Putting Fairness Back into America’s Tax System

Democrats in Congress have convened a series of hearings on tax policy that could lead to long-overdue changes. With this forum and the energy generated by the 2008 presidential campaigns, they have the opportunity to reverse the Bush administration’s tax cuts for the rich, rejecting the notion of making them permanent, as well as to limit the Alternative Minimum Tax to its original intended goal of taxing those in the highest income brackets.

In pursuing these goals, Democrats can reassert the consensus ideas of tax justice and progressivity that had been the traditional mainstays of federal tax policy. The urgency to recapture taxation issues from the Republicans increases daily. Despite the always-popular talk in Washington about lowering taxes, given our spiraling expenditures for defense, homeland security and social service entitlements, one thing is certain: taxes will be raised.

Democrats and progressives must reclaim progressivity as a basis for resolving tax issues and ensuring tax fairness. In recent decades, progressive taxation based on ability to pay has been subordinated to market ideologies and concepts of economic efficiency. The nation has shifted from a concept of tax fairness and equity as the moral and ethical underpinnings of tax policy to a myopic emphasis on taxation’s economic effects. Ensuring tax equity, however, requires qualitative political judgments. The goals of the general welfare—a stable society, democratic principles and the common good—have lost out, when tax policy has been debated, to self-serving commercial and libertarian interests. Conservatives and antitax forces have transformed the Great Society into the Economists’ Society.

During the solid economy of the Eisenhower administration in the 1950s, the top marginal tax rate—levied on those in the highest income brackets—never fell below 90 percent. Now these top marginal rates are at the lowest of the post-World War II period. Since the early 1960s, top corporate rates have fallen, from 52 to 35 percent. The percentage of federal revenue from corporations has decreased, from 21 percent in 1964 to 7.4 percent in 2004. The federal tax on property—another form of capital—has fallen since the 1960s, despite explosive growth in earnings and capital gains.

Thus, corporate income and property taxes, longstanding factors in achieving tax justice, have been reduced to a minor role in providing revenues. Necessarily, with these reductions at the top, taxes on labor income have increased. Lower- and middle-income groups have encountered higher taxes because of rising payroll taxes—now composing a staggering 5 percent of the Gross Domestic Product (GDP).

The Bush administration’s top domestic priority for the last six years has been tax reductions for high-income citizens and business interests, despite a budget drain soon to exceed $700 billion for a war of choice. The administration has never been made to explain or document by analysis how it would pay for its extensive tax cuts while escalating its federal expenditures and war costs. Nor has it stated what the long-term effects would be of making the tax cuts permanent. Make no mistake, all aspects of tax equity are now under siege. President Bush’s tax cuts are the culmination of the decline of progressivity. Concepts of progressivity and class inequality are deemed to be “class warfare”—politically incorrect for inclusion in economic or political deliberations.

Republicans have built their successes on pledges of tax cuts. Their rhetoric has cleverly decoupled taxation from expenditures. Over the last quarter-century, they have readily supported the antitax movement and its “no new taxes” petitions. They have persuaded Americans that they can have it both ways—wars, homeland security and expanded entitlements and domestic programs—and not have to pay for them. Additionally, many conservatives view reduced taxes as a means of forcing reductions in longstanding social programs by “starving the beast” of big government.
Democrats have retreated, lost their nerve and their economic message, and settled for tinkering around the edges of fiscal issues with small fixes. All of Washington knows that hard decisions on public finance loom imminently. Taxes will be raised. The question is—on whom?

THE ALTERNATIVE MINIMUM TAX TRAP—Having just filed their tax returns, many middle-income Americans were no doubt shocked to learn that they were subject to the Alternative Minimum Tax (AMT). The Minimum Tax, enacted in 1969, was originally designed to target wealthy taxpayers who had escaped paying any federal taxes—taxes that most Americans were paying for the war in Vietnam. The stated “fairness” intention of the original Minimum Tax has gradually collapsed under its successor, enacted in 1986, the Alternative Minimum Tax. In recent years, the wealthy have been minimally affected because their non-AMT income-tax rates are higher than the rates that would apply under the AMT. However, since the AMT disallows many common deductions that middle-income tax payers had come to rely on, it disproportionately entraps them.

The Bush administration tax cuts pushed many more taxpayers into the AMT-payment trap, more than doubling their numbers. Without fundamental changes in federal tax laws, the AMT distortions and unintended unfairness will only worsen. AMT liability is on track this year to ensnare 23.4 million—one in four of all U.S. taxpayers. It is projected that these 23.4 million taxpayers will owe an extra $6,800, on average. According to a recent Congressional report, households with incomes as low as $50,000 to $70,000 could be hit with the AMT for their 2007 taxes.

Meanwhile, the estate tax—on the books since 1916 and paid only by the wealthiest 2 percent of Americans, i.e., those with estates in excess of $2 million—was repealed in 2001 with broad bipartisan support. The gradual repeal is now under way and will take full effect in 2010. By 2016, over $369 billion in revenues will have been lost if repeal is made permanent. The damage of this repeal to the longstanding American consensus on progressive taxation would be immeasurable. Most remarkably, it has resulted from the campaign of a small band of conservatives funded by a few very rich individuals.

PAYROLL TAX OR PAYROLL SCAM?—The 1983 tax increase, intended to strengthen Social Security, was a hike in the existing payroll tax; it was not an income tax in that it was not varied according to income level. It was, and is, a flat-rate tax on wages with no zero bracket or accommodation for total income, family size or deductions, exemptions or credits. The wage earner still has to pay an income tax on wages that include the amount of the payroll tax withheld from his pay—even though it is never received in his paycheck.

The payroll tax, now levied at a rate of 15.3 percent, is regressive in that poor and middle-class taxpayers have a relatively greater burden in paying it than the wealthy do. In fact, for most American taxpayers—some 75 percent—the payroll tax, not the income tax, is the largest tax they pay. Its extraction, use and effect are hidden behind the “contribution” label.

All the money generated by the tax increase of the 1983 Social Security Amendments law—an increase intended to improve the solvency of the trust fund and build up a surplus in preparation for some staggering new obligations—is being used for current federal expenditures, thereby disguising the true amounts of our deficits and bankrupting Social Security. Despite the large and expanding surplus of IOUs in the trust fund, now totaling $2 trillion, payroll taxes have never been reduced since their creation in the 1930s. So much for all the talk of across-the-board tax cuts—especially those intended to stimulate the economy!

REASSERTING PROGRESSIVITY—While the decline of progressive taxation in public finance has many causes—Republican control, the dominance of market economics, and antitax movements—a primary reason has been the failure of persuasion and the scarcity of well-articulated arguments for progressivity. Another reason has been limited vision and aversion to risk-taking by Democrats and progressives. While incremental changes and expanded credits may alleviate some unfairness, such tinkering with the tax code, characteristic of the last several decades, will not offset recent regressive trends. To reverse these trends, their underlying assumptions, e.g., that “government is the problem,” must be challenged with effective arguments drawn from basic progressive philosophy.

Republicans own the issue of taxation, and it is theirs to exploit. Democrats and progressives have let that happen. Feeble complaints and generalities about “tax cuts for the rich” are inadequate to counter sophisticated “no new taxes” campaigns and antitax propaganda. The argument for a shift to a more graduated, and hence more fair, income tax—the argument that animated our politics in the past—is compelling. Its reasoning can be set forth as follows:

1. Those who gain the most in income and wealth from American society and its economic infrastructure not only have the greatest ability to pay, they also derive far and away the greatest benefits. The nation’s tax burden provides for more than the usual and obvious benefits that all Americans enjoy—national defense, police protection, roads and highways. It also sustains an elaborate, orderly, stable and subsidized U.S. economy. America has made all this possible. Wall Street works because property interests are protected and regulated; corporate profits in 2006 were at record highs. The wealthiest 10 percent of U.S. families hold 63 percent of all family assets. Within a framework of tax justice, founded in republican and liberal ideals, it follows that those who benefit the most should pay the most.

2. Government works. Only government can perform certain functions, enforce personal and property security and ensure a fair and stable economic environment. The U.S. Interstate Highway system (the greatest public works project in history), the G.I. Bill, the Internet, half the nation’s annual medical coverage, and the most powerful military ever—all have resulted from public programs.

3. Even the most ardent critics of progressivity and the most ardent advocates of flat- and/or consumption taxes concede that some amount of wages need to be exempt from taxation. To adjust for harsh market outcomes, the goal is to shelter the poor from taxation as much as is practical. While federal income tax policy has not opted for a zero rate on all incomes below the poverty level—subsistence wages—it has recognized progressivity with its Earned Income Credit (EIC). However, increases in the EIC in 1990 and 1993 merely offset rising payroll taxes and drastic cuts in welfare programs. The EIC’s subsidy rates need to be increased and eligibility broadened.

4. The general welfare argument is basic: that which makes everyone better off is preferred. It is grounded in a social contract and democratic processes reflecting the community’s judgment of what constitutes fairness and how to maximize the stability and aggregate welfare of the society as a whole. Advanced Western societies have honored the traditions of equal worth of all citizens and the Golden Rule. Tax policies need to sustain these norms.

5. It is easier to collect taxes from those who have the most. It is the most effective and reliably productive way to raise revenues—to go where the money is. When the nation at the state and federal levels needs yearly revenues of nearly $4 trillion—over 35 percent of GDP—some form of progressivity becomes a revenue necessity. It is simply not possible to satisfy our current revenue requirements by taxing the poor and the middle class at ever higher rates.

6. Overwhelmingly, today’s state and local revenue systems are regressive. To finance these governments, tax systems extract more, proportionately, from their poorer citizens than from their wealthier ones. Progressivity at the federal level, then, is a means of compensating for the regressivity in the nation’s overall tax system.

7. In a mature economy like ours, with poor rates of saving and slow or faltering growth, the government can stimulate spending by adjusting tax rates and increasing public expenditures. Progressive taxation during these periods boosts consumption and stimulates economic activity.

8. The marginal utility of income tends to fall as income rises. An extra dollar is worth more to a low-wage worker than to a high-wage one, since the former has fewer dollars to spend. Since corporations and those with higher incomes receive a relatively higher value from public goods and services than do other taxpayers, equitable treatment would require that the highest earners pay more for them. Thus, a utilitarian outcome is achieved and the society’s aggregate welfare is maximized.

9. America has spawned a recent proliferation of millionaires and billionaires, while middle-class incomes have stagnated. The wealth of upper-income Americans has been zooming along, creating two Americas. Inherited wealth, or excessive concentrations of wealth, leads to an elitist and aristocratic society, and a less free and virtuous democracy. The U.S. has become the most unequal of rich nations.

IT’S ABOUT JUSTICE—The concept of progressive taxation does not easily fit the way economists think. They prefer mathematical models and scientific demonstrations and are less at home with qualitative judgments. It is hard to quantify the benefits of progressivity—to set marginal rates and verify the outcomes. Critics claim that progressive taxation destroys incentive, thereby threatening capital structures and the nation’s standard of living. But they are hard-pressed to present verifiable evidence that economic incentive is dampened by higher marginal rates on upper incomes. In the 1950s and again in the 1990s, income taxes increased and the economy grew robustly.

Increased progressivity addresses the inequity of the low taxes on corporations and investments and the high taxes on wages. A fairer and simpler tax code with far fewer tax breaks would help restore much-needed trust in our tax system. Tax policy decisions are ultimately political rather than economic ones. They are properly made by elected officials to accommodate the society. Tax justice is critical to political equality and to guaranteeing Americans the means of equitable participation in their society.

We have witnessed the Republicans’ wide-ranging dismantling of America’s system of progressive taxation. The Democrats need a basic strategy to counter this agenda. Do they have one? Do they have the will and the stamina necessary to carry out such a plan?