The Price of Taxing the Rich

The more I look at the economic situation of the United States, the more sympathy I have for economists and politician/bureaucrats—their task seems almost impossible.

The genius of the American economic experiment has been that our society has ever sought to increase the gross domestic product and to distribute the benefits evenly.

Most states are funded mainly by income taxes. Now, we are facing a situation where the incomes of some few families are going up rapidly, and this should be producing lots of tax money for the states. However, state/federal budgets are in deficit. Why has this happened?

Californians have studied this phenomenon most closely, where the distress over the economy is most acute. In California, before the recession, half of the state’s income came from the top 1% of its earners, i.e., those households with incomes above $490,000/year.

It has been found that the highest income groups experience the greatest income volatility when anything happens to the economy or to the progressive tax structure, which we have in almost all states and in the Federal income tax system, i.e., the higher the income, the higher the tax bracket.

Many people, mostly Democrats, have thought that to save failing state and national economies, it is necessary to tax the wealthy as heavily as possible in order to fund lots more government programs and to distribute wealth more evenly. This sounds very logical; but this approach has its difficulties.

The situation that now exists is one in which the top earners are paying very high taxes; and those taxes are driving the people with the least money in the high tax bracket out of the high bracket because their income has volatilized downward. The others in that high tax bracket, however, have figured out how to make lots of money due to the exit of their lower income competitors. This effect is producing an even greater spread in the income of Americans, with the very rich becoming even richer. Of course, the very rich are paying lots of income tax; and they are keeping the government tax income up. But…the problem is that as the income of the people who are losing net value and income declines, they are not investing in the economy. For that reason, the economy is lagging—despite the fact that the very rich are making a lot of money.

The logical imperative for government and economists, today, is to keep the base of upper income people very broad and the tax rate low. That goal is hard to reach; but raising taxes at a time like this is only exacerbating the problem. It is driving many rich people out of the investment mode and making the very rich even richer, though fewer in number.

This blog post was inspired by articles in the Wall Street Journal, 26 March 2011, pages C1 and C2.