Taxes are in the news. We all just finished our returns for 2016; Donald Trump again says he can’t disclose his own. But he also unveiled an outline of his planned “reform.” Issues are myriad, so let’s review some basic economics of taxation.
Start with “incidence.” This is whose income is actually reduced by a tax, not necessarily the person writing the check.
Most people know this. Sales tax is listed on sales slips. And people know that even if gas taxes aren’t itemized, we still pay them.
But not all consumption taxes are viewed the same. There is little opposition to a tax on medical devices. Manufacturers hate it, but not the public. Raising a tax on beer causes more outcry than on heart valves.
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Public perceptions are mixed. Some believe that employers really pay half of total FICA taxes. Others think all FICA ostensibly paid by employers actually comes out of wages and that the “employer portion” is a charade.
Actually, neither side is correct. The total tax is split, but with employees paying the lion’s share. Yet the exact split depends on many factors.
A second important concept is that of a tax’s “burden” and “excess burden.”
The burden of a tax is its total economic cost, not only in tax paid but in government administering it and payers keeping records, filling forms and so forth. Moreover, it includes costs of avoiding the tax, such as hiring attorneys to devise estate plans to minimize taxes.
Finally, the burden includes economic losses due to inefficient uses of resources motivated by the tax. A farmland owner like me may not invest to improve the land. But my renters won’t either, because they may not have the land long enough to be paid back. The land would be managed better if I sold it to the operators. If I sell, the capital gain is taxed. If I hold it till death, the “basis” of the property “steps up” to its market value. That income will never be subject to income taxes. So I don’t sell, even though the land would be managed better if I did. The result is inefficiency.
This provision causes a third of all capital gains income to escape federal income tax. Nearly all that benefits the top 10 percent of wealth owners.
So the burden of a tax contains several components, of which the tax paid is one. Subtract that from the total to get “excess burden.” That is the total cost to the economy above revenue to government. The higher a tax’s excess burden, the greater the wasted resources.
Another concept is that of “regressive, proportional and progressive” taxes. Narrowly, they refer to the tax “rate” versus the tax “base.”
The base is whatever is taxed whether income, sales or gallons of gas. If the rate is high when the base is low, and drops as the base increases, a tax is regressive. If the rate stays the same when this base changes, the tax is proportional. If the rate increases as the base increases, it is progressive.
That is the strict definition. More generally, it relates to income rather than a specific base. How does proportion of income paid change as income changes.? If the percentage of income paid for a tax decreases as income increases, it is regressive. If this stays the same, it is proportional. If it increases, the tax is progressive.
By strict definition, sales taxes are proportional. The rate is the same on $10,000 in taxable items or $200,000. Ditto for the gas tax, as the per-gallon rate stays the same regardless of quantity. And ditto for FICA taxes that equal 15.3 percent of earned income up to the cap of $127,200 and 2.9 percent above that.
In another sense, sales and gas taxes are regressive. Poorer households pay a higher proportion of their income, because their purchases take more of total income, especially where food is taxed. FICA is also regressive, since the Social Security part of it cuts out at the cap and applies only to wage and salaries, not investment income. The tax burden is huge for minimum-wage earners and negligible for investment bankers.
The individual income tax applies higher rates as income increases and therefore is progressive. Since the estate tax hits only the richest one-half percent of estates, it too is progressive. Almost all other taxes are slightly to highly regressive. Across all state and federal taxes, the U.S. system is roughly proportional.
Now consider the news. Any Republican tax “reform” will eliminate the estate tax. It is progressive and it has high excess burden. And any “reform” will leave “step-up basis” intact. That is highly regressive and has huge excess burden.
A 20 percent “border adjustment tax” would have unclear incidence. Trump and Paul Ryan would have you believe that Chinese and Mexican exporters will pay. But at root, it taxes imports. These nearly always are paid by consumers through higher prices. It would be regressive, just like the sales tax.
Yes, the tax would make the dollar more valuable against other currencies. That would offset some effects, since a dollar would buy more imports. But the stronger dollar would hurt incomes of farmers and any industry that exports or competes with imports. This is a huge and poorly understood can of worms.
U.S. corporate and individual income taxes are the most complicated of any wealthy country. Complication always increases burden, not only in filling out forms, but, more importantly, in motivating wasteful resource use. The federal complication stems from businesses and interest groups petitioning for special treatment. Their efforts have a cost.
St. Paul economist and writer Edward Lotterman can be reached at firstname.lastname@example.org.