Thursday, December 6, 2012

Tax Brackets As Far As The Eye Can See

As I mentioned in my pony tax reform proposal, one of the key successes of Reagan conservatism has been to collapse the tax preferences of the upper-middle class, rich, super rich, and mind bogglingly rich, even as fractal inequality has led to a wider gap in living standings among these income tiers. Giving the same tax treatment to these varied levels of affluence has not always been customery.

Consider this: if Obama's tax plans were to become law, all married households earning $250,000/year or more would face the same top marginal tax rate of 39.6%. $250,000 in today's dollars is about $35,000 in 1960. According to the Tax Foundation's history of tax rates, in 1960 there were seventeen tax brackets above the $35,000 level, going all the way up to a 91% tax on income above $400,000 (about $3 million after adjusting for inflation). Even if we go back to the mid-Reagan years, there were four tax brackets on income levels above $125,000 which is $250,000 in today's dollars. Income above $360,000, about $720,000 in today's dollars, faced a 50% top marginal rate.

Ronald Reagan sought to shrink the number of brackets in the name of "tax simplification". But this is less relevant in an era of widespread computing resources and cheap tax software that's capable of helping most filers with their basic needs. Even if you don't use Turbo Tax or other filing assistance software, the number of brackets doesn't make computing tax liability hard. For the 85% of households below $100,000, the IRS publishes tax tables (PDF) so that you can compute your tax liability without even using a calculator. Above that level of income there's a three-step calculation, though most people who earn that much money with either pay for tax filing software or hire a tax accountant.

If we were to replace tax brackets with a smooth tax function, we can produce
progressive taxation that reflects the current record levels of inequality
at the top-end of the income spectrum. This example isn't perfect -- effective
income tax rates for anyone earning less than $30,000/year are zero instead of
today's 6.8% -- but it's a step in the right direction.
We could even make one's overall income tax rate a smooth function of income. A friend of mine in the finance industry suggested letting tax rates grow logarithmically. Subtract out the first $20,000 of income. Then, as your income increases as a multiple of 10, your tax rate increases by 21% on any income in excess of $20,000. So, someone earning $120,000 would owe $21,000 in taxes (21% of $100K); someone earning $1,020,000 would owe $420,000, (42% of $1 million) and so on. Taxes on the working poor and middle class would go down or stay flat; taxes on the upper-middle class would go up slightly; and taxes on the various levels of "f***ing loaded" would rise subtantially. Taxes on the top 5% of households ($300,000 in income) would rise from 24.1% to 30.4$; on the top 1%, they would rise from 28.9% to 46.2%, not far from my proposed millionaire's bracket of 45%. The top 400 tax filers -- who earn on average $20 million per year in wages--would face an income tax rate of 70.3%, versus an effective tax rate today of 20% (though their tax rate on earned income is probably closer to 35%). This particular tax function isn't perfect, since there's a big difference between collecting a little bit of revenue from the bottom 40% of households and collecting none at all, but the concept is sound. We just need to come up with a slightly better function.

The thing that actually makes tax filing complex is the various attempts we've made to institute social policy through the tax code. There are deductions and credits for rearing children, for student loan interest, for college tuition itself, for mortgage interest, for certain business & health care expenses, for teachers who purchase school supplies, for buying a hybrid car, and so on. Each deduction or credit has a different level (or levels!) at which the subsidy is reduced or eliminated. The more we can rely on direct government expenditure rather than tax credits to support whatever activity the government is trying to promote, the less time and money Americans will waste in April.
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