How is and how should wealth be divided? 5,522 recently surveyed Americans were surprisingly consistent both in a false sense of how it is divided and their ideal for how it should be distributed. They said the top 20% has 60% and should have 30% to 40% of total wealth. The top 20% in fact has 85%. They said the bottom 40% has 8% to 10% and should have 25% to 30%. In fact, the bottom 40% has a tiny 0.3% of the total, so small it’s invisible in the chart below.
That survey sample is ten times the size of most polls and the answers were consistent across age, income level and party affiliation. 90.2% of Republicans, for example, said the ideal distribution of wealth should be as shown above. What this survey tells us is our tax system is not delivering results most Americans believe it does or results they want. I will explore what we should aim for in a future post. This one lays the groundwork of how our existing tax system works.
Our tax system is complicated and costly. The IRS alone employs about 100,000 workers and, much more important, estimates that taxpayers and businesses spend about 6.1 billion hours a year complying with filing requirements. If tax compliance were an industry, they note, those 6.1B hours would translate to 3 million workers. Those workers would in 2008 have been paid $163 billion. $163B is fully 11% of 2008 total income tax receipts. Tax compliance would, too, be a high growth industry. The tax code grew over the past 10 years from 1.4 million to 3.8 million words. Nobody knows all its details. And so far we’re talking only about Federal income tax.
So we should change our tax system, perhaps radically. To decide how it should work (I don’t yet have an opinion about that) we should first understand how it does operate now and what major changes have been made in the past. The composition of tax revenues and their percentage of GDP have changed greatly over the last century. Total federal, state and local tax revenues grew at what looks like an insane rate to around $4T.
But GDP also grew at a startlingly high rate. We can better understand tax revenue trends by viewing them as a percentage of GDP. Total government revenue grew from 7% of GDP at the start of the 20th century to 36% now, about where it was in 2000.
The balance of Federal, State and Local government revenues shifted substantially. At the start of the 20th century Local revenue was 4% of GDP, Federal 3% and State 1%. WW1 changed that dramatically. Federal revenue spiked to 8% and total revenue to 15% of GDP. Federal revenue dropped sharply back to around 5% through the ’20s. Increases in response to the Great Depression drove total revenue to 19% in 1933, of which 6% was Federal, 4% State and 9% Local. WW2 caused another huge spike in total revenue to 30% of GDP in 1945 dominated by Federal at 24%. Federal dropped to 16% of GDP by 1950, spiked back to 20% at the time of the Korean War and has stayed mostly in the high teens since then. State revenue hit 8% in the 1982 recession and has subsequently fluctuated between 8% and 10%. Local revenue hit 6% in 1982 and has since fluctuated between 6% and 8%.
The sources of tax revenue also changed. At the start of the 20th century it almost all came from ad valorem taxes. They’re based on ownership of an asset and include property taxes, sales, value-added and import taxes collected at the time of the transaction, and inheritance taxes. The Federal government originally got its revenue from import tariffs while State and Local governments levied property taxes. Income tax was established in 1913. It went to 5% of GDP in 1921 following WW1, settled around 2% through most of the ’20s and ’30s, spiked to 16% in 1944 and settled between 11% and 12% thereafter. Ad valorem taxes doubled from 5% or 6% at the start of the 20th century, peaked during the Great Depression at 14% then dropped to 10% by 1960 and 7% now. Fees and charges grew slowly to 1% until WW2 then faster to almost 3% now. Social insurance taxes established in 1937 to fund Social Security were less than 1% in the first year, grew to around 10% in the 1980s and are now around 6% of GDP.
State government revenue was primarily ad valorem until the ’70s although they began collecting income tax in the ’20s and social insurance in the ’30s. It is now about equal thirds income, ad valorem, and fees and business revenue. State income taxes rose sharply in the ’70s and ’80s then flattened. Revenue from fees and lotteries have been growing since the ’80s.
Local government is about half ad valorem taxes, half fees and business revenue.
How much tax do we pay in total? It is often said that half of all Americans pay no tax at all but even those with earnings so low they pay no income tax still must pay sales and other such taxes. The following chart shows what percentage of total tax revenue is paid by each income group. The lowest 20% (who average about $12,400 per year), paid 16.0% of their income to taxes in 2009, the next 20% (about $25,000/year), paid 20.5%, the middle 20% (about $33,400/year) paid 25.3% and the next 20% (about $66,000/year) paid 28.5% of their income in taxes.
The chart shows the top 20% in more detail. The lower half, i.e., the next 10% (about $100,000/year) pay 30.2% of income as taxes, the next 5% ($141,000/year) pay 31.2%, and the next 4% ($245,000/year) pay 31.6%. The top 1% ($1.3 million/year) pay 30.8% of their income to taxes.
So a progressively higher percentage of income is collected in total by all levels of government from the lower income four fifths of Americans. The rate of increase slows markedly at the top, however, and then falls. The very top 1% pays less than the 9% just below them and only a fraction more than those in the 80th to 90th percentile.
Another way to look at income earned vs tax paid is what percentage of all tax revenues is contributed by each income level. That may be more surprising. The top 20% gets 59.1% of all income and pays 64.3% of all taxes, the bottom 20% gets 3.5% of all income and pays 1.9% of all taxes. This means that while those with the highest incomes do pay a higher fraction as taxes, even those with the lowest incomes pay a substantial part of the total.
In addition to tax collected we must also consider tax that is intentionally not collected. Congress can fund what it legislates either with revenue that Treasury collects, or via tax incentives, revenue it exempts from collection. The individual and corporate income tax code now contains almost 200 tax preferences in the form of exclusions, exemptions, deductions from gross income or via a credit, preferential tax rates, and tax deferrals that together result in more than $1T of uncollected potential Federal income tax, more than a quarter of the $4T that is collected.
There have been exemptions, e.g., for religious establishments, ever since taxes began. As our tax code has grown more complicated so has the variety of exemptions. One reason legislators like them is they provoke less electoral objection. For example, it is US policy to subsidize home ownership and the subsidy is delivered as a tax deduction. Someone with a 25 percent tax rate who pays $10,000 in mortgage interest can deduct it from their gross income, cutting their tax payment by $2,500. The same subsidy could be delivered as a direct payment of $2,500, not a tax deduction. But because a deduction is money the government never gets it is rarely questioned even by those concerned about government spending, and it increasingly benefits those with high incomes and big mortgages.
Some tax preferences are narrow in scope. The Black Liquor Credit, for example, was established as an incentive for “green” biofuel. It also has the unintended effect of allowing paper mills to claim credit for a pulp by-product. It would not have survived if it was a cash payment. The big-ticket tax preferences, however, benefit large segments of the public and promote things most taxpayers like. The mortgage interest deduction as an example is among the largest items along with the employer exclusion for health care benefits which encourages employers to provide coverage for their workers, and the exclusion of retirement plan contributions which encourages saving for retirement.
The top 60% of estimated total tax expenditures for FY 2010 through FY 2014 according to the Joint Committee on Taxation are:
- $659B – Exclusion of employer contributions for health care, health insurance premiums, and long-term care insurance
- $597B – Exclusion for retirement plan contributions and earnings
- $484B – Mortgage interest deduction for owner-occupied housing
- $403B – Reduced rates of tax on dividends and long-term capital gains
- $337B – Exclusion for various Medicare benefits
- $269B – Earned income tax credit
- $237B – Deduction for non-business state and local taxes
- $194B – Exclusion of capital gains at death
- $187B – Deduction for charitable contributions
In future posts when we examine government spending, what tax revenues pay for, we must consider all the above.
In the next post or two we will explore what can be taxed and the effectiveness of each type of tax in our economy’s longer term future:
- Income, what people and corporations earn (e.g., income tax, social insurance programs)
- Wealth, what people own (e.g., annual real estate tax, inheritance tax)
- Consumption, what people buy (e.g., sales tax added to restaurant bill or embedded in gas price, value added tax paid at each step from raw materials through manufacturing and retail to end user)
- Usage of public goods (e.g., road and bridge tolls)
- Financial transactions (e.g., stock sales)
How will the results of potential tax strategies be impacted by changing demographics, availability of energy and other commodities, and advances in computer and communications technology? How might the future role and size of government change? Some opinions I’ve had about government policy still feel right, but many are not surviving closer study of the facts. That’s familiar in the consulting process. I will reach conclusions about what to do even though in this case I have no client and no deadline.