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What is a Fair Tax?

by D. Eric Schansberg, Ph.D.

 Since the early days of his campaign, President Bush has proposed reducing marginal income tax rates for all who pay income taxes. If successful, it would be the first rate reduction since President Reagan and a bi-partisan Congress lowered the top marginal rate from 70% to 28% in 1981. As Congress continues to iron out another bi-partisan compromise, it appears that tax rates on income earned in the top bracket will be reduced from 39.6% to 33%. (The top rate creeped upward after two nearly-identical tax increases enacted under Presidents Bush I and Clinton.) Because the tax cut will disproportionately benefit relatively few people, it has been attacked with standard ‘class warfare’ rhetoric. But of course, relatively few people currently shoulder the brunt of the income tax burden. At present, the top 1% of income earners pay 35% of all income taxes and the top 10% pay 65%. Since middle-class and lower-income households pay little or no income taxes, it would be difficult to benefit them significantly through income tax reform. In addition, Bush and others have pointed to the stimulative effect of cutting income tax rates. In a word, it is these two arguments-- what economists call ‘efficiency’ and ‘equity’ considerations– which frame the political debate: will it help the economy overall and is it fair to individuals?

Efficiency: Lower marginal tax rates change a number of incentives, and thus, encourage people to behave in certain ways. In particular, if one is allowed to keep more of the fruits of one’s labor, there is a greater incentive to engage in productive behavior. For example, if one earns an additional $100,000, federal income taxes on that income would diminish from $39,600 to $33,000. To some extent, this would encourage high-income earners to work harder and would promote more entrepreneurial behavior. In addition, such workers would be less likely to choose non-wage forms of compensation (for example, non-taxable fringe benefits), to use relatively inefficient tax shelters, and to otherwise avoid or even evade income taxes. All of these, especially the tendency to work harder and innovate more, promote job creation, income growth, and a healthier economy. In a qualitative sense, these effects are beyond debate, but there is much debate and speculation over their quantitative impact. In any case, a cut in the marginal income tax rates can be expected to increase productive behavior and economic growth.

Equity: But is cutting the top marginal tax rate ‘fair’?. Of course, ‘fairness’ is in the eyes of the beholder. For example, what percentage of income taxes do you think the top 10% of income earners should pay: 10%, 50%, the current 65%, 100%, etc.? Of course, such opinions are subjective and largely arbitrary. By way of another example, one could argue that applying a marginal tax rate of 100% to all income over $100,000 would be ‘fair’, since rich people could live on that much and the government needs to take their money to use for other purposes.

Another view of equity asks why different individuals should pay different marginal tax rates. For example, a flat tax would apply one marginal tax rate to income earned over some level of exempted income and perhaps a few income deductions. Those with higher incomes would still pay higher average tax rates, but all people would face the same marginal tax rates. (For example, a 20% marginal tax rate on all income over $40,000 would result in a $2,000 tax bill and a 4% average tax rate for someone earning $50,000– while someone earning $90,000 would pay $10,000 and have an average tax rate of 11%.) Although Bush is not proposing a flat tax, he is proposing a flatter tax structure than the one we have currently.

Another equity consideration is that cutting marginal tax rates does not necessarily imply reducing tax revenues. Remember that lowering marginal tax rates encourages more productive behavior and less tax avoidance and evasion. This means that lower tax rates also increase taxable behavior. If the change in behavior is significant enough, revenues from the wealthy would actually increase. The three most recent changes in the tax structure reveal that this is of more than a theoretical interest. If this were to happen with this tax rate decrease as well, it brings an interesting catch-22 for most liberals– do they prefer higher marginal tax rates on the rich or higher revenues from the rich?

All that said, in my opinion, the marginal tax rate cut is good policy, but not ideal: it is spread out over too long of a time period and its effects are concentrated later rather than sooner. It is probably smart politics: it energizes his ‘political base’, fulfills a campaign promise, and may not have been possible later (especially if the Republican presence in Congress diminishes in 2002). But it misses a more pressing federal tax reform issue: the tremendous burden of payroll taxes, especially on those in the lower-income classes. The efficiency effects of such a tax cut would probably be greater and the equity arguments would certainly be more compelling. With this victory in hand, hopefully, Bush will soon turn his attention to taxes that affect the working poor, using his bully pulpit to encourage states to quit imposing income taxes on those at the poverty line (almost one-third of the states do this, with Kentucky as the worst in the nation) and working to reduce federal payroll taxes.

D. Eric Schansberg

Professor of Economics, Indiana University Southeast (New Albany, IN)

Adjunct Scholar, Acton Institute (Grand Rapids, MI)