Yesterday, the Congressional Budget Office released a report showing how effective federal tax rates have changed over the years. It makes for some interesting reading and it helps to put tax policy in perspective.
Joe-the-plumber's famous question to President-elect Obama during last fall's campaign highlighted an ever-present conundrum in public policy: how should the burden of paying for government be spread across people with different incomes? Should our tax system redistribute wealth, and if so, how much?
One useful starting point is to look at some hard numbers from this CBO study.
As you are learning from your study of tax law, many low-income taxpayers have negative effective federal income tax rates, due to refundable tax credits such as the Earned Income Credit and Additional Child Tax Credit. The CBO numbers confirm this. However, the CBO numbers also show that low-income households pay other types of taxes, e.g., Social Security, Medicare, and excise taxes (gas, tobacco, alcohol). In addition, as we will discuss in incidence analysis, they may indirectly bear the burden of other types of taxes. For example, to the extent that corporate income taxes are passed on to consumers in the form of higher prices or passed along to workers in the form of lower wages, low-income taxpayers may indirectly bear some of the burden of corporate income taxes.
The CBO numbers show that the highest income taxpayers have received a disproportionate share of income in recent years and have also paid a relatively high share of taxes. However, the effective federal income tax rates paid by the richest taxpayers have actually fallen somewhat compared to 30 year ago.
In the late Carter years and just prior to the Reagan tax cuts, the CBO numbers show that top 5% of the population paid an effective federal tax rate (for all federal taxes combined) of about 28%. The big Reagan tax cut dropped that rate to as low as 24% in the mid 1980s. However, increasing concerns about the deficit drove the rate back up to around 26% in the later Reagan years, where they pretty much stayed during the first President Bush years. During the Clinton years, the rates on that top 5% group rose back to 28%, and during the years of the second President Bush they fell as low as 25%. In the most recent year for the CBO study, the rate for that group had risen somewhat to 26%.
Looking at Table 1, we can also see that effective federal tax rates have fallen for all income groups since 1979, and, in fact, they have fallen most for the most vulnerable segment of the population, the lowest 20% of the income distribution. Many of us would say this is a good thing.
However, most economists believe that these tax cuts for everyone are not sustainable indefinitely. The federal government is running a large and growing deficit, and demographic trends mean that Social Security and Medicare will require increasingly large amounts of tax revenues in the decades ahead. Somebody will have to pay eventually.
So, the question is: how should the burden of raising those additional necessary revenues be spread across the different income segments of the population?
President-elect Obama initially proposed to cut taxes for everyone but the top 5% and to raise the tax rates for the top 5% by a rather modest amount. In view of the current economic situation, he now suggests that he may wait a while before increasing anybody's taxes.
Although the federal government is in a position to put off tax increases for a while (since the rest of the world is happy to lend the US Treasury money at phenomally low interest rates, in some cases very close to 0% interest!), this situation is clearly not sustainable indefinitely.
So the question remains: how should we spread the burden across different income segements? We'll talk more about this in class.
Bed Buffalo Alert: The CBO numbers all refer to a concept they call the "effective tax rate," which is an average tax rate. That's appropriate for thinking about equity and tax burden distribution questions. The numbers President-elect Obama was using in his discussion with Joe the plumber were actually marginal tax rates, which are a very different concept, and one that we will discuss in the context of efficiency questions. The distinction between effective average rates and marginal rates is a frequent source of confusion and definitely qualifies as a "bed buffalo." There is a mathematical relationship between the two concepts, but they are quite different and distinct. While a person in the top 5% of the income distribution might have a marginal income tax rate of 35%, their effective average income tax rate might well be around 20%. Again, we'll talk more about this in class.