President Obama says over and over again that high-income Americans don’t pay their fair share of income taxes. He says this with such conviction and confidence that many believe him—the tax code is unfair because high-income people pay too little. True, there is a lot wrong with our tax code and it is unfair, but the president is simply wrong if he believes our highest earners are not paying their fair share.
The top 1 percent of taxpayers pay more in federal income taxes than the bottom 90 percent. (The bottom 50 percent pay no income tax at all.) Clearly, our tax system is highly progressive, either when considering income taxes alone or consolidating personal income, corporate, estate and payroll taxes. I suppose one could argue that the code should be even more progressive, but that is a tough argument to make on the basis of fairness.
It’s also true that our tax code is replete with preferences, penalties and subsidies of all kinds. On this issue, I agree with the president that it is unfair, although we disagree both on the nature of the unfairness and what to do about it.
The structure of the tax code and how the data are collected and reported actually understates its progressivity. For example, higher earners receive a larger share of their income in the form of municipal-bond interest, dividends and capital gains. Municipal-bond interest is not taxed at all, benefitting the municipal issuers, not the holder of the bonds. If interest from municipal bonds were taxable, their rates would be higher and taxed. After-tax income would be the same, but reported tax rates would be higher.
Similarly, dividends and capital gains are taxed at a lower rate than are salary and wages. But corporate earnings are taxed first at the corporate level and then again at the individual level. Consequently, the individual corporate shareholder pays an effective rate which is actually higher than the rate on salary and wages. Thus, the reported tax rates for high-income people are understated.
Lower down the income curve, health-care benefits and retirement plans by corporations and governments are real income to individuals but are not considered as such, effectively lowering the recipients’ tax rates. This “subsidy” is paid for by higher rates on everyone else, particularly those who pay for their health care and retirements on their own. In addition, some transfer payments from the government—food stamps, some Social Security and Supplemental Security Income benefits—are not taxed at all, thereby overstating tax rates for lower income people.
Scores of common tax deductions are also unfair. Taxpayers who have mortgage-interest payments, own their homes, or make charitable donations receive deductions subsidized by those who don’t. Taxpayers who buy solar panels get a deduction, and anyone who buys an electric car gets a subsidy from taxpayers. People who donate appreciated securities get a tax deduction on the appreciated amount but pay no capital gains taxes on the appreciation. And the list goes on, each preferred group benefitting at the expense of everyone else.
What should be done to improve our arcane, complicated and unfair tax system? First, eliminate all preferences in the tax code and, if we still want to subsidize certain behaviors, pay for them through a legislative appropriations process, making them transparent to the public.
In other words, everyone earning the same amount of money should pay the same in federal taxes, regardless of how they earned their money and regardless of how they choose to spend it. What would be fair is all Americans paying federal taxes on all their income, whether it is earned in the form of cash or benefits, and paying taxes on earnings only once.
This Op-ed appeared in AEI on 6/18/12