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The Folly of High Marginal Rates

What is it with liberals and their obsession with high and progressive marginal tax rates on large incomes? The supercommittee’’s attempt to reduce the deficit now seems likely to founder on the Democrats’’ insistence on raising tax rates on the rich. Raising revenue by eliminating deductions and loopholes, which the Republicans have suggested, is not enough.

The other day, Alan Blinder, a liberal economist at Princeton and former vice-chairman of the Federal Reserve, had an op-ed in the Wall Street Journal entitled “The Folly of the Flat Tax.” He pointed out, correctly, that a flat tax would be politically difficult in the extreme to get enacted. But his main objection is that it would make the tax code “far less progressive.”

Really? Less progressive than a tax code under which the second richest man in the world pays a lower effective rate in taxes than his secretary? How do you get less progressive than that?

Many people,— including not a few all too willing to argue tax policy, —are ignorant of the difference between the marginal tax rate and the effective tax rate. I doubt Professor Blinder is, but he is hopelessly confusing them here.

The marginal rate of taxation is the tax rate on the next dollar of income. If Warren Buffett were to earn an extra dollar in salary this year, he would owe the government 35 cents on that extra dollar. The effective tax rate is the percentage of taxable income that goes to the government. If someone earns $100,000 and sends Uncle Sam $21,000, his effectve tax rate is 21 percent. His marginal rate under current law would be 28 percent.

Raising marginal rates has two effects in the real world (i.e. the parts of the world that are located more than ten miles from Capitol Hill). First, it discourages wealth creation. The more of the next dollar earned that is taxed away, the less incentive, obviously, there is to go to the trouble to earn that dollar. Spending the time in leisure rather than work becomes a less costly option with every uptick of the marginal rate.

Second, it increases the political pressure to provide escapes from the high rates. In other words, the higher the marginal rate, the more lobbying for new loopholes goes on to prevent those high rates from actually being collected. And the more tax accountants and lawyers scour the endless depths of the tax code to figure out how to structure tax avoidance schemes that will be at least arguably legal.

And the rich have much more political influence than the not-so-rich. Do you think you could get your congressman or senator on the phone in ten minutes flat? I doubt I could. Do you think Warren Buffett could? See what I mean?

The results are that the high marginal tax rates are ineffective in making the rich pay “their fair share.” Raise the top marginal rate to 100 percent and Warren Buffett would still be paying a lower effective tax rate than his secretary, because his secretary’’s income is mostly in wages and Buffett’’s is nearly all in dividends and capital gains, which are taxed at a much lower rate.

(To be sure, we could raise the tax rate on dividends and capital gains to the same rate as wages, but that would cause corporations to stop issuing dividends, which come out of corporate profits that have already been taxed anyway, and cause shareholders to stop realizing capital gains and, worse, to stop risking their capital, the only way to “grow the economy.”)

If liberals want to actually sock it to the rich instead of only giving the appearance of doing so while not destroying the American economy in the process, they need to raise the effective tax rate of the rich. The marginal rate is irrelevant.

How do you do that? Simple: eliminate the millions of words of the tax code that are the result of 90 years of crony capitalism and lobbying and which allow the rich to escape high marginal rates. Then eliminate the high marginal rates, the progressivity of which is entirely illusory, and watch the bucks flow into the treasury under a flat tax. The flat tax, thanks to having only a personal deduction, has real progressivity. Under a flat tax, the higher one’’s income, the higher that person’’s effective tax rate inescapably is.

But liberals these days, like Bourbons two centuries ago, can learn nothing and forget nothing, so they will continue to demand what they can’’t have in a democracy–high marginal rates on large incomes.

 



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