normative, that are always asked pertaining to economic policy: is the policy consistent with efficiency? And also, in terms of equity, is it a “just” scheme? While investors are most concerned with (objective) efficiency in order to optimize returns to capital, the (subjective) equity question cannot only not be ignored, it may ultimately be more important. Indeed, in the long run, only a tax system that is seen to be morally just — by the taxed citizens themselves — will be sustainable at optimal levels of efficiency (those who do not appreciate this fact need look no further than the current destruction of civil society in Greece for confirmation).
In the following we address this latter issue (and will write on the former, the tax system’s economic efficiency, later this year). First, supporters of progressivity often cite none other than Thomas Jefferson, who seemingly had sympathy for progressive taxes. Initially, it is true, Jefferson came to a favorable opinion on progressivity while in pre-revolutionary France, where he saw great income disparities in an unfree society ruled by an oligarchic class:
Another means of silently lessening the inequality of property is to exempt all from taxation below a certain point, and to tax the higher portions of property in geometrical progression as they rise. – Thomas Jefferson to James Madison, 1785.
His position, however, has been misconstrued as unqualified support for progressive taxation, when what he really objected to was the forced regressivity imposed upon French citizens by the ruling oligarchs — a condition that hardly pertains to the outcome in a constitutional polity that guarantees individual liberty. For the oligarchs and land-owners in France paid no taxes, foisting collections for government burdens upon the merchants and the serfs. Given this, Jefferson’s favorable predisposition toward progressivity was in many ways a reaction to the illiberal exploitation that was soon to beget the turmoil of 1789.
However, later in life Jefferson still seemed to find merit in progressivity:
The rich alone use imported articles, and on these alone the whole taxes of the General Government are levied… Our revenues liberated by the discharge of the public debt, and its surplus applied to canals, roads, schools, etc., the farmer will see his government supported, his children educated, and the face of his country made a paradise by the contributions of the rich alone, without his being called on to spend a cent from his earnings. — Thomas Jefferson to General Tadeusz Kościuszko, 1811.
An income tax did not exist at the time, and the taxes Jefferson referred to – that supported a much smaller federal government as a percentage of the total economy back then — were all import duties and tariffs and/or excise taxes. And by definition, import tariffs are in essence a tax on consumption, and not income, a tax regime virtually no one, and certainly not Jefferson, would not find “equitable.” And as modern economic theory has subsequently demonstrated, from the vantage point of economic growth, taxing consumption is far more “capital-friendly”, that is, conducive to investment and prosperity, than taxing income. It is therefore a stretch to assume that Jefferson would support the contention of Messrs. Obama and Romney today that progressive income taxes are morally just.
What can we say about this, then, since it is by definition a normative issue? First let us stipulate that taxation in America is already steeply progressive. The top 1% of all wage income-earners paid 17% of all federal income taxes in 1980, but today that share is up to 39% (for 2010 — and that figure has been over 40% in recent years). This is an interesting fact in and of itself since President Reagan initiated a round of tax-rate cutting that has left rates far lower than they were in 1980, a demonstration of the Laffer Curve effect.
Of course proponents of progressive rates argue that this is not an issue, because the top 1% also consume and own vast amounts of wealth. And in any case, they say, total taxation, including payroll and excise taxes as well as income from other sources than wages is on the whole more regressive. Perhaps, but as economists Harvey Rosen and Ted Gayer pointed out in their 2005 (post-Bush tax cuts) book, the top one percent of income earners nonetheless paid 27.6% of all federal taxes (including payroll, excise and corporate shares) in 2004, a figure a 2010 Congressional Budget Office report said had climbed to 28.1% by 2007 (increasing during the Bush years, evidently!). Meanwhile, nearly half of all Americans pay no federal income taxes at all, and Rosen and Gayer show that the average tax rate (for, again, all federal taxes) on the bottom quintile is 4.3%, while it is 31.2% for the top 1% of all income earners. So the unambiguous empirical fact is that the U.S. is a highly progressively-taxed country. Is this a good thing from a moral perspective, that in turn has bearing on wealth-creating economic activity, by which we mean rising investment, job creation, output, and equity values?
It is ultimately a subjective evaluation, but clear thinking on morality can inform our analysis of the positive effects of progressive taxation (after all, Adam Smith’s best book, perhaps, was not the Wealth of Nations, but rather his 1759 tome with the title Theory of Moral Sentiments — classical writers well-understood the thesis that ultimate “fact” and “value” cannot be distinguished, and that a proper moral framework for an economy, embodied in a deep respect for property rights, rule of law, and individual liberty was both necessary and sufficient for long-term prosperity). The great progenitor of modern theories of public finance, A.C. Pigou (Keynes’ teacher and later critic), pointed out in his 1951 textbook on the subject that the oft-used theory used to support tax progressivity, that of diminishing marginal utility, was not appropriate for this discussion. That the marginal dollar of income has less utility for a millionaire than it does for an unemployed welfare recipient is axiomatic, but of course the millionaire is, appropriately, already the recipient, pari passu, of a proportionately higher tax bill. To prove the moral case for progressivity — that, in President Obama’s exact words, the rich should pay “their fair share”, it would have to be shown that the marginal utility of the last $100,000 of income for the millionaire was providing less satisfaction than the last $1,000 for the worker making $10,000 in income.
To say this colloquially, Messrs. Obama and Romney feel that the millionaire should feel as much pain from losing his last 10% of income — should bear as much burden from this loss — as does the worker who loses his last 10%. President Obama and evidently Governor Romney both posit that this is not the case with flat-rate taxation; they believe that the loss of the last 10% is not equiproportional for both without progressive rates. But there is of course no way to know that empirically, and indeed, there are sound reasons to think the opposite is true — that progressive taxation is “unfair” to the higher-income earners by taking an “unjust” amount of their property from them, that ultimately harms the economy as a whole.
In 1845 Ramsay McCulloch wrote:
The moment you abandon . . . the cardinal principle of exacting from all individuals the same proportion of their income or their property, you are at sea without rudder or compass, and there is no amount of injustice or folly you may not commit. The reasons that made the step be taken in the first instance, backed as they are sure to be by agitation and clamor, will impel you forwards . . . . why not take 50 per cent from the man of two thousand pounds a year, and confiscate all the higher class of incomes before you tax the lower? . . . . Graduation is not an evil to be altered with . . . . The savages described by Montesquieu, who to get at the fruit cut down the tree, are about as good financiers as the advocates of this sort of taxes.
In other words, McCulloch pointed out that once the “nose went under the camel’s tent” of progressive taxation, it would be a slippery slope pursued by the political class as they sought to commandeer ever more resources from the private sector. And indeed, in terms of historical timing, just three years later, in 1848, Karl Marx and Friedrich Engels came out with the Communist Manifesto, which recommended steeply progressive taxes for the express purpose of the redistribution of wealth and confiscation of property from the bourgeoisie.
And here is where the question of morality meets up with economic efficiency. Because as soon as the producer class comes to believe that their property, which includes the right to the just fruits of their labor, is at some level to be abnegated, they will rein in productive, wealth-creating activity. As McCulloch described it, indeed, a process of decapitalization sets in. This in fact is why the well-known empirical correlation between liberty — in which we include the protection of property rights and lower rates of marginal taxation rather than higher — and prosperity has existed in a statistically significant way from the time of Adam Smith’s more casual observations.
Our own view, in short, is that it is unfortunate from the vantage point of economic growth that the debate over progressive taxation is evidently closed now in the United States, and for the sake of the investor class, jobs, economic growth, and wealth creation, hope that it is one day revisited. For steep progressivity is, at root, an attack on both property and blindness in the application of law. Marginal rates of taxation now approach 60% in states like New York, and “the rich”, rather than acquiesce to Mr. Obama’s concept of paying their “fair share”, are simply vacating the state and/or ceasing in the taxable production of goods and services: chronic deficits leading to fiscal collapse then appear on the horizon in such cases. Greece is a current exemplar of the extreme end to which this situation leads, and no amount of moralizing about “fairness” is relevant on the streets of Athens today.
For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at firstname.lastname@example.org. The views expressed here are solely those of the author, and do not necessarily reflect that of colleagues at Alhambra Partners or any of its affiliates.
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