USC Gould School of Law

February, 2014

From Progressive Taxation to a Progressive Fiscal System

Edward D. Kleinbard Professor of Law [email protected] © Edward Kleinbard 2014

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This presentation is drawn from What’s Our Government Good For?, a book scheduled to appear in October 2014 (Oxford U. Press). Do not redistribute or cite this material without express written permission.

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Confessions of a Tax Apostate •  Imagine a firm that devoted itself to hypothesizing ideal capital structures rather than to what it was selling •  How different are we when it comes to fiscal policy? •  We know a lot about deadweight loss of taxation –  Practice constrained by administrative, salience and political economy issues more than theoretical gaps

•  How much do we know about opportunity costs of not pursuing one or another social investment or insurance project? •  In other words, what are the returns to government spending?

•  Possible explanations •  Social focus on progressive income tax for last 100 years? •  Optimal tax framing of issues? 3

What Was New About the Income Tax? •  When introduced in 1913, the personal income tax embodied two fundamental principles that were deliberate departures from earlier fiscal instruments: •  Taxation of capital income •  Progressive rate structure

•  Social debates still fixated on progressive income tax as if that were our actual objective •  But it turns out that a progressive tax is not always sufficient to get to a progressive fiscal system

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Capital Income Taxation is Inherently Progressive •  First, in the obvious sense that the rich have more capital (and therefore capital income) than do the poor! •  Second, capital income taxation is progressive along the margin of time. Capital income simply shifts consumption across time, so this is the right margin •  This is the “tax wedge” that upsets economists •  As capital income compounds, the tax bite takes a larger and larger fraction of the whole pretax return •  So even a “flat” capital income tax is progressive in application

•  Leads to perverse incentive to early consumption 5

Why Do We Want Progressive Taxation? •  Historical answer: as an indirect means to tax capital •  Several implausible or circular theories •  Benefits theories; ability to pay

•  Declining marginal utility of income? •  Declining marginal utility of pineapple consumption is easy to accept, but does that apply to all uses of income?

•  Dime-Store Rawls: Insurance salesman behind the veil? •  Because our real interest is inequality as such? 6

Different Theories Point in Different Directions •  Declining marginal utility of income •  Still some positive utility! •  Really different from just asserting a preference for equality? •  Leaves the size of government as an exogenous preference

•  Insurance theories •  Refocuses debate on how much insurance we want to buy •  Progressive tax itself becomes the logical expression of the insurance program •  Premiums in arrears •  Or more simply, progressivity as the vehicle for delivering some insurance benefits (tax relief via lower rates as insurance payout) 7

Progressive Tax as Inequality Antidote •  Sets up impossible political economy debates •  How much redistribution is enough? •  “Class warfare” etc •  Frames issue as zero sum debate

•  Puts Cart Before Horse •  Shifts focus away from the returns to government spending • 

Economic (in narrow sense) as well as social returns

•  And shifts focus away from distribution of that spending

•  Self-defeating because self-limiting in unintended ways •  Adverse incentive effects and political economy constraints 8

“Redistribution” Framing of Issue •  “Redistribution” = most odious word in fiscal language •  Legitimates pretax “distribution” •  Assumes a “take” from the rich and “give” to the poor construct • 

Substitute “social investment” and the tenor of discussion changes

•  Treats preference for equality as an idiosyncratic taste •  Typically ignores positive returns to spending • 

Economic returns in narrow sense, social returns in broader sense

•  Optimal tax theory must shoulder some blame here •  “Redistribution” setup to standard optimal tax analysis encourages casual thinking about spending side •  Government exists to spend, not to tax 9

Competing Measures of Progressivity •  Kakwani Index – a dangerous measure • 

Measures progressivity of a tax system in the abstract

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A tax that raises little money, but does so only from the most affluent, is scored as highly progressive

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The US personal income tax is very progressive, by this measure

•  Reynolds-Smolensky Index • 

A true ‘before and after’ measure

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Compares standard inequality measure (Gini index) before and after handprint of government

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Ideally compares market incomes with after-tax/after-transfer incomes

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Three variables: the progressivity of the tax system in the abstract, the size of the tax system, and how the resulting revenues are spent. 10

So What Do We Know About Progressivity of Fiscal System? •  Not that much! First CBO analysis November 2013 •  Highlights • 

40% of government spending is undifferentiated

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Transfers reduce inequality less in 2007 than in 1979

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Elderly childless households capture ~70% of transfer payments

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And elderly get NET ~$20,000/household [all benefits* – taxes paid]

•  Lowlights • 

Unconvincing methodologies for distributing undifferentiated spending

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Ignores large tax expenditures, like employer-sponsored insurance, as having unique distributional consequences

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Does not deal with intergenerational distributional issues

* “Benefits” includes undifferentiated spending allocated by market incomes 11

Average Benefits and Taxes Per Household (2006)

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Data Source: CBO

Note: Includes Undifferentiated Benefits Distributed by Market Incomes

Average Benefits and Taxes of Nonelderly Households (2006)

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Data Source: CBO

Note: Includes Undifferentiated Benefits Distributed by Market Incomes

Annual Distributive Share of Transfers Minus Taxes

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Source: CBO and Author’s Calculations

What Drives Progressive Fiscal Systems? •  Spending Not Taxes!

•  Lowlights •  Spending Not Taxes! (Source: CBO, The Distribution of Federal Spending and Taxes, and author’s calculations.)

•  Other Countries Have figured this out!

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Regressive Taxes Can Fund Progressive Tax and Transfer Systems

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Similar Results if Undifferentiated Spending Considered

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The Size of the System Drives The Results

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And Large Tax Systems in Practice Are Not Very Progressive

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Lessons for Today •  There are two levers of progressivity! •  Taxing and spending follow separate trajectories •  Practical and incentive effect reasons to limit progressivity of tax system •  Which leads to reliance elsewhere on larger but nonprogressive tax systems plus progressive social investment

•  Larry Summers’ VAT joke doesn’t get it quite right •  VAT – a regressive tax but a progressive fiscal instrument

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