By Robert J. Shapiro
Make no mistake: Drastically simplifying this mess would be sound economics. The less the tax code influences how people and firms consume, save, earn and invest their income, the more efficiently our markets can allocate the economy's resources. And by broadening the tax base, simplification allows us to raise the same revenues with lower rates something that's almost always better for the economy.
Many would-be reformers, however, harbor larger ambitions than closing loopholes and simplifying the system. Proposals such as the flat tax and a national sales tax suggest that the real issue lies not just in the current code's complexity but in the principle of progressive taxation itself or, more radically still, in government's authority to tax people's incomes at all. In fact, every advanced nation relies substantially on progressive income taxes; and in the United States, our increasing reliance on free markets has strengthened the social and economic case for progressive taxation here. Finally, the data show that the progressive features of the current tax system entail notably higher taxes only for the highest-income people, while reducing the burden on more than 85 percent of American families.
The new radical critique of the system has surfaced recently in libertarian claims that all tax cuts are desirable, regardless of social or even economic effects, because they would allow people or businesses to keep more of what they earn. Behind the obvious pander lies an earnest (if thick-headed) critique of both taxation and democracy itself. This view sees the economic choices of individuals as morally superior to the political decisions of any group. In this alternate universe, markets always trump politics and tax cuts are always preferred to the uses that a community may make for its revenues.
Those who make this case do not fully understand markets or democracy. It is true that a community cannot maintain itself without recognizing property rights. But people produce property in economic activities shaped not simply by their own work but also by political and social institutions that are part of the community.
People don't welcome taxes, but we agree to pay them so our community can purchase the public goods we deem appropriate. In this sense, taxes embody a civic relationship of mutual responsibility. Were it otherwise, the United States could not rely as much as it does on people's voluntary compliance.
This compliance also depends on people's judgment that the tax burden is distributed fairly. Which brings us to the heart of the current debate. Underlying the case for a flat or proportional tax is a view of fairness based on simple equality: A tax is fair if everyone is subject to the same rules, pays taxes at the same rate and therefore bears the same burden. The alternative view of fairness, which supports progressive taxation, stresses people's different circumstances: Taxes are fair when everyone pays according to their ability, and therefore the tax system should exempt the poor and apply to everyone else rates and relative burdens that increase with income.
The choice depends on what you see as the role for govern ments and markets. Flat taxers worry about the government's potential threat to their liberties in this case, taking their money. They believe that by burdening everyone equally with a flat tax they would create the broadest possible resistance to enlarging that burden. Furthermore, if taxes impose an equal economic burden on everyone, perhaps they will also increase economic growth by ratifying the market's distribution of rewards. And flat taxers consider this outcome just, because they believe that markets distribute income based on how hard people work. A true flat tax system is one in which each person claimed the same share of national income after paying taxes as he did before paying them.
Advocates of progressivity worry more about how the marketplace's choice of winners and losers can threaten people's autonomy. They see progressive taxes as a way to curb concentrations of economic power. In this view, incomes reflect not only people's own efforts but also circumstances beyond their control. Tax progressivity can advance equality of opportunity and real justice by changing the market's distribution of income. The test of a progressive tax is the degree to which, after paying taxes, those at the top are left with a smaller share of all national income than before, and those at the bottom a larger share than before.
Each approach can claim its own basis in economics. The case for a proportional tax stresses that while all taxes discourage work and saving by reducing people's rewards, a flat tax should discourage them least because a system with only one rate will have the lowest possible top rate. Flat taxers also argue that economic efficiency requires that taxes reflect what people would actually pay for the public goods provided by government. Since such goods as national security and public parks benefit everyone equally, they conclude that everyone should pay at the same rate to finance them.
The economic case for progressivity begins by noting that people work and save in order to satisfy their own needs and desires, not to pay taxes. Taxes don't change those needs and desires, so they shouldn't discourage anyone from working or saving. Progressivity advocates also argue that economic efficiency requires that everyone bear not an equal tax but an equal sacrifice. From this optic, tax rates should rise with income until an additional dollar of tax entails the same sacrifice from the highest and lowest income taxpayers.
Economic theory cannot settle the issue; but the evidence provides a bit more support for progressivity. As near as we can tell, tax rates do affect people's work efforts and saving, but only when the rate is very high and then only to a modest degree. In short, high income people don't work or save less when progressivity increases their tax rate; they find ways to avoid it or live with it. Even worse for flat tax advocates, people don't save much more when the tax on their savings is cut sharply. In 1995, for example, the personal net saving rate remained less than 5 percent despite more than $120 billion in direct tax incentives for personal saving.
The positive case for progressivity as the better measure of tax fairness emerges more clearly from the underlying issue of income differences. In theory, flat-taxers are right to criticize a tax system that would penalize people for differences in income that reflect only how hard they choose to work. In real life, income differences reflect much more than effort, if only because people don't start in the same place. At the least, people are born with different talents and grow up in families, neighborhoods and cultures with different resources to prepare them for market competition. Luck usually plays a part too. Moreover, the more free markets are, the larger the rewards people can secure by leveraging their talents, resources and good fortune and America's markets are generally more free than those in other advanced countries.
Progressive taxes cannot undo this and shouldn't try. But our commitment to free markets, while disposing the United States to harsher economic inequalities, also can oblige those who benefit so much from them to contribute more as well. The point of progressive taxation is not to penalize those who succeed, but to protect those who have not.
As it happens, that's roughly how the current system works. Toting up the combined impact of personal and corporate income taxes, payroll taxes, excise and estate taxes, the data reveal a number of basic and important facts about the current state of tax fairness.
* Everyone bears some of the burden including families living in poverty, who today pay on average more than 6 percent of their income to the federal government. Affluent people pay the bulk of federal taxes not because the system is sharply progressive, but mainly because they earn the bulk of all the income subject to tax.
* The combined tax burden is significantly progressive at the bottom and the top, but not in-between. Families with incomes under $20,000 have roughly 20 percent more to spend after paying taxes today than they would under a comprehensive flat tax, while those in the top one percent with incomes averaging $486,000 pay nearly 30 percent higher taxes than they would under a truly proportional system. The additional tax burden for the nation's highest earners, going to finance progressivity, equals about 9 percent of their annual income.
* The tax burden on middle-class Americans is already nearly proportional. The current system provides benefits equal to 3 percent of income or less to families earning under $75,000, and costs families earning $75,000 to $200,000 roughly that same 3 percent.
* The federal tax burden rises most sharply as a family moves up from poverty to the middle class; beyond that, the tax burden increases at a much slower rate. A family living on $6,000 a year pays out about 6.4 percent in federal taxes, and as its income quadruples to $25,000, the share paid in taxes nearly triples to 16.8 percent. If the family increases its income another 20-fold to reach $500,000, its tax burden will only double to 32.7 percent.
* Two groups bear lighter tax burdens than others: Elderly Americans pay significantly less than younger people with comparable incomes; and at low and moderate income levels, families with children pay less than other households. Lower taxes on families with children simply reflect the dependent's exemption and the Earned Income Tax Credit (EITC). Lower taxes on the elderly are mainly a consequence of taxing more lightly the capital income and transfer benefits on which they generally rely, compared to the wages on which working families depend.
* Shifting from the current system to a strictly proportional one would mean higher taxes for all poor families and most of the middle class. The Armey and Forbes flat tax proposals retain two of the current system's basic progressive features a separate business tax and an expanded income-tax exemption for initial income and repeal four others. Gone under both plans would be the EITC for working poor people, estate taxes on the wealthy, reductions in the value of income tax deductions for the affluent and graduated tax rates for everyone.
In fact, fairness under these flat tax plans would be more nearly regressive than truly proportional, because they would shift part of the burden from capital to labor. Under both, capital would be taxed once under the business tax while wages and salaries would be taxed twice under the income and payroll taxes. Since the top 10 percent of families derive 30 to 48 percent of their incomes from capital, as compared to 6 to 10 percent for everyone else, these plans necessarily mean higher taxes on middle-class people and lower taxes on the wealthy.
Under these flat tax schemes, for the first time in our history, the tax system would redistribute income towards higher-income people. Those at the top would claim a larger share of national income after paying their taxes than they did before paying them, and taxation would reinforce the income inequalities produced by free markets. And that would flunk any test of fairness yet proposed.
Robert Shapiro directs economic studies at the Progressive Foundation. This essay is adapted from a coming report, "Why Fairness Matters: Progressive Versus Flat Taxes."
© Copyright 1996 The Washington Post Company