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The elusive goal of tax fairness

What's fair when it comes to taxes? Progressivity and non-avoidance.

Source: Zucman, The Hidden Wealth of Nations
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The other day, some folks asked me to talk to them about “tax fairness.” My first thought was, “what’s tax fairness?”

So I looked at some polls and took a convenience sample (asked a bunch of people, from my 16-year-old to fellow D.C. wonks) and came up with this: to most people, tax fairness means a progressive tax system (where rates rise with income) without tax avoidance or evasion (avoidance is legal; evasion is not).

There’s even a coalition — Americans for Tax Fairness — organized around those principles, with an emphasis on raising ample revenue. My colleague Ben Spielberg put it similarly: “Tax fairness means that the tax code should reduce inequality and boost opportunity. It must raise enough revenues, predominantly from those with the greatest ability to pay, to pay for public goods.”

Don’t worry, I spoke to some conservatives, too. Some preferred a flat tax, but most were comfortable with progressive taxation. On the other hand, they don’t think you can keep raising taxes only on those at the top of the scale. Some share a concern about what Jeb Bush calls “free stuff,” i.e., when politicians make promises to lower income people paid for by taxes on higher income people (I’ll have more to say about this label in a forthcoming post).

The polls show that most people think the amount of income tax they pay is fair, but that share has fallen considerably from around 90 percent in the 1940s to around 60 percent in recent years. One of the most interesting polls is the one you see here, where they showed people various tax schedules and asked them which one they thought was the fairest. About 75 percent thought a progressive (vs. a flat) schedule was fair, and the top choice had everyone paying something, with the wealthy facing much higher rates than the poor.

So how does the U.S. system stack up vis-à-vis tax fairness? Well, like the system itself, the answer is complicated. First, our federal income tax rate system is progressive, though less than it used to be. Second, there’s so much tax avoidance and evasion that the progressivity gets significantly dulled when it comes to the actual liabilities faced by certain taxpayers. Third, state and local taxes tend to be pretty regressive.

Put it all together and you have the mildly progressive tax system you see in this useful table by Citizens for Tax Justice. Low-income households pay 19 percent of their income in taxes at all levels of government, middle-income families pay 27 percent, and the richest 1 percent pay about 33 percent. What’s particularly notable from CTJ’s analysis is how shares of income pretty closely mirror shares of taxes paid. The poorest families pay only 2 percent of all taxes but they only have 3 percent of all income. The top 1 percent pays 24 percent of all taxes, but they hold 22 percent of all income.

That’s one measure of fairness, and reasonable people can disagree as to whether the U.S. tax code should be made more progressive. Certainly, as economic inequality steers more growth to the top of the income scale, that seems like the right place to start in the spirit of those of us who share Spielberg’s sensibility.

But where reasonable people should be solidly on the same page is around the other dimension of fairness: reducing avoidance and evasion. Here is where we have a large, growing problem for at least four reasons.

  • Business income is increasingly being claimed as personal income (see figure below), and as I explain here, business income “passed through” to the individual level is the single largest source of the “tax gap” (the difference between what people owe and what they pay; it amounts to over $300 billion/year). Sole proprietors, e.g., have been found to report less than half of their income to the IRS.
  • As Gabriel Zucman documents in his essential new book, “The Hidden Wealth of Nations,” the share of U.S. foreign profits booked in tax havens has grown from about 20 percent to 50 percent (see figure above).
  • As Austin, Burman, and Rosenthal show in a forthcoming paper, the share of corporate stock held in taxable household accounts has fallen from around 80 percent in the mid-1960s to about 25 percent now, meaning most such stock is now untaxed by U.S. authorities or held in tax-favored vehicles, like individual retirement accounts.
  • Congressional conservatives are bolstering the cause of tax evasion by cutting the budget of the IRS. Since 2010, their budget is down 18 percent in real dollars; enforcement staffing is down by 20 percent. Such budgeting supports the tax gap: Treasury estimates that each additional $1 spent on IRS enforcement yields $6 of additional revenue.

It’s more than a little odd to have these heated debates about tax reform when we’re neither adequately enforcing the current code nor blocking avoidance tactics that gut the tax base and diminish progressivity.

And there are many other aspects of the U.S. tax code that are patently unfair. There’s the fact that much asset-based income is taxed at lower rates than regular income. The code is littered with upside-down subsidies providing tax breaks for those who least need them. The effective tax rate on business investment returns that were debt financed is negative, since interest payments are deductible (private equity firms make a killing off of that one).

And while it’s not my topic today, the tax proposals of the Republican candidates would all make the code far less progressive and strongly violate the revenue conditions of the fairness criteria cited above.

Asking around, I found that most people have an intuitive sense of what’s fair when it comes to taxes. The problem comes once you start digging into the data. We’ve got a ways to go to get from here to fairness.