Despite the vicissitudes of U.S. tax policy’s last two decades, there has been one constant: an ever-narrowing tax base. Through tax hikes and tax cuts, the goal has been to pluck a shrinking gaggle of geese laying revenues’ golden eggs. There is an ironic economics in this growing dependence on America’s top income groups at the same time that perceptions of income inequality are increasingly lamented. However that irony should be secondary to the serious concerns about volatility and sustainability it raises for America’s fiscal and economic policy.
The Sixteenth amendment spawned an income tax that now seems quaint in its simplicity and intent. Affecting fewer than four percent of Americans, the 1913 law began taxing incomes above $3,000 at one percent and topped out at a mere seven percent. Increased to fund World War I, it shrunk quickly back thereafter.
World War II was a thoroughly different story. Not only was the war bigger, the government was as well. The income tax base broadened to encompass 75 percent of Americans, versus just five percent in 1939. And when the war ended, the income tax, like the government, did not retrench.
While the enlarged revenue demands now appear permanent, the income tax’s scope has been shrinking over the last two decades’ two major tax hikes and two major tax cuts.
The landmark 1986 tax reform lowered rates across-the-board but, because rates fell much more for lower income levels (65 percent for those making $10,000 or less versus 2 percent for those making $200,000 or more), the proportion of total income tax paid by income groups above $50,000 rose. The 1990 and 1993 tax hikes concentrated their increases (gross increases of $164 billion and $268 billion, respectively, over five years) on higher earners, increasing the effective tax rates for all earning above $20,000. The 2001 tax cut was similar to the 1986 reform in that its reductions were proportionally greater for lower incomes.
By 2006, the share of income taxes paid by the top 10 percent of earners was 70.8 percent, while the bottom 50 percent paid -0.3 percent — The President’s bipartisan Tax Reform Panel stating “taxpayers in the lowest two quintiles [of earners] actually receive more in refunds from the federal government than they pay in income taxes and, as a result, have negative tax income burdens.”
Defenders of the current distributional impact often note that income tax is just a portion of the total federal tax burden and that lower income groups face a significantly higher tax burden from payroll taxes. Neglecting this argument’s self-fulfilling aspect when lower income groups’ income taxes are increasingly favored in tax legislation, 2006 payroll taxes accounted for 34.8 percent of the total tax burden. Yet even when the total federal burden is analyzed, the top 10 percent of earners paid 54.5 percent of taxes and the bottom 50 percent paid just 6 percent.
Recent American tax policy’s distributional trend is unmistakable. Seen from this perspective, it is even easier to understand the clamor over the alternative minimum tax’s impending impact. It is not about dollars alone, but distribution. Unless repealed, this alternative tax system, with its severe limitations on tax preferences, would put tens of millions of income earners back on the tax rolls – diametrically opposed to the last two decades’ trend.
America’s revenue pyramid is essentially inverted, now balancing precariously on a narrowing apex of top earners. The economic and political implications of America’s inverted revenue pyramid are real and serious. Our revenue stream is certainly more volatile, as seen in the 2000-2001 downturn when falling incomes among top earners (particularly capital gains) yielded dramatic drops.
Economically, more and more of the population is divorced from the effects of the negative economic policy of tax hikes, since they do not pay them. And they are more and more separated from the effects of positive economic policy, since they do not receive them — except through refundable credits. The worst economic medicine of more government spending is encouraged either way. Politically, our Founders would have quaked at the implications of a decreasing minority funding an increasing majority and it creates a system that is ever more difficult to reverse in a democracy.
Despite the concentration of the tax burden on a shrinking percentage of the population, calls for its continuation will only grow. From the redmeat rhetoric of the 2008 presidential promise-factories to the impending explosion of babyboomer entitlement spending, the demands for additional revenue will grow and the search will begin at the top. Yet the facts of current federal tax distribution should give pause for fundamental questions.
How progressive can our tax code be? The top 50 percent of US earners are now shouldering over 100 percent of the income tax burden when the outlays from refundable tax credits are included. When does progressivity begin to affect behaiour? Many of these top earners are also older workers who could take earlier retirement rather than higher tax bills. Such a reduction in high skilled workers would weaken the economy, because salaries ultimately accrue to productivity, not simply positions.
Today’s taxation distribution recalls the modern tax code’s very beginning when a small group of top earners bore the brunt of revenue demands. However there is an important distinction. Then it financed a small government temporarily enlarged by increased spending. Today we have a small tax base financing a large permanent government driven by expanding entitlement spending and soon to get enormously larger. This reality should make us increasingly dubious of politicians’ claims for free-rider spending in exchange for top-end taxation. As distributional analysis shows, the most lucrative revenue target is shifting down America’s income ladder.