Is this a time to rethink our Progressive Tax System?

I wrote this essay as a final paper for English 104 class in 2009.

In this essay I want address a belief amongst many Americans that progressive tax system is unfair for high earners and corporations. It has also been argued that progressive tax is a net detractor from economic growth. Words like socialism and Marxism have made a comeback in the media due in no small part to emergence of the new national hero - "Joe the Plumber." Joe has secured his place in history when he stood up to "tax and spend" and "income redistribution" ideas of Barack Obama by confronting him in a televised moment on the campaign trail. Simply put Joe claimed that small business owners will fire people and reduce investment if new administration chooses to dial back lofty tax breaks introduces during Clinton and George W. Bush administrations. While some might dismiss him as an aberration, and a tool of the conservatives, I have personally witnessed many members of the lower and middle middle-class accepting and sharing his views that business and high earners must pay less in taxes than they pay themselves. Logic and philosophy of progressive tax system deserves further exploration because many members of the middle class, who suffer from loopholes in our current tax policy that allows rich to pay as little as 15% in taxes, readily join "Joe the plumber" in condemning progressive tax system. Common earners' strong support of Joe's ideas should make any proponent of the Progressive Tax system to pause and question his or her beliefs.

The best way to facilitate a discussion of the progressive tax system would be to address two main topics: supply side economics and general fairness or unfairness of the progressive tax system.

Supply side economics is a school of thought that promotes a theory that the best economic growth occurs when suppliers are given incentives in the form of cuts to income and capital gains taxes. Supply-siders consider suppliers and high income earners to be the driving force of the economy, hence leaving greater amount of money in their pockets would encourage various forms of spending which would stimulate the economy.

While the crux of the theory was formed by two economist friends on the back of a napkin, full understanding of the theory requires serious academic undertaking. Fortunately, Arthur B. Laffer, one of the scholars who formulated the theory has published an article "The Laffer Curve: Past, Present, and Future." In this article published in 2004 at the Heritage Foundation, a conservative think tank, he explains the inner workings of the theory in layman's terms as follows:

The basic idea behind the relationship between tax rates and tax revenues is that changes in tax rates have two effects on revenues: the arithmetic effect and the economic effect. The arithmetic effect is simply that if tax rates are lowered, tax revenues (per dollar of tax base) will be lowered by the amount of the decrease in the rate. The reverse is true for an increase in tax rates. The economic effect, however, recognizes the positive impact that lower tax rates have on work, output, and employment--and thereby the tax base--by providing incentives to increase these activities. Raising tax rates has the opposite economic effect by penalizing participation in the taxed activities. The arithmetic effect always works in the opposite direction from the economic effect. Therefore, when the economic and the arithmetic effects of tax-rate changes are combined, the consequences of the change in tax rates on total tax revenues are no longer quite so obvious (Laffer).

What this basically says is that government net tax receipts will rise despite lowered tax rate due to stimulative effect that tax cuts have on investment and economy as a whole.

 

An opposing strategy applied in all civilized countries including United States advocates for a Progressive Tax system, which increases effective tax rates as incomes rise. Current U.S. tax system however provides high earners with ways to tame and elude the progressive nature our tax code by giving them great latitude in how to recognize profit and income. The loopholes are so effective that some billionaires get away with paying as little as 15% effective tax rate on their income. The issue of inequality in taxation has been brought to the forefront in the recent US Presidential race. Barack Obama, a winning candidate in the US presidential elections of 2008, has been labeled a socialist and "tax and spend" democrat for promoting a more progressive tax plan that would lessen the spread in taxes paid by the rich and the middle class.

Rich Karlgaarld, an editor of Forbes magazine wrote the following passage that illustrates the classical supply-side argument: "The most effective tax cuts are those that encourage investment and production--the supply side of the economy. These tax cuts would be on individual and corporate income, capital gains and dividends. Such cuts would lift spirits immediately and the economy soon after" (Karlgaarld 37). Karlgaarld proceeds to quote his boss Steve Forbes as saying "Reduce taxes on production and you get more production. More production means that more goods and services must compete for your dollars. That's how prices go down, not up. This is not hard to figure out! It is simple supply and demand. If you want prices to go down, increase supply. Incentivize the suppliers" (37). While it is true that tax incentives to producers contribute somewhat to the amount of production and investment into business, it does not necessarily follow that this is the most effective policy for sustained economic growth. John Kenneth Galbraith, a respected economist writes that "The poor and those of average income spend reliably from that they earn; the rich do not. Thus, progressive taxation has a stabilizing role in helping ensure that what is received as income is returned to the market as demand for good produced" (Galbraith 30). What follows is that making our tax system more progressive will encourage spending and demand. Galbraith also discredits attempts to increase after-tax income of the rich in order to encourage economically productive effort as "carrying the case the case too far" (30).

I agree wholeheartedly with Galbraith's arguments and also want to make a case that nothing encourages production and investment into business as robust demand. You don't have to incentivize Apple to produce iPods or iPhones. Toyota can manage to produce popular and quality vehicles without relying on handouts from American taxpayers. Gifting tax gifts to businesses to encourage growth is a form of reverse Darwinism that is a bad investment for our government. It unnecessarily increases incomes at the top of the corporate structures at the expense of government tax receipts.

Our businesses would be in a very bad shape if tax gifts would be sole source for economic growth and investment. Fortunately, we have a great and flexible financial products market. Businesses can obtain financing for expansion as long as they can prove, by conducting a prudent analysis of the opportunity, that it will be beneficial to their bottom line. Expansion for the sake of expansion does not result in sustainable growth and is actually something that can result in demise and destruction of a company. One needs to look no further than United Airlines, Ford, Kmart, Circuit City, to see how expansion in core business or via acquisition can bring a company to a bankruptcy.

Discussion of the tax policy towards business can be a civilized academic exercise, but nothing can match the heat and excitement when conversation turns to personal income taxation. Galbraith writes that "it is held that there is a moral entitlement: the man or woman in question has the right to receive what he or she earns or, more precisely, what he or she receives. This can be asserted with emphasis, on occasion with asperity and often with righteous indignation" (Galbraith 61). But how do you counter such assertion? Doesn't person have a right to hold tight to all of his/her earnings? Why does it matter what their income level is? The idea of entitlement to our compensations and view of taxation as an evil force is very hard to counter. However, Galbraith brilliantly explains that "Much income and wealth comes with slight or no social justification, little or no economic service on the part of the recipient. Inheritance is an obvious case. So also the endowments, accidents and perversions of the financial world" (61). A good modern day example of Galbraith's perversions can be seen in recent headlines when Lehman's CEO made out with millions in bonuses and options over his years of service that led to demise of the company. Freddy Mac, WaMu, and many other companies were led by executives that received astronomical compensation while being accomplices to policies that nearly destroyed American economy. Wall Street Journal article claims that "Freddie Mac's departing chief, Richard Syron, could walk away with an exit package totaling as much as $14.9" (Scannell A.21). At the same time many dedicated teachers, social workers, and regular working Americans are having hard time making the ends meet. These are the perversions and accidents of the economy that are unacceptable to a reasonable person. While higher taxation of executives would not help prevent the current economic crisis, it should cool any argument based on great utility of these minds to the overall economic growth.

Galbraith quotes Federal Reserve with the following statistics as of 1989: top 1% of American households owned nearly 40% of the nation's wealth in 1989, the top 20% more than 80%. The lowest-earning 20% of Americans had 5.7% of all after tax income. Despite the great economic growth experienced in the fifteen years that passed since, the divide has not changed. Article in 2004 Business Week states that "The top 1% of households owns nearly 40% of total household wealth -- more than the bottom 90% of households combined -- and earns half of all capital income. Income and wealth are more unevenly distributed among Americans than at any time since the Jazz Age of the 1920s. On measures of income and wealth inequality, the U.S. tops the charts among the advanced industrial nations" (Tyson 32). We can not continue the business as usual rewarding very few at the top, while increasing our national deficit to a double digit trillion amount, with a big portion of the borrowing coming from Social Security and Medicaid trusts.

A key to America's economic recovery is resurgence of demand for goods and services. This demand must be broad-based and sustainable. An effective progressive tax system is an important component in ensuring broad-based stimulative participation in economy by most citizens. While simplicity of Joe's (the Plumber) approach to taxation is appealing, we must be careful to not put the interests of the few over sustainability of the whole financial system.

Bibliography

Galbraith, John Kenneth. The Good Society - The Humane Agenda. Boston: Houghton Mifflin Company, 1996.

Karlgaarld, Rich. "Stagflation's Supply-Side Cure." Forbes 181.6 24 March 2008: 37.

Laffer, Arthur B. The Laffer Curve: Past, Present, and Future. 1 June 2004. 2 November 2008 <http://www.heritage.org/research/taxes/bg1765.cfm>.

Scannell, Kara and Dvorak, Phred. "The Fannie/Freddie Takeover: Pay Packages for CEOs Likely to Spur Scrutiny." Wall Street Journal [New York, N.Y.] 9 September 2008: A.21.

Tyson, Laura D'Andrea. "How Bush Widened The Wealth Gap." Business Week November 2004: 32.