Over the past three years, my tax rate has increased to over 60% of my income. This includes Federal and State Income Taxes, Social Security Taxes, Workmen’s Compensation, Medicare Tax, Sales Tax, and Property Taxes. This tax rate, combined with the costs of living in an area where I earn a high enough income to pay over 60% taxes, has given me some pause. The amount remaining after taxes, and high rents, provides for Ramen noodles and an occasional beer.
This post reviews various “theories” of taxation, starting in the late 19th century. All of these theories recognize the difficulty of high rates of taxation decreasing the motivation of high earners to continue earning. For example, at a 100% tax rate, the government could redistribute all income to meet its obligations. In fact, incomes would no longer be individual citizens’ incomes; it all would be the government’s income.
Government could then provide citizens their daily Ramen allocation – probably no beer though. People would work their 10-12 hour days, eagerly looking forward to their Ramen, and a bit of rest before the next day. People could even work seven days per week. Why not? Such a scheme would provide the resources needed to redistribute income to the 50%+ low-income Americans who pay no income taxes.
I could see many of the “powers at be” being quite excited about this model. The most capable people would be indentured to support the least capable. This is not a new idea. Many people have thought about this possibility over the past 100+ years.
Edgeworth (1897) discusses what he terms the pure theory of taxation. Written before the 1913 establishment of U.S. federal income tax, he focuses on taxes on the consumption of goods and commodities. Invoking the principle of equal sacrifice, he assesses impacts of taxes on each stakeholder. Equal sacrifice is defined as each taxpayer losing the same utility to the tax collector – in other words, the goal is equality of perceived pain for each taxpayer.
Ramsey (1927) continues this line of reasoning. He is concerned with the following: Given a bundle of goods and commodities, how to design the differing tax rates on each type of item to minimize loss of utility of those taxed. He mathematically shows that “the taxes should be such as to diminish the production of all commodities in the proportion” (p. 54). The key point here is that taxes on goods and commodities will diminish consumption of them.
Mirrlees (1971) explores the theory of optimal income taxation. He presents a mathematically rigorous approach to determining optimal progressive income taxes such that taxes impose equal utility losses on everyone. Individuals have a utility function for consumption (x) and time worked (y). An individual of ability n is paid ny for his or her work. The government imposes an income tax percentage of c(ny) on this income. The overall result is that a c(ny) function that is linear in rate progression is near optimal, unless “the supply of highly skilled labor is inelastic.”
Mirrlees suggests, however, that greater equality could be achieved by taxing people by ability to earn income, perhaps proportional to IQ, rather than actual income. He argues that this would be “an effective method for offsetting the unmerited favors that some of us receive from our genes and family advantages.” The difficulty that Mirrlees is trying to overcome with this idea is that high tax rates are likely to discourage high ability people from maximizing their earnings, thereby undercutting the tax revenues that were expected from them. Taxing by IQ, in theory at least, implies that people would have to pay taxes on what they could earn even if they chose not to earn these amounts. It is, of course, very difficult to imagine this ever being implemented – but is it?
More recently, Feldstein (1982) and Summers (1981) address the impacts of tax rates and inflation on investments. Feldstein argues that, “Inflation creates fictitious income for the government to tax” (p. 154). Taxes are paid on inflated returns while investors only gain real returns. In this way, a positive real return can become a net loss once taxes are deducted.
Summers (1981) discusses trends in business investments versus those made to satisfy regulations, e.g., pollution control. The investment rate in the 1975-1979 period was 3%, the lowest in three decades. Total taxes (on corporate profits, dividends, and capital returns) declined from 71.5% in 1953 to 52.7% in 1979. Inflation soared, “In a tax-less world, firms invest as long as each dollar spent purchasing capital raises the market value of the firm by more than one dollar” (p. 77). However, as Feldstein notes, high inflation rates undermine this possibility.
Much more recently, Mankiw, Weinzierl, and Yagan (2009) discuss optimal taxation in theory and practice. They argue that, “The social planner has to make sure the tax system provides sufficient incentive for high-ability taxpayers to keep producing at the high levels that correspond to their ability, even though the social planner would like to target this group with higher taxes.” They report a range of lessons from their review: 1) optimal marginal tax rate schedules depend on the distribution of ability, 2) the optimal extent of redistribution rises with wage inequality and 3) optimal taxes should depend on personal characteristics as well as income.
Thomas Piketty has focused on income inequality and capital taxation (Piketty & Saez, 2012; Piketty, 2014), with his 2014 book receiving an enormous amount of attention. They focus on “socially-optimal capital taxation,” on both savings and bequests, to deal with the problem of a “large concentration of inherited capital ownership.” They assert that, “Inequality permanently arises from two dimensions: differences in labor income due to differences in ability, and differences in inheritance due to differences in parental tastes for bequests and parental resources.”
They show that the “socially optimal” tax rate on inheritances, TB, can range from 40-60% to 70-80% when bequests are highly likely. Increasing TB allows decreasing the tax rate for labor, TL. For a 20% bequest probability, TB = 73% and TL = 22%. Their model also includes a tax rate for capital gains, TK. They consider how people shift income from monies subject to TL versus TK. They find that the optimal TK increases with uncertainty about future returns due to TB. They also consider a consumption tax, TC. This tax can enable TL < 0, which implies a labor subsidy for low-income people.
Of course, whatever schemes are proposed for TB, TL, TK and TC, high ability people will figure out how to take advantage of these schemes, effectively thwarting income redistribution. People with high incomes and/or wealth, will have the resources to hire high ability people to figure this out for them. Thus, any scheme is subject to “gaming” and adaptation will inevitably be necessary.
So, is my frustration with my 60% tax rate justified? I clearly am doing my part to help with income inequality. Further, I am still working; so the tax rate has not reached the extent to which I have given up trying. Of course, I am keenly aware of my financial commitments. The 40% that I still get to spend covers many things. There is a point, however, where living in a high cost of living area to earn a highly taxed income is no longer worth it.
I have a vague sense that the taxation system understands this, if only implicitly. The intention is to squeeze as much revenue as possible from highly capable earners to just before they are no longer willing or capable. Upon retirement, the taxation system will drain taxable resources from former earners via one mechanism or another, e.g., required Medicare charges linked to income. It almost seems that the system will, if possible, create penniless citizens just as they draw their last breadths in nursing homes, having no assets and supported by Medicaid.
There are various mechanisms to fend off this future. Trusts can be formed and foundations can play a role. However, perhaps with the exceptions of the super rich, the system is designed to suck resources from capable people who earned them and redistribute these resources to people who need them. Interestingly, this redistribution leads to a subset of these under-resourced people becoming enormously successful and then being subject to the same dynamic.
The redistribution of resources keeps society from rebelling. High ability folks – creative and crafty – understand how to prosper. The social and political system knows how to balance idea generation, venture formation and allocation of resources, while also redistributing income to support those who, for one reason or another, cannot compete. Those losing income, like me, gripe and complain but, as the long history discussed above illustrates, redistribution is a necessity of modern society. The mechanisms and magnitudes are debatable, but the phenomenon is not.
Edgeworth, F.Y. (1897). The pure theory of taxation. The Economic Journal, 7 (25), 46-70.
Feldstein, M. (1982). Inflation, capital taxation and monetary policy. In R.E. Hall, Ed., Inflation: Causes and Effects (pp. 153-168). Chicago: University of Chicago Press.
Mankiw, N. G., Weinzierl, M., & Yagan, D. (2009). Optimal taxation in theory and practice. Journal of Economic Perspectives, 23 (4), 147-74.
Mirrlees, J.A. (1971). An exploration of the theory of optimal income taxation. The Review of Economic Studies, 38 (2), 175-208.
Piketty, T. (2014). Capital in the Twenty-First Century. Cambridge, MA: Belknap Press.
Piketty, T., & Saez, E. (2012). A Theory of Optimal Capital Taxation. Cambridge, MA: National Bureau of Economic Research, Working Paper 17989.
Ramsey, F.P. (1927). A contribution to the theory of taxation. The Economic Journal, 37 (145), 47-61.
Summers, L.H. (1981). Taxation and corporate investment: A q-theory approach. Brookings Papers on Economic Activity, 1, 67-140.