I saw a couple of things over the last couple of days about progressive taxation — one was a Malcolm Gladwell video on youtube about how a top tax rate of 91% is awesome and Manhattan Democrats are way smarter than Floridian Republicans; the other an article by Greg Mankiw in the New York Times about how he wants to write articles, but is disinclined too because if he does, Obama will steal from his kids.
Gladwell’s bit seems like almost pure theatre to me — the only bit of data is that during and after WW2 the US had a top marginal tax rate of just over 90% on incomes of $200,000 (well, except that WW2 and the debt the US accrued in fighting it isn’t actually mentioned). Gladwell equates that to a present day individual income of two million a year, which seems to be based on the official inflation rate; comparing it against median income at the time (PDF) gives a multiplier of 13.5 ($50,000/$3,700) for a top-tax bracket household income of $5.4 million ($2.7 million individual). I find it pretty hard to reason about making that much money, but I think it’s interesting to notice that the tax rate of households earning 5x the median income (ie $250,000 now, $18,500 then) is already pretty similar: 33% now, 35% then. Of course in 1951 the US was paying off debt, rather than accruing it… (I can’t find a similar table of income tax rates or median incomes for Australia; but our median household income is about $67,000 now and a household earning $250,000 a year would have a marginal rate between 40% and 45%, and seems to have been about 75% for a few years after WW2)
Meanwhile, Mankiw’s point comes down to some simple compound interest maths: getting paid $1000 now and investing it at 8% to give to your kids in 30 years would result in: (1) a $10,000 inheritance if it weren’t taxed, or (2) a $1,000 inheritance after income tax, dividend tax and estate tax — so effectively those taxes add up to a 90% tax rate anyway. If you’re weighing up whether to spend the money now or save it for your kids, you get two other options: (3) spend $523 on yourself, or (4) spend $1000 through your company. An inflation rate of just 2.2% (the RBA aims for between 3% and 4%) says (3) is better than (2), and if you want to know why evil corporations are so popular, comparing (3) and (4) might give it away…
An approach to avoiding that problem is switching to consumption taxes like the GST instead of income taxes — so you discourage people spending money rather than earning it. At first glance that doesn’t make a difference: there’s no point earning money if you can’t spend it. But it does make a huge difference to savings. For Mankiw’s example: 47.7% income tax ($1000 – $477 = $523) equates to 91.2% consumption tax (as compared to 10% GST); but your kids get $10,000 so can buy $5,230 worth of goods and still afford the additional $4,770 in taxes. As opposed to only getting $1,000 worth of goods without any consumption taxes.
The other side of the coin is what happens to government revenues. In Mankiw’s example, the government would receive $477 in the first year’s tax return, $1,173 over the next thirty years (about $40 per year), and $571 when the funds are inherited for a total of $2,221. That would work out pretty much the same if the government instead sold 30-year treasury bonds to match that income, and then paid off that debt once it collected the consumption tax. Since US Treasury’s are currently worth 3.75% at 30 years at the moment, that turns into $3,900 worth of debt after thirty years; which in turn leaves the government better off by $870. The improvement is due to the difference between the private return on saving (8%) versus the government’s cost of borrowing (3.75%).
Given the assumptions then, everyone wins: the parent, the kids, the government. It’s possible that would be the case in reality too; though it’s not certain. The main challenges are in the rates: if there’s a lot more saving going on (because it’s taxed less and thus more effective), then interest rates are liable to go down unless there’s a corresponding uptick in demand, which for interest rates means an uptick in economic activity. If Mankiw’s representative in being more inclined to work more in that scenario, that’s at least a plausible outcome. Similarly, if there’s a lot more government borrowing going on (because their revenue is becoming more deferred), then their rates might rise. In the scenario above, bond rates of 4.85% is the break even point in terms of a single 91.2% consumption tax matching a 47.7% tax rate on income and dividends and a 35% inheritance tax.
Not worrying about taxing income makes a bunch of things easier: there’s no more worries about earned income, versus interest income, versus superannuation income, versus dividend income, versus capital gains, versus fringe benefits, etc.
One thing it makes harder is having a progressive tax system — which is to say that people who are “worth” more are forced to contribute a higher share of their “worth” to government finances. With a progressive income tax, that means people who earn more pay more. With a progressive consumption tax, that would mean that people who spend more pay more — so someone buying discount soup might pay 10% GST (equivalent to 9.1% income tax), someone buying a wide screen tv might pay 50% (33% income tax) and someone buying a yacht might pay 150% (60% income tax). Because hey, if your biggest expenses are cans of soup, you probably can’t afford to contribute much to the government, but if you’re buying yachts…
One way to handle that would be to make higher GST rates kick in at higher prices — so you pay 10% for things costing up to $100, 50% for things costing up to $10000, and 150% for things costing more than that. The disadvantage there is the difference in your profit margin between selling something for $9,999 including 50% GST and $16,668 including 150% GST is $1.20, which is going to distort things. Why spend $60,000 on a nice car at 150% GST, if you can spend $9,999 on a basic car, $9,999 on electonics, $9,999 on other accessories, and $9,999 on labour to get them put together and end up with a nicer car, happier salesmen, and $20,000 in savings?
Another way to get a progressive income tax would be by doing tax refunds: everyone pays the highest rate when they buy stuff, but you then submit a return with your invoices, and get a refund. If you spend $20,000 on groceries over the year, at say 20% GST, then reducing your GST to 10% would be a refund of $1,667. If you spend $50,000 on groceries and a car, you might only get to reduce your GST to an average of 15%, for a refund of $2,090. If you spend $1,000,000 on groceries, a car, and a holiday home, you might be up to an average of 19.5% for a refund of just $4,170. Coming up with a formula that always gives you more dollars the more expenditure you report (so there’s no advantage to under reporting), but also applies a higher rate the more you spend (so it’s still progressive) isn’t terribly hard.
The downside is the paying upfront is harshest on the poorest: if you’re spending $2,000 a month on food it doesn’t help to know that $1,200 of that is 150% GST and you’ll get most of it back next year if you’re only earning $900 a month. But equally it wouldn’t be hard to have CentreLink offices just hand out $1,120 a month to anyone who asks (and provides their tax file number), and confidently expect to collect it back in GST pretty quickly. Having the “danger” be that you hand out $1,120 to someone who doesn’t end up spending $2,000 a month or more doesn’t seem terribly bad to me. And there’s no problem handing out $1,200 to someone making thousands a week, because you can just deduct it from whatever they were going to claim on their return anyway.
As I understand it, there’s not much problem with GST avoidance for three structural reasons: one is that at 10%, it’s just not that big a deal; another is that since it’s nationwide, avoiding it legally tends to involve other problems whether it be postage/shipping costs, delays, timezone differences, legal complexities or something else; and third is that because businesses get to claim tax credits for their purchases there’s paper trails at both ends meaning it’s hard to do any significant off-book work without getting caught. Increasing the rate substantially (from 10% to 150%) could end up encouraging imports — why buy a locally built yacht for $750,000 (150% GST) when you could buy it overseas for $360,000 (20% VAT say) and get it shipped here for $50,000? I don’t know if collecting GST at the border is a sufficiently solved problem to cope with that sort of incentive… On the other hand, having more people getting some degree of refund means it’s harder to avoid getting caught by the auditors if you’re not passing on the government’s tithe, so that’s possibly not too bad.