If you are going to argue that people who make mistakes should be ostracized . . .

. . . it’s best not to make a serious mistake in your attack.  Here’s Matt Yglesias:

The answer is that the column labeled “Share of taxes of richest decile” is in fact the share of income taxes paid by the richest decile. The federal income tax in the United States does, in fact, have a progressive rate structure. Federal payroll taxes, state and local sales taxes, most excise taxes, and property taxes all have a regressive rate structure. So, yes, if you look exclusively at the most progressive element of the American tax code, it’s highly progressive. If you compound that exercise by mislabeling your chart, then you can mislead people. You might think it’s a little strange that Greg Mankiw, an economics professor, would mislead people by uncritically endorsing such a misleading chart but Mankiw believes that progressive taxation is immoral and should be opposed even if it enhances human welfare. Perhaps this same moral theory leads him to believe that misleading people about the subject is an act of justice. If so, then I’m not sure it’s really in the interests of Harvard (or the many universities that assign his textbook) to entrust him with the instruction of teenage economics students.

Now I’m not going to argue that the chart Mankiw links to is exactly correct, but it looks like it’s in the right ballpark.  And I could tell that Yglesias’ assertion about income taxes was wrong without even looking up the numbers.  The top 10% in America pay way over 45% of income taxes, at least as tax incidence is normally estimated.  (BTW, the assumption that the incidence of income taxes falls on the people who write out checks to the IRS seems crazy to me, but my fellow economists of the left and right don’t agree.)

It is common knowledge among progressive public finance experts like Peter Lindert that the European tax regimes are able to collect more revenue than ours (as a share of GDP, not in total) by having a more regressive tax system.  Mankiw’s link may not be exactly right, but the stylized facts are in the right ballpark.  Given that Yglesias is a fan of the European welfare state, I’m surprised he hasn’t read Lindert’s research.

Actually, what most surprised me was the very low share of income earned by the top 10% in Switzerland.  That can’t possibly be right, can it?

Yglesias’ strongest argument might be that tax plus transfers in Europe might be more progressive than taxes alone.

BTW, I agree with Yglesias that a progressive (consumption) tax system is desirable, and don’t really buy into Mankiw’s “just deserts” approach.  So this post has nothing to do with my ideology.  (Of course if I had been born as Greg Mankiw I might feel differently about the just deserts approach.)

To summarize, it’s still safe to use Mankiw’s text, but Cowen/Tabarrok is also excellent.   (Can’t afford to piss off any influential bloggers.)

Update:  Scott Winship sent me a post with some quite interesting graphs on income inequality.  (BTW, I don’t think income inequality is the best way to measure economic inequality–I prefer consumption inequality.  But income is what most people use.)

Income: A meaningless, misleading, and pernicious concept

And now, finally, my post on the optimal tax regime.  It will be nice to finally get this off my chest, as you can’t imagine how enraged I get reading progressives talk about the “principle” that all forms of income should be taxed equally (which is like a “principle” that all fruit should sell at the same unit price.)  Or when they discuss Gini coefficients of inequality based on meaningless income data (not to mention ignoring the fact that the economic incidence of a tax is totally different from its legal incidence.)

Bear with me as I start from first principles; this is an important post.  I will try to convince my progressive readers that they should favor complete abolition of all personal and corporate income taxes, as well as all inheritance taxes.

Suppose 2 brothers both make $100,000 a year.  One spends his income on watermelon, and the other spends it on blueberries.  Would it make sense to decry the inequality of this society, merely because the blueberry eater got to consume a larger number of “fruits” (because their unit price was lower?)  Clearly not, and for two very good reasons.

1.  They are each free to buy either type of fruit.

2.  The higher unit price of watermelon indicates they are more highly valued (per individual fruit.)

Now assume it’s possible to invest income at a real rate of interest that allow one to quintuple one’s wealth between age 25 and 65.  (Say a 40 year zero coupon real bond yielding around 4%.)  In this example let both brothers consume nothing but blueberries.  One brother chooses not to save at all, the other saves 40% of his income.  One eats $100,000 worth of blueberries today; the other eats $60,000 today and saves $40,000.  After 40 years the thrifty brother gets to eat $200,000 worth of blueberries.  Both also get some social security at 65.  Here’s my question:  In this society is there any economic inequality?

I don’t see how anyone could say there is.  Both have exactly the same wage income at age 25.   Yes, they do different things with it, but that’s their choice.  At age 65 one has zero income outside social security, and the other has $160,000 in capital gains, which is generally considered “income.”  But nonetheless there is complete equality for two reasons:

1.  Both are free to choose whether to save or not, so we have no evidence that one brother had more utility than the other.

2.  In present value terms their total lifetime consumption of blueberries is identical.

The mistake is assuming that blueberries in 40 year are the same thing as blueberries today.  Future blueberries only cost 1/5th as much, as they are much less valued than current blueberries.  They are different goods just as much as watermelon and blueberries are different goods.  That $160,000 gain is not “income” in the way most people think of the term, i.e. as some sort of goodie available for spending.  Rather it reflects deferred consumption.  The $200,000 received at 65 is exactly equal in present value to the $40,000 saved today.  Indeed it is the very same wealth, simply measured at a different point in time.  It is nonsensical to say the thrifty brother has income of $100,000 today plus another $160,000 at age 65, you’d be counting the same income twice.

Studies of economic inequality should completely ignore all capital income, and measure only labor income, or consumption.  Indeed the present value of labor income should equal the present value of consumption.  And as we will see, a labor tax (like the 2.9% Medicare tax) is identical to a consumption tax (like a VAT.)

Consider how a 50% payroll tax would affect the previous example.  Every figure would be cut in half.  The spendthrift would consume $50,000 today, and the thrifty guy would consume $30,000 today and $100,000 at age 65.   An equal-sized VAT would have an identical effect, cutting consumption for each person in half, at each point in time.

But now consider a 50% income tax.  The spendthrift would be affected in exactly the same way as with the other two taxes.  But the thrifty guy would pay a much higher tax.  He’d save $20,000, and that would produce $100,000 in 40 years.  The government would then take $40,000 of the so-called capital “income” in taxes, leaving him with only $60,000 for consumption.  If he wants to prepay his future tax liability, he must save $8,000 today in order to pay a $40,000 tax bill at 65.  That means $8,000 of his current saving goes to pay future taxes, and only $12,000 goes toward future consumption.  His total tax is then (in current dollars) $50,000 plus $8,000, or $58,000.  His tax rate is 58%, against 50% for his spendthrift brother.  And all because they have different preferences, not because one brother is in any meaningful sense “better off” than the other brother.  It’s no different from putting a higher income tax rate on a brother who eats blueberries, as compared to one who eats watermelon, merely because he has more blueberries in numerical terms.

At this point you might be thinking “Yes, but wouldn’t eliminating all income and consumption taxes be a giveaway to the rich?”  No, it would be restoring fairness by taxing the thrifty and spendthrift at equal rates.  If we think the rich should pay more tax, then let’s put a progressive consumption tax into effect.  This is easy to do, just turn the regressive FICA into a progressive payroll tax, with much higher rates for those with high wages and salaries.  This sort of tax can achieve any desired degree of progressivity.   Unlike most libertarians, I think a progressive payroll tax is desirable for simple utilitarian reasons.  I don’t buy the “I worked hard for it, it’s my money” argument, for two reasons:

1.  Most of your income comes from luck.  If you’d been born in a poor peasant household in Asia or Africa, your income would be low no matter how hard you worked.  You hit the jackpot just being born in a developed country.

2.  Our wealth comes from living in a highly functional society, thus part of your wealth is due to the fact that your neighbors don’t go around raping and pillaging as in the old days, but rather peaceably go to polling stations to vote.  Am I saying; “It Takes a Village?”  Sort of, more precisely “it takes a civic-minded culture.”

At this point my progressive readers might be willing to go for the progressive consumption tax for those who worked hard and saved their money.  But surely not for that deadbeat trust fund kid, who is living off daddy’s wealth?  Surely there should be an inheritance tax so that those with inherited wealth don’t go through their entire life without paying any tax?

If this is what you are thinking, you are still confused.  I will show that, if anything, we should be subsidizing those trust fund deadbeats.

First recall that if we have an optimal payroll tax then the money they inherit is all after-tax money.  And if we had a VAT, then the heirs would have to pay taxes on their consumption.  Now let’s go back and look at the case of the two brothers.  Suppose both have arrived at age 65 with $10,000,000 in wealth.  Also assume that we have a steeply progressive payroll tax, so they are considered morally justified in spending the wealth they have accumulated after paying those taxes.  The only issue being considered is whether we should have an inheritance tax on top of the payroll tax.  So let’s assume a 50% inheritance tax is introduced.  Compare the follow two scenarios:

1.  Brother A spends the entire $10,000,000 on fancy sports cars, yachts, champagne, glamorous parties, etc.  Brother B spends $5,000,000 and gives $5,000,000 to his only child.  Who should pay more tax?  We’ve already agreed that the guy who consumes all his wealth has already paid his dues through the progressive payroll tax. If not, then make it more progressive.  The other guy would have to pay $2,5000,000 in inheritance taxes, leaving his kid with $2,500,000.  It seems to me that on both efficiency and moral grounds the more generous dad should not pay more, but rather should actually pay less taxes than the other guy:

1.  He is less selfish, so virtue ethics favors the one who makes bequests.

2.  Because of diminishing marginal utility, it’s better to share your wealth with one other person.  He wins on utilitarian grounds.

3.  The inheritance tax discourages saving, and thus reduces the capital stock.  This lowers the real wage of workers who work with physical capital.

Brace yourself.  The optimal policy is a negative inheritance tax.  At age 65 both rich guys should be forced to put some amount (let’s say $100,000) into a government fund.  When they die, the $200,000 should go to the kid who also inherited the rich guy’s money.  I know what you are thinking—why not give the $200,000 to the poor?  Because we already assumed the existence of a progressive payroll (or consumption) tax, which is redistributing the optimal amount of money to the poor.  This extra tax is just trying to make things a bit more equal among two old rich guys, and one worthless trust fund baby.

[Yes, I’m sort of joking here—just trying to rigorously apply the logic of egalitarianism.  (For my trust-fund kid readers–I have nothing against you, I am just parroting society’s prejudices.)  But I am serious about favoring a progressive consumption tax.  Indeed I favor it so much that I would prefer it even if it meant I paid more in taxes than I do right now.  You will never find me complaining that I can’t get by on a family income of over $250,000.]

I think people have a huge mental block about these ideas, because they grossly misunderstand the actual incidence of taxes.  For instance, most people think consumption is much more equal than income, and hence that consumption taxes are regressive.  Actually, consumption taxes are proportional to consumption, which is the only meaningful benchmark.  Income is meaningless gobbledygook.  And most people think wealth is much less equal than income.  But how can both of these perceptions be correct, when wealth is nothing more than the present value of all future consumption for you and your heirs!  Actually, inequality of wealth and consumption are exactly equal, when properly measured in present value terms.  OK, to make this true I have to treat gifts from the rich is part of their consumption.  But even in a society where the wealthy made no gifts, most people would be shocked to find out that wealth and consumption inequality are equal.   And the reason is that our minds are being twisted and distorted by a meaningless concept—income.  People find it hard to shake the notion that income is actually measuring something meaningful.   So we use it as a sort of benchmark for everything from tax progressivity to Gini coefficients.

The beauty of the progressive consumption tax is:

1.  No tax forms for 90% of Americans, it’s automatically collected like FICA.

2.  It’s fair to high savers, treating them equally to spendthrifts.

3.  It encourages more saving and less consumption, which America desperately needs.  This raises economic growth.

The ideal tax system would be:

1.  Externality taxes such as a carbon tax.

2.  A land tax

3.  A progressive consumption tax, preferably on wages and salaries (as the VAT is harder to make progressive.)

4.  If we opt for the high-tax Nordic model, you might also need a VAT.

But why go for the high-tax model, when the lowest-taxed developed country entity in the world has the best infrastructure?  And the second lowest-taxed rich country also has enviable infrastructure plus universal health care combined with a Japanese-level life expectancy?

It would only take four things to make me become a card-carrying Democrat:

1.  If they dumped Keynesianism and favored using monetary policy to target NGDP

2.  If they favored replacing our current tax system with a progressive consumption tax

3.  If they favored replacing the public school monopoly with universal vouchers.

4.  HSAs through forced saving plus subsidies for the lower incomes

Progressive blogger Matt Yglesias already agrees with me on the first two, and Sweden adopted the third.  Singapore combines the 4th with universal health care.  So how can any progressive call me a reactionary Chicago-school economist?

I suppose what’s holding back vouchers in America is liberal sensitivity regarding our troubled racial history, and also a fear of religious schools.  But that’s for another post.

So why the inflammatory title of the post?  I hope I showed that “income” is meaningless if it includes capital income.  It is misleading because it leads people to talk about the share of “income” earned by the top 1% as if it is all actual labor income, whereas it is often mostly capital income, aka deferred consumption and not income at all.  And it’s harmful because it leads to the establishment of an extremely annoying, inefficient, and sometimes even repressive system called the income tax.  And it punishes thrift and rewards spendthrifts.

PS.  Of course there are real world problems with estimating wage income.  How should we deal with the self-employed?  One option might be to tax income from proprietorships, allowing the expensing of investments.  I hope commenter Mark can help me out here, as it’s been 30 years since I read any public finance and am relying on my feeble memory.

Update:  A commenter pointed out that Steve Landsburg did a similar post just a few days ago.

Why is the government trying to force me to divorce my wife?

Over the next few months I plan to explain my deep hatred for the income tax.  What most bothers me about the tax is not the amount that I pay (although I believe my wife and I pay more than usual for people with our incomes) but rather the sheer insanity of the entire system.  We can certainly afford to pay our tax, so I am not trying to plead poverty.  What bothers me is that I must spend several days each year just doing the paperwork.  This year I finally relied on HR Block, and had to pay $610 dollars for the privilege.  I read that in Sweden the government simply sends you a bill.

Then there are the perverse incentives created by the tax.  Today I’ll discuss the marriage penalty.

Why is there so little discussion of the marriage penalty in the press?  And why do both political parties seem to favor it?  I can’t answer these questions, but will try to speculate anyway.  I’d also appreciate your thoughts.

I first became aware of this problem after I got married.  I noticed that the combined income of my wife and I pushed us up into higher tax brackets.  Initially the problem was trivial.  But as we got older and got promotions our income rose into the upper middle class range (low 6 figures) and then it became very noticeable.  Suddenly we had to pay the AMT, although if we were single we would not earn enough to trigger an AMT tax.  The official 15% capital gains tax rate became a joke, as the realization of significant capital gains can push you into the AMT, which can dramatically affect the tax on your non-capital gains income.  I won’t bore you with all the confusing details, but I am shocked each year when I compute how much lower our total tax would be if we were both single.

Indeed the new health care bill makes the marriage penalty even worse for married couples earning between $250,000 and $400,000.  Contrary to what Obama says, workers making $130,000 (married to each other) might have to pay higher taxes as a result of the health care bill.  So it isn’t just the “rich,” the upper middle class will also be affected.  Under the bill a cohabitating couple where each person makes $200,000 from interest, dividends, or rental income will pay an extra $5900 in taxes if married, but no extra taxes if “living in sin.”

You might think this is just some sort of unfortunate “glitch” in the tax code, and that it will be fixed once the authorities become aware of it.  I think they already are aware of it.  The marriage penalty has been around for decades; it would have been fixed if the government wanted to fix it.  But why would the government be so opposed to people getting married?  Isn’t marriage generally considered a good thing?  My theory is that both parties want to fix it, but they can’t agree on how to do so, so nothing gets done:

1.  The Republicans might prefer a flat tax, which would avoid the problem of people getting pushed into higher tax brackets after they get married.  But the Dems consider that sort of tax regime to be insufficiently progressive (especially given the regressive nature of payroll taxes.)

2. The Dems might be willing to allow married people to file as a single person, but Republicans oppose that because they think it would favor working moms over stay at home moms.  I.e. consider two families that live next door to each other.  In one family both husband and wife make $100,000.  In the other family the husband makes $200,000 and the wife is a homemaker.  Under current law they pay the same amount of taxes, and I think Republicans are OK with that.  If married people were free to file under the single person’s tax rates, then the family with two people each making $100,000 would pay less taxes than the person making $200,000.  Actually, that seems very fair to me, as a family with someone making $200,000 plus a homemaker is much better off economically than a family where each spouse makes $100,000.  In the latter case they still have all the chores to do at home, or else they’d have to hire maids and nannies.

Here is the bottom line.  The government is discriminating against people according to their marital status.  Two families that live side by side, each with two adults earning $130,000, might each pay very different amounts of taxes.  The family where the two adults are legally married pay more taxes than the next door neighbors, who might tell all their friends and relatives that they are married, but in fact secretly got a divorce and are now living in sin.  Does that seem fair?

BTW, this isn’t just a problem that affects the upper middle-class; low income workers also face a large implicit marriage penalty, as benefits like the EITC get phased out much more quickly if two low income people get married.  Indeed in percentage terms this probably affects them much more than me.  (Interestingly, as the marriage penalty got worse for low income workers, their marriage rate fell.)

My wife and I would be better off getting divorced.  Unfortunately, women tend to be rather sentimental about marriage.  So it may not be easy for me to convince my wife of the logic of this argument.  But here’s something I can say for sure.  If we did get divorced to save $80,000 to $100,000 in taxes over our lifetime, you’d never know about it.  It would be between us and the IRS.

As a good libertarian I oppose having any government policies hinge on whether people are married or not.  (I.e., governments should not recognize marital status.)  I believe all upper-middle class libertarian couples should stay single, to help “starve the beast.”  Let’s hope Megan McArdle’s recent ceremony was just for show, and that they “forgot” to have it formalized at City Hall.

Gay men may actually benefit when gay marriage is legalized at the Federal level, as the social pressure to get married is lower than for heterosexual couples.  So they will be able to more easily choose the marital status that best fits their particular tax status—assuming that society doesn’t start pressuring gays to get married.  Unfortunately, Americans often seem to want to either ban things or mandate them—with no in-between option of freedom.

I suppose some of my more conspiratorial readers think that Obama is increasing the marriage penalty because gays are an important part of the Democratic coalition.  Please spare me!  That would be about as likely as the first African-American President paying for health care with a tax that only hits white people.

PS.  I do know that many gays are actually hurt by being forced to file as single.

PPS.  I am one of what Joe Biden calls the “super-rich” who will be hit by the planned expiration of the Bush tax cuts for upper income people, and I make well under $150,000.  So much for Obama’s promise not to raise taxes on people making less than $200,000.  My income is a bit more than a Boston cop, but a lot less than a Massachusetts turnpike cop.  I guess a Boston cop who is married to a highly-skilled nurse is also “super-rich.”  Again, the money doesn’t bother me, I have plenty since I am a high-saving nut.  What bothers me is the thought that when I retire I’ll be paying more taxes or getting less Social Security benefits to help those “unfortunate” guys who made just as much as me, but never saved anything.  The guys who have garages filled with expensive toys.