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The Effect of Progressive Tax Codes

March 1, 2001
By Bill Ahern

Arguments over tax plans are really arguments about how "progressive" our tax system is. Our current federal income tax code has five rates: 15 percent, 28 percent, 31 percent, 36 percent, and 39.6 percent.

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Arguments over tax plans are really arguments about how "progressive" our tax system is. Our current federal income tax code has five rates: 15 percent, 28 percent, 31 percent, 36 percent, and 39.6 percent. This is a progressive structure, meaning the more you earn, the more you pay as a percentage of your income.

To evaluate whether a tax-cut plan makes the current code more or less progressive, the question to ask is similar: How would the plan change the percentage of income taken in taxes from each "income group," this year and in the future?

When the rates are left unchanged over several years, tax burdens rise by themselves because people earn more and find themselves paying higher rates. As a result, tax collections rise at a faster rate than taxpayers' income. So while the nation's income has increased at a 6.2 percent clip over the past decade, income tax collections have grown by 7.9 percent.

Any nation with a progressive tax code, then, must enact periodic tax cuts unless it wants the government to collect and spend an ever-larger fraction of the people's income.

In addition to causing these "autopilot" tax increases, progressivity creates much of the tax code's complexity. Nevertheless, the income tax code has been progressive since its inception, and during last year's Presidential campaign both major party candidates proposed plans that would increase this progressivity.

Percentage of Income vs. a Percentage of the Tax Cut

When a worker gets his annual raise, and people ask him what he got, they expect an answer like "3 percent" or "7 percent" or "10 percent." What those answers mean, of course, is the percentage of the person's income­-not the percentage of the total raises handed out by the company. When you earn interest on a deposit at the bank, you earn a percentage of the amount you have in the bank­-not a percentage of the total interest paid out by the bank.

A tax cut is similar. Each taxpayer should measure the benefits of a tax-cut proposal as a percentage of his or her income, and researchers or reporters measuring the effect of the plan should examine its effect on each income class as a percentage of income-­not as a percentage of the total tax cut.

The public is invariably surprised to learn that the top-earning 1 percent make 18 percent of the money and pay 34 percent of the income taxes. This large share of income earned and taxes paid by the top 1 percent is nothing new, but over the past 20 years both percentages have slowly, steadily increased. Any reform other than an across-the-board tax cut, such as lowering the ceiling on the income a household can earn and still be required to pay only the lowest tax rates, increases the income tax's progressivity.

Other Forms of Income

Two forms of taxes commonly thought to add to the progressivity of the tax code should be treated with particular caution.

Corporate taxes are collected by the government from corporations, but these taxes are ultimately paid by the corporations' shareholders, customers, and employees in the form of lower share value, higher prices, and lower wages.

Even if one assumed, as some economic studies do, that corporate taxes fall only on shareholders, it is false to claim that the corporate tax burden is paid only by the wealthy. The Federal Reserve reports that over 48 percent of Americans now own shares of stock.

Estate taxes are quite similar to corporate taxes. Like a corporation, an estate is a legal entity, not a tax-paying person. The government collects money from the legal entity, which then distributes less money to the heirs than it would have. It is the heirs, not the deceased or the "estate," who pay the tax. Heirs belong to all income groups; estate taxes hurt those in the lowest as well as the highest income groups.

Even if one assumed that dead people could pay taxes, the notion that only the wealthy would benefit from ending estate taxes would be false. An elderly person with $1 million in assets might earn approximately $80,000 annually in interest and dividends. That wouldn't even put him in the top 10 percent of earners; yet upon his death he would have a taxable estate.

Bill Ahern is communications director for the Tax Foundation.

For more information ...

Indiana and a Progressive Tax Structure. How much income must you make to be assessed the highest tax rate in states with a progressive income tax? Less than you think. (Indiana Policy Review, Autumn 1999, 4pp.)

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