Tax policy - the charts tell the story

Tax policy and deficits will be two of the most important presidential issues over the next four years. The Bush tax cuts will roll-off. The Federal deficit continues to rise, so there is a need for greater revenue or a cut in spending if there is a desire to rein in financing. However, given the current recessionary environment, it is unlikely that we will see a decline in government spending. Hence there will be a need for more revenue just to keep deficits at current levels. There are also difficulties on the revenue side of the government equation because if economic growth is slowing there will be less tax receipts as the economy shrinks.

Now one response could be that deficits do not matter. There is no crowding out or rise in interest rates. The relationship between deficits and interest rates empirically has been up for dispute. However, there is the additional issue that more of the deficit is held in the hands of foreign government. We are not in a closed financial system. This financing has been a gain for the US because we could borrow to enhance our own standard of living but there will be a point where we send more and more cash flow to non-US investors.

The issue with tax policy is that it is not about just raising revenue and promoting growth. Most of the discussion is not about those two objectives but about the equity of the tax system. Who is paying and how much. This is where the discussion get political and seem to move away from analysis of the data.

The graphs from the IRS provide an interesting point of view on tax policy. The first graph looks at the average tax rate for an number of income percentiles. All of the income percentiles show declines in the average tax rate. The tables shows the average progressivity of the tax system. The bottom 50% of income pays a rate less than 5% while the top 1% pays about 22.5%. The average rates are not as high as the marginal rates but clearly higher income tax-payers pay a higher as a percentage of their income.

The second graph shows the tax shares as percentage of the income percentile. The top 1% of the taxpayers pay about 40% of all income taxes. The top 10% of taxpayers represent 75% of all of the income taxes paid. The payment of taxes falls to those who are producing the most economic value as measured by income.

Is this a "fair" system? How much is appropriate for each of these group? If there is a 5% shift of the tax burden, would we feel the system is then fair? Is this the most efficient system at raising the most tax revenue?

For the majority, it clearly has not been a disproportional burden; however, since the marginal propensity to consume is always higher at lower income any taxes will have a a greater impact on consumption for the middle class. If this is the measure of fairness, then at the extreme we should move all of the taxes to the wealthiest tax-payers because more of their spending is on disposable consumption. If the question is put to a vote, the result would be simple, higher taxes on the few as imposed by the many. Does that work?

The answers are not easy but the impact could be large if there is longer-term slowdown of economic growth.