Are US taxes progressive all the way to the top 1%?

When we ask the question in the title, we normally go back to the annual surveys of income distribution conducted by the Census Bureau under the name of  Current Population Surveys (CPS). I am using here, to derive the figure below, the “lissified” (internationally harmonized) CPS data for 2010 and 2013.  The data very clearly show that the average tax rate (federal and state) increases in disposable income. For the top percentile, it reaches 34 percent. This is exactly what we would expect from a progressive income tax system: richer people pay higher share of their income in taxes.

            There are however two problems with these data. First, survey data underestimate income at the top (most of all, income from capital). For example, interest, dividends etc. represent only 7% of market income in survey data, but about 12% of income in IRS fiscal data. And most of capital income is received by the very rich.  (And to make things  simpler I will speak throughout of capital income like interest and dividends, not of capital gains or losses.) So if top incomes are underestimated then the calculated average tax rate (taxes/income) shown in Figure 1 is overestimated. The “true” tax rate is less. I will call the underestimation of top incomes by surveys, “top income survey bias”.  

But there is an even bigger problem: tax data shown here are only estimates, calculated by CPS from the simulations based on what people with such reported incomes should pay in taxes. CPS does not ask for taxes paid; it asks only for all types of incomes and then applies the tax rules in the simulations it runs to come up with the estimates shown in Figure 1. The bottom line is this: we really do not know how much is being paid in taxes.

Let’s move to the second source: fiscal data provided by the IRS. These are the data used, among others by Saez and Piketty to show changes in US inequality over the long-run. But while IRS provides for the recent years, a rather large sample of income data (for up to several hundred thousands of respondents)  it does not provide data on taxes paid. Moreover, the income concept used by the IRS, the so-called Adjusted Gross Income, is what should be best described as “political income”. It is whatever income the Congress decides is income. It excludes such obvious economic incomes like interest on state and local bonds. It also excludes all non-taxable transfers like social security benefits or cash value of various in-kind socials transfers, or indeed imputed income from own housing. (Obviously, if something is not subject to taxation, you are not going to report it on your tax form.) At the very top, the data are “blurred” for confidentiality reasons: some income fields are represented as means of several households. The same approach (“censoring” or “top-coding”) is used by household surveys too. Finally, IRS data do not cover the entire population because some 5-7% of people do not file tax returns.

Yet its most serious defect for our purposes is that income reported by the rich is a “castrated” income, compared to a true economic income, because it deducts all kinds of “expenses” that no economist would consider as such but which the fiscal system allows. Vacations, travels, lunches, are treated as “business expenses” with which to offset income, so that the ultimately reported fiscal or political income may be significantly lower than a real income as defined by economists. Many of us have heard of business trips to France in July, entirely written off (thus reducing the fiscal or “political” income). Such expenses should normally be classified as any other consumption item and not as an income deduction. Similar examples abound. The most important thing is that such loopholes  (as they are I think mistakenly called) are really designed and used only by the rich. Majority of people whose income is in wages do not have incentive  or wherewithal or rationale to create false companies or consultancies whose main objective is to reduce their fiscal income. So, for the top income group, we are faced here too with a significant underestimate of income. Let us call it “top income fiscal bias”.

Thus we come to the third source of data: Congressional Budget Office (CBO) that gets the data on fiscal (political) income from IRS plus some confidential data on taxes actually paid, and tries to match this information with income from household surveys. CBO is quite forthcoming about the serious data inadequacies it faces (see appendix on Data and Methods, p. 31).  

 For 2011, CBO comes up with the estimate of the overall federal tax rate (including indirect taxes and social security) by income level as shown in Figure 2.  The top 1% is estimated to have paid some 29% of their market income in taxes, a rate higher than that for other groups.

            While CBO does probably the best job possible with what it has, note that the results are based on (1) matching of information, not on actual data on taxes and incomes, and, more importantly, on (2) income data which are seriously underestimated at the top. They suffer from both survey and fiscal top income biases, in addition to another bias due to tax evasion, which I have left out of consideration altogether, but which is certainly the greatest among the top.

            Or to give a concrete example. In 2011, the average market income of households that were in the top 1% was, according to the CBO,  $1.45 million. The calculated federal tax rate was, as we have seen, 29%. But to $1.45 million, we should add income that was wiped out thanks to the political income bias plus all income that was simply not reported whether because of survey inadequacies or because of tax evasion. If these two sources add to say 50% of the officially reported income, then the average tax rate is no longer 29% but 19%. And we cannot be sure that it is the highest average tax rate assessed as we would normally expect if the system were progressive throughout.

            In conclusion, I think it is fair to say that, a century after the system of direct personal taxation was introduced in the US, one really does not know what is the tax rate paid by the very top of the income distribution. It could be that Mitt Romney’s average tax rate of 13% is not that uncommon.

Inequality: the structural aspects

Despite the unprecedented attention that income and wealth inequality has received in this year’s presidential campaign in the United States and in several recent elections in Europe, one cannot but have the impression that for many centrist politicians, inequality is just a passing fad. Their belief is, I think, that once the economies return to sturdy growth of at least 2 to 3 percent per year, and unemployment falls to 5 percent (or in Europe to single digits), people will just forget all about inequality and everything  will go back to where it was some twenty years ago. Nobody would care about inequality again.

This, I think, is an illusion because it disregards the structural changes in societies wrought by the long and sustained process of increase in wealth and income inequality during the past 40 years. When there are deep structural changes, reminiscent of similar processes that have played  out in Latin America during most of the 20^th century, aggregate indicators, such as the growth rate of the economy (which is nothing else but the growth rate of income at the mean of income distribution, that is around the 65^th or 70^th percentile) lose the meaning that they normally have in economically more homogeneous societies.

I see three such structural changes: disarticulation of many Western societies, political influence of big money (plutocracy), and inequality of opportunity.

Disarticulation was a term used by the dependencia literature of the 1960s-1970s to express both the divergence of interest and different positions in the international division of labor of various classes in the developing world. On the one hand, there was a domestic elite linked with capitalists internationally, participating in the global economy, both on the production side (as high-skilled workers or capitalists) or in consumption  (as consumers of international goods and services). And then there was a majority of the population that lacked any connection with global economy and produced and consumed locally.   

The situation in rich countries, and especially in the United States,  is nowadays somewhat similar (see my earlier post, “Disarticulation goes North”). There is an elite (whether it is the notorious top 1% of 5% or even 15%), that is entirely plugged into the global economy and that lives and consumes globally. Then, there is a shrinking middle class, whose incomes have been stagnant for 30 to 40 years and which is linked to the global economy in a negative way, that is, lives in a permanent fear of job or income loss because of competition from poorer countries or migrants. These groups, rather than the bottom of the income distribution, are the disenchanted groups, so easily won over by Trump’s protectionist speeches.  I am not discussing whether their expectations can ever be satisfied in a globalized economy or not; I simply want to note a deep disconnect between the interests of the top and the interests of this middle class, a breach that has been created by globalization and rising income inequality. When the economic interests of the two groups are so divergent, it becomes hard even to speak of something that would be a “national economic interest”; moreover the divergence of interests carries over to a number of other divergences, in the way of life, perception of politics, cultural interests. This is the first structural gap.

The second is simply the extension of the first into politics. Due to a number of accommodating processes, including most famously Citizens United vs. Federal Electoral Commission, the role of big money in politics, always important in the United States, has further  increased.  But even without the facilitating court decisions (and these decisions could, in turn, be considered endogenous to the process of income differentiation), the very increase of income inequality would have brought greater political power to the rich. More concentration in economic power simply means that there are fewer people who have sufficient funds to help politicians and political causes they either like or (more probably) benefit from, and the economic concentration thus naturally leads to the concentration of political funding. Ultimately, influence in politics simply reflects uneven economic  power. This then in turn, as has been argued by several political scientists (Benjamin Page, Larry Bartels and Jason Seawright; Martin Gilden’s “Affluence and Influence”) leads to political decisions that economically favor the elite, and ultimately to further deepening of the economic differentiation.

The third structural change wrought by income inequality is rising  inequality in opportunities. As income inequality gets more entrenched, it does not end simply In current income inequality but tends to carry over to the next generations. The chances of success of children from the rich and poor families diverge. In a process similar to what we can observe in Latin America, the divergence is not simply limited to inherited wealth, but is transferred to the acquisition of education (where increasing importance of private  education further exacerbates the trends), and family connections and networks that are often crucial for success.

Now, these structural inequities will not go away, may even be deepened, when the economy goes back to its long-run rate of growth. Higher rate of growth and lower unemployment might have been sufficient before the structural fault lines became strong because growth would have “papered over” these differences. But when the structural cleavages are deep, growth alone (as we have seen in the case of Latin America, again) is not enough. If I can risk a medical analogy, an ordinary cold may be cured by essentially doing nothing other than lying in bed and taking more liquids. Gradually we revert  to the status quo ante. But if the cold continues for a while and transforms itself into a more serious illness, which is what a long process of inequality has done to the body-politic, stronger remedies are needed.

I recently reread some of Simon Kuznets’ writings from the 1960s. He argued that every income distribution should be judged by three criteria: adequacy, equity and efficiency. Adequacy is ensuring even the poorest have an income level consonant with local customs and economic ability of the society.  Equity is absence of discrimination whether it is a discrimination in current incomes, as for example in racial or gender wage gaps, or in future possibilities (what we now call inequality of  opportunity). Finally, efficiency is achievement of high growth rates. When it comes to the interaction between equity and efficiency, Kuznets sees it going both ways: in some cases, pushing for equity too hard, as in full egalitarianism, may have detrimental effect on the growth rate. But in other cases, the very achievement of higher growth rates requires greater equity, be it because a significant part of the population is otherwise socially excluded,  not allowed to contribute, or because it leads to the fragmentation of society and political instability.  I believe that Simon Kuznets would have seen today’s position of the developed Western economies as being at that second point, and argued that pro-equity policies are not a waste of resources but rather an investment in, even the prerequisite, for future growth. 

Migration’s economic positives and negatives

I was always a strong believer that geography determines one’s worldview. (I think it is de Gaulle who is credited for saying that “history is applied geography”.) When you spend one month in Europe traveling to various places, you just cannot avoid the biggest issue in Europe today:  migration.

So let me go briefly over some key issues (again). I discuss them at much greater length in the third chapter of my forthcoming book “Global inequality: a new approach for the age of globalization”.

To an economist, it is clear that most (not all; I will come to that later) economic arguments are strongly in favor of migration. If comparative advantage and division of labor have any meaning they must hold worldwide; they are surely not valid only within the confines of the arbitrarily drawn national  borders. It was very well, and presciently, asked by Edwin Cannan a century ago: “if…indeed, it [ìs] true that there is a natural coincidence between self-interest and the general good, why…does not this coincidence extend, as economic processes do, across national borders [?]” (quoted from Frenkel’s 1942 Presidential address to the South African Economic Society; Tony Atkinson brought to my attention this undeservedly  obscure reference).  If this were not the case, we could equally plausibly argue that there should be limits to the movement of labor between the regions of a single  country. Since almost nobody would argue for that, it logically follows that the same principle of free movement must hold internationally. In other words, free movement of labor leads to the maximization of global output. We also know that migration, by raising incomes of the migrants (who are generally poor), is the most potent force for the reduction of global poverty, as well as for the reduction of global inequality.

So far so good. But, it could be argued, would not migration reduce wages of native  workers with whom migrants compete? Although empirical studies find the negative effect on comparable native workers to be small (and we shouldn’t forget that there are also native workers who benefit from migrations, if their skills are complementary with those of migrants), the effects may not be zero. But there Lant Pritchett’s point comes to the rescue: to migration, Pritchett argues, we should apply the same principles  as we apply to trade. We are not against free trade even if it has negative effects on some domestic producers. The first-order effects of free trade are positive, and we deal with the second-order negative effects  by compensating the losers (paying unemployment benefits or retraining workers). The same principles should apply to migration.

Thus we have seemingly solved, from an economic point of view, the problem of migration. It must be a force for the good and if there are problems or objections to it, they must stem from extra-economic reasons like social cohesion, preference for a given cultural homogeneity, xenophobia and the like.

However, I think that this is not so simple. There may be also some negative economic effects to consider. I see three of them.

First, the effect of cultural or religious heterogeneity on economic policy formulation. In the 1990s, Bill Easterly has started a veritable cottage industry of studies arguing that religious or ethnic heterogeneity makes economic policy less efficient, subject to constant conflict and horse-trading: I let you devalue if you let me impose price controls. The literature was concerned mostly with Africa (trying to explain its dismal growth performance), but there is no reason not to have it apply to Europe too. The rationale of Easterly’s effect is that groups jockey for the projects or policies that benefit their members, in conditions where trust between the groups, because of religious or ethnic differences, is low. Thus, one group would like currency devaluation if its members are engaged in export activities or import substitution, and another would prefer protection for the goods their members are mostly producing. It is true that the minorities’ economic roles in Europe are not as clear-cut as they are in Africa: Muslims in the UK do not have a preference for low or high exchange rate of the sterling since they are not concentrated in specific industries in the same way that the ethnic groups  in Nigeria who live in the Delta have an incentive to ask for a high share of oil revenues. Nevertheless, the difficulty of policy coordination in the presence of religious or ethnic diversity should be kept in mind. It may become more important in the future as Europe becomes more diverse.

Second, cultural differences may lead to the erosion of the welfare state. This was the point brought up twenty year ago by Assar Lindbeck. The roots of the European welfare state (most clearly seen in the Swedish “Our Home” beginnings in the 1930s) were always strongly nationalistic, based on a homogeneous community and mutual help between its members. It relied on commonality of norms or affinities between the  members.  But if that commonality no longer exists, the observance of certain norms upon which the welfare state is built (e.g. not to call in sick when one is not, or not to drink at work) is shaken, and the welfare state begins to be eroded. If you do not observe the same norms as I, and benefit at my expense, I lose interest in funding such an arrangement. Migration thus poses an important threat to the integrity  of the welfare state in Europe. It is not by accident that the current policy moves in the Nordic countries can be, without giving it a pejorative meaning,  described as a welfare state for the native-born population, or differently as national socialism.

Third,  migration might have important negative effects on the emitting countries. The point was made a couple years ago by Paul Collier in his book “Exodus: How Migration is Changing our World”. I was inclined to dismiss it as a veiled xenophobia which does not dare express its opinions openly, until I read last Summer several articles on the effects of large emigration from smaller East European countries. These countries have been losing a significant number of their doctors, nurses or engineers to the richer countries in the West and the North of Europe. Now, one could say that eventually higher salaries for doctors in the East will be sufficient to keep them at home or perhaps bring doctors from elsewhere, say from Nigeria to Hungary. But that approach ignores the length of time that it takes, not only to train doctors but for the markets to send the correct signals and for the people to act upon them. As Paul Krugman has nicely said “If history did not matter, adjustment would be instantaneous”. But while economic model might assume such an instantaneous adjustment, the real life does not. In-between thousands of people may die because of poor health care. Similarly, loss of some specialists may be, especially in small countries, very hard to compensate. If your country trains ten water sanitation engineers annually, and if they all move to richer counties, soon you will find yourself without anybody being able to control water quality.

We have, I think, to take into account also the negative economic effects of migration. I do not think that the three effects I listed here (and perhaps there could be others) are sufficiently strong to negate the positive economic effects. But they cannot be entirely disregarded or ignored either.