Tax Blood and Rich Turnips

President Obama believes that if we tax the rich more that we can make everything right in America.

We hear a constant refrain that the rich do not pay their "fair share".

Of course, the facts directly contradict these statements.  As I have written before, the United States has the most progressive tax system in the world.  The rich pay a higher share of their income in taxes in the U.S. than in any other country that you can name.  More than Australia. More than Canada. More than France. More than Sweden. More than the United Kingdom.  More than any of the European welfare states.

What is true is that there is a much greater share of income concentrated in the top 1% than was the case 30 years ago.  This is an issue I also wrote about earlier this year in my post, 1% + 99% Should Be Greater Than 100%.  The share of income of the top 1% went from 8.30% of total income in 1981 to 16.93% in 2009.  This was matched by a similar increase in the tax share-17.58% paid by the top 1% in 1981 to 36.73% in 2009 proving that the taxes on the rich grew just as much (actually a little more) over the same period.  See chart.

Phil Gramm and Steve McMillin put it all together in an op-ed in The Wall Street Journal recently with a great analysis of the reasons behind the growth in income equality and why there are real limits to how much "tax blood can be extracted from rich turnips".

Gramm and McMillin list three dynamics that have resulted in the growth in income inequality.

First, is the fact that much more business income is now reported on individual tax returns in the form of partnership and subchapter-S corporations.  In 1986, just 5.6% of income for the top 1% was from these sources.  By 2007, almost 19% of the income declared on individual returns came from business income. Similar growth has also been seen in capital gains and dividend income.  As these marginal rates have been reduced, the amount of income reported on individual returns has grown significantly.

Second, the growing participation of China, India, Brazil and other emerging countries has affected incomes in the United States.

The vast expansion of labor engaged in world commerce has raised the return on capital and reduced the relative return on labor. The share of income flowing to capital—both traditional and human capital such as education and training—has risen. 

In relative terms, the return to unskilled labor has fallen. Short of a crippling reversal in world trade, which would reduce the value of both labor and capital, this effect will dominate world markets for the foreseeable future. Since high-income Americans own more capital and have higher levels of education and training, their incomes have grown faster than everyone else's.

Third, technological advances and increased economic freedom have affected income equality.  People like Bill Gates and Steve Jobs created fantastic new products that increased both productivity and our quality of life.  However, the information age spreads money around much differently than the manufacturing age we were in 30 years ago.  As I pointed out in my 1% + 99% blog article.

Manufacturing spreads income in a much broader swath in an economy.  You need to pay a lot of workers to build an automobile.  You only need a couple of computer programmers to develop a video game that might sell millions.  For example, the Call of Duty: Modern Warfare 3 game that was released last year grossed $1 billion in the first 16 days it was for sale. 

It is understandable that many see  all of this as "unfair".  However, who determines what is "fair" and "unfair"?  That is why it seems logical to look at other countries to determine the level of taxation that our "rich" pay compared to others to get some objective measure of "fairness".

While income distribution has become a source of protest and political debate, any analysis of taxes paid in high tax-and-spend countries shows that the U.S. has the most progressive income tax system in the world. An inconvenient truth for the advocates of higher taxes on America's rich is that big governments in developed countries are funded not by taxing the rich more than the U.S. does, but by taxing everybody else more.

Gramm and McMillin provide the numbers to back it up pointing out that if the United States taxed like France and Sweden it would hardly affect the rich.  The bottom 90% would see their taxes double.

In an eternal irony unique to large welfare states, it is the expansion of government in the name of the poor and middle class that always costs poor and middle-class families the most. When the U.S. collects 16.1% of GDP in income taxes, the top 10% of taxpayers pay 7.3% and the other 90% pick up 8.9%.

In France, however, they collect 24.3% of GDP in income taxes with the top 10% paying 6.8% and the rest paying a whopping 17.5% of GDP. Sweden collects its 28.5% of GDP through income taxes by tapping the top 10% for 7.6%, but the other 90% get hit for a back-breaking 20.9% of GDP. 

If the U.S. spent and taxed like France and Sweden, it would hardly affect the top 10%, who would pay about what they pay now, but the bottom 90% would see their taxes double. 

Since OECD members have significantly higher consumption taxes on average than the U.S., the total tax burden of bigger government is even more heavily borne by lower-income citizens in developed nations than these numbers suggest.

This is a big reason why I have so much trouble with President Obama's approach.  If he wants to model the United States on the European social model then he ought to be honest about it.  Put it out there and let the people decide.  We know they like the things that government can give them.  We need to find out whether they are willing to pay for them.

President Obama's health care reform package was the perfect opportunity for him to put it to the test.  It was easier to just send the bill to the rich and put in a mandate.  He clearly could have funded the program and got everyone to pay by putting in a broad-based tax (like Social Security or Medicare).  He never even tried.

At some point, all of this government spending either needs to be paid for or we need to drastically cut back.  Either way, it is the 99% or the 90%, not the 1% of 10%, who is going to feel the most pain.  As Gramm and McMillin point out, there is only so much tax blood that can be extracted from the rich tax turnips.