Encore – So, is the U.S. tax system regressive or progressive?

Last night, I heard a group of pundits claiming that the US tax system is regressive when payroll taxes (for Medicare and Social Security) are considered.  Huh?

This encore was originally posted on Aug.3, 2008.

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OK, I’m officially confused. Is the current U.S. tax system “regressive” – the more you make, the lower your effective rate – or is it  “progressive” – the more you make, the higher your effective rate. 

The politicos and pundits – even the smart ones – seem split on the question.  So, which is it?

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Summary

Practically everyone agrees that the U.S. federal income tax structure is progressive (i.e. high earners pay a higher tax rate).  But, the Reagan and Bush tax code changes did make it less progressive than it was in the 1960s; there are some isolated anomalies ( e.g. Warren Buffett and his secretary); and it may be less progressive than some folks want.

The estate tax (a.k.a, “death tax”) is – by definition —  progressive since only the wealthiest 1% of folks who die pay it.

• Note: there’s a difference between “income” and “wealth” – while high income usually correlates with high wealth, income is a “flow” variable and wealth is a “stock”.

So, any dispute must arise from so-called  “payroll taxes” – the paycheck deductions that fund Social Security and Medicare. 

There is a single rate for Medicare (1.45%) that is applied to all wages; and.there is a single rate for Social Security(6.2%) that is applied to at most $102,000 in wages.  Employers match their employees’ contributions dollar-for-dollar.

• Note: most economists argue that, in the final analysis, employees bear the full burden of their employer’s matching amounts since employers most likelycover the tax by reducing wages.

Since the same rates are applied to all taxpayers , and since Social Security’s“base earnings” are capped at  $102,000, then payroll taxes are regressive with respect to current earnings.  But – as I’ll demonstrate is future analytical posts – Medicare benefits are the same, regardless of how much a taxpayer contributes (and high earners contribute more than low earners); and Social Security benefits are “coupled” to earnings via a very progressive formula – i.e. high-earners get disproportionately less in benefits.  So, taking into account the benefits received as well as the contributions made, both programs are very progressive.

The bottom line: all of the components are progressive:  federal income taxes, estate taxes, payroll taxes.  So, it logically follows that the combined program is progressive.

In this post, I’ll set-up the issue and provide some references.  In subsequent posts, I’ll provide some numbers and analysis that support the above conclusions..

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The Details

The question: Is the current U.S. tax system “regressive” – the more you make, the lower your effective tax rate – or is it  “progressive” – the more you make, the higher your effective tax rate.

Let’s look at the pieces that make up the U.S. tax system..

There’s the estate tax (a.k.a. “death tax”).  It’s clearly progressive since only the richest 1% of folks who die pay it.  As the exclusion levels increase under the Bush plan, fewer dead people have to pay it – making it even more progressive.  When it gets eliminated entirely in 2010, it stops being progressive, but it doesn’t start being regressive.  It just stops.

The estate tax in small potatoes in the overall  tax mix.  The big behemoth is the federalincome tax.  The aggregate statistics  (i.e. looking at the broad population , and not just Warren Buffett and his secretary) are – in my opinion – incontrovertible.  Higher income folks – say the top 50% — pay a higher effective income tax rate and shoulder over 97%l of the federal income tax burden. The federal income tax is progressive.  Period..

Why then, do many really smart, well-intended people say the tax system is regressive and that high earners aren’t paying their fair share?

• Note: though some people use the terms interchangeably, “regressive” and “fair share” are not synonymous.

First, what some of them are really saying is that the income tax code isn’t as progressive as it used to be (true, but so what?),  or that it isn’t as progressive as the tax code in other countries, say France (true, but — for sure — so what?),  or that it’s not progressive enough based on higher order socio-ethical criteria (very important, but also, quite debatable).

• Note: for a recent, left-leaning, comprehensive recap, see “How Progressive is the U.S. Federal Tax System?”, Journal of Economic Politics, http://elsa.berkeley.edu/~saez/piketty-saezJEP07taxprog.pdf

A more structural argument posed by many people is that so-called “payroll taxes” that fund Social Security and Medicare are regressive and tilt the balance of the tax system..

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For example, Robert Reich, Bill Clinton’s former Secretary of Labor says:

The fact that “84.6% of all federal taxes are paid by the top 25% of income earners, and over a third are paid by the top 1%, advances a specious argument.

Most Americans pay more in payroll taxes than in income taxes … payroll taxes take a much bigger portion of the paychecks of lower-income Americans than of higher-income.

Viewed as a whole, the current tax system is quite regressive.”

http://economistsview.typepad.com/economistsview/2007/10/robert-reichs-p.html

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OK, so parsing Reich’s argument, if the overall system is regressive, and if major parts of the system —  income and estate taxes are progressive – then it logically follow that payroll taxes are both substantial (especially to low-earners) and very regressive.  The culprit is payroll taxes.

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The Tax Policy Center—  a joint venture of the Urban Institute and Brookings Institution and self-proclaimed non-partisan organization   – explains:

“Taken as a whole, the federal tax system is progressive: on average, households with higher incomes pay a larger share of their income in federal tax than do those with lower incomes. In other words, the overall average effective tax rate-total tax paid as a percentage of income-rises as income rises.

But not all taxes within the federal system are equally progressive. The estate tax is the most progressive federal tax. The individual (and corporate) income taxes are also progressive. In contrast, payroll taxes for Social Security and Medicare are regressive, claiming a larger share of income from lower-income than from higher-income households.

For 2008 average effective payroll tax rates are estimated at 8.4 percent for the bottom fifth of income earners, and 10.4 percent for the next fifth, but only 5.7 percent for the top fifth. Households in the top 1 percent will pay an estimated average of only 1.5 percent of their income in payroll taxes.

This regressivity of payroll taxes stems from two factors. First, the Social Security portion of payroll taxes is subject to a cap: in 2008, individuals pay Social Security tax on only their first $102,000 in earnings. Second, higher-income households tend to receive more of their income from sources other than wages, such as capital gains and dividends, which are not subject to the payroll tax.”

http://www.taxpolicycenter.org/briefing-book/background/distribution/progressive-taxes.cfm

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The underlying logic of the regressive claim is simple. Take Social Security: A worker gets docked 6.2% on wages up to $102,000.  The rate drops to zero for any wages over $102,000.  So, somebody earning $50,000 has $3,100 deducted from their paycheck [6.2% times $50,000];  somebody earning $102,000 has $6,324 deducted —  a greater amount, but the same 6.2%;  somebody earning $200,000 has $6,324 deducted — the same as the worker earning $102,000, but representing a lower effective rate (3.2%).  The more that somebody earns over the $102,000 maximum, the lower the effective rate. By definition, that’s a regressive tax since the rate declines as income gets higher.  Case closed. Right?

Not so fast.

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The Urban Institute gets to the real core of the question:

The payroll tax is very regressive with respect to current income: The average tax rate falls as income rises …  (But) the regressivity of the payroll tax is mitigated to a substantial extent when Social Security and Medicare benefits are considered as well..

http://www.urban.org/publications/1001065.html

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In other words, the single payroll tax rate and the cap on taxable earnings combine to make payroll taxes appear regressive when analyzed solely based on current payroll deductions but, the benefits the taxes buy (retirement income and health insurance) are so progressive – i.e. highearners get muchlowerbenefitsperdollarthanlowearners — .that the net effect on tax payers is progressive – very progressive.

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A Congressional Joint Economic Committee states the case more directly:

The rapid growth in payroll taxes over the past 40 years has imposed a large burden on working Americans. This burden has fallen disproportionately on low-income workers. However, in the context of a comprehensive tax policy, it is misleading to focus on the short-term burden imposed by payroll taxes without accounting for the future benefits (since) the progressivity of the benefit formulae outweigh the disproportionate burden imposed by the taxes.

As a result, low-wage workers can expect to receive benefits that exceed the sum of their and their employers’ payroll tax contributions. Middle- and high-wage workers, on the other hand, can expect to pay substantially more into the system than they will receive in benefits.

Overall, middle- and high-wage workers subsidize the income and payroll tax liabilities of low-wage workers, leaving most low-wage workers with net negative tax liabilities throughout their lifetimes.

http://www.house.gov/jec/fiscal/tx-grwth/payroll/payroll.htm

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