Bear with me here. I need to talk about something really exciting. Hold on to your seats as we dive into the exciting world of… marginal tax rates!
Okay, now that I’ve gotten that out of my system, I regret to inform any reader that this really is going to be about taxes. More specifically, this is about what appears to be a common misunderstanding about taxes in America.
But before I really dive in, let me give some background.
It starts with an interview.
Newly elected United States Representative (and all-around badass) Alexandria Ocasio-Cortez was interviewed on 60 Minutes last weekend. The interview was pretty wide-ranging, but there was one point in particular that seemed to get a lot of attention.
Representative Ocasio-Cortez explained that programs she championed could be funded by an increase in the top marginal income tax rate. This is not a new idea, of course. Just a few years ago, President Obama pushed a modest increase in the top marginal rate to 39% from the Bush era (which has been subsequently dropped to to 37% under Trump).
But what Ocasio-Cortez proposed was far more dramatic. Instead of a restoration of the Obama-era rate, or even a moderate increase over that number, she suggested 70%.
This notion was immediately attacked. Naturally.
Seventy percent? How dare you demand hardworking Americans pay a majority of their income in taxes! That’s just leftist fantasy, according to Louisiana Congressman (and white supremacist party-goer) Steve Scalise.
Others have made similar comments. Many – mostly on the right – are aghast at such a lofty number. Does this silly girl (yeah, many have gone there) not know anything?
Well, yeah, seems like she does.
There appears to be two misconceptions that I’ve seen regarding income tax rates in America.
Let me preface this with the aside that I’ve heard these particular misunderstandings for years, well before a certain freshman Congresswoman decided to actually speak up about what really isn’t a radical idea.
The first misunderstanding is that this is a weird, radical, extreme left wing notion.
Well, no. The top marginal rate on the highest incomes was raised to over 90% during World War II, and that leftist crazy Dwight Eisenhower saw fit to keep the rate at that level throughout his presidency.
In the early 60s, John Kennedy managed to get the top rate lowered – all the way down to 70%. It was reduced to around 50% under Jimmy Carter, and then under Reagan, the rate dropped all the way into the high 20s.
Since then, it’s gone up and down, but never north of 40%. Meanwhile, government revenues have declined, and the gap between the wealthy and the poor has grown at an enormous rate.
And for the most part, the economy boomed during the era of seventy-to-ninety percent. Inequality was lower than now, and the middle class grew. Tax rates on the super-wealthy were not holding America back.
Several legitimately brilliant economists have come to the conclusion that the optimal top rate is much higher than what we currently have. Peter Diamond and Emmanuel Saez calculated that a 73% rate would bring in the highest possible revenue without reaching the point where the wealthy become disincentivized from trying to earn more. Saez also collaborated with Thomas Piketty and Stefanie Stantcheva, and came up with a potential top optimal range between 71 and 83 percent, depending on certain scenarios. Benjamin Lockwood went with a range of 70 to 90 percent.
The Laffer Curve isn’t entirely wrong. There likely is a point where the top rate becomes so high that it ends up resulting in decreased revenue. But that rate is far higher than what Arthur Laffer claimed, and his conclusion (cut rates on the rich!) has been proven dead wrong by… well, reality.
There’s more than enough theoretical and historical evidence to show that a serious bump in the top tax rate will be good for the majority of taxpayers, and the economy as a whole.
This isn’t a crazy concept.
The second misconception is one that both the aforementioned Scalise and Norquist appear to have made – and one that I’ve seen for ages, often from people like Scalise who should know better.
The top marginal rate is not the same as the effective rate. A rich person paying a 70% tax rate would not be paying that much overall, because with a progressive income tax, people only pay the specific rate for the amount of money they earn in each income bracket.
I love spreadsheets. Yeah, I’m weird. But I think many would agree that this may be best explained visually. I would imagine my last paragraph made any reader’s eyes glaze over. So check this out:
Under the current American tax scheme, at the federal income tax level, there are seven income brackets, each with a different percentage rate. It looks more or less like this:
Imagine a guy who makes good money, but isn’t necessarily stinking rich. We’ll say he brings in $250,000 in pre-tax income in a year. We’ll call him Rich. You know, because he’s kind of… ah, forget it.
Anyway, Rich is taxed at 10 percent for the first $9,525 of his income, 12% for the next $21,974, and so on. So his taxes for the year can be broken down thusly:
Rich’s final bracket is the 35 percent bracket – but he’s not actually paying 35 percent on all his income. His final percentage, when all is calculated, comes to 25.28%. It’s not all that complicated. It took me 5 minutes with Excel to put this together. The number of tax brackets and the individual rates have never been the reason for the complexity of the US tax code. Any time a political figure announces a tax plan with fewer brackets as a way to simplify the code is completely missing the real problem. Doing that is like clipping your toenails as a way to lose weight. It will technically do something, but it won’t be significant.
Anyway, a bracket with a higher top rate will also not lead Rich to necessarily pay an enormous amount more. At least, not in a way that’s going to ruin his life.
Proposed progressive changes to the income tax have often added more brackets, and increased the rates on the higher levels. Often, the brackets at the bottom manage to see a decrease, too. A 70 percent top rate could actually mean a middle and lower class tax cut, depending on how it’s done.
I’m not a tax policy expert. I can barely budget my own expenses. I couldn’t tell anyone what the optimal rates within a new, more progressive bracket should be. But in a hypothetical world where we elect a progressive president and a Democratic Senate in 2020, Ocasio-Cortez becomes Speaker of the House by 2026 (when she’s gearing up for her 2028 presidential run), we could see real change to taxes in America. In a potential compromise situation, where we add a few brackets and lower the rate on the first five, someone like Rich might even enjoy a slight tax cut. For example:
In this scenario, we have a top marginal rate of 65 percent. And Rich’s top bracket has seen an increase from 35 to 38 percent. But Rich is actually saving a little money. The lower rates bring his total rate from 25 down to around 23%:
Good for Rich.
But in this same scenario, we’re going to introduce Rich’s boss, Gilded. Call him Gil for short. Now, Gil owns the company. He’s bringing in 12.5 million bucks a year. He’s doing very well for himself. Under our current tax system, his effective rate isn’t much different from the top marginal rate, because most of his income is in the top bracket (over $500,001). He’s paying 36.7% of his income in federal taxes. Well, he probably isn’t, but that’s another issue entirely.
Right now, Gil is officially forking over around four and a half million dollars to the Feds, out of his original twelve and a half. Under the hypothetical progressive changes I presented above, he’s suddenly set to pay quite a bit more.
That big top bracket doesn’t start until the 10 millionth dollar earned. As Alexandria Ocasio-Cortez described it, the tippy-top. So, for a guy making 12.5 million, the bracket doesn’t do that much. But we’ve filled in the gap some below that, so Gil is definitely paying his share. His top marginal rate is 65 percent, and he ends up with an effective overall rate of 52 percent. That’s another two million bucks that go to the government, and will ideally be redistributed to those who could use it.
And Gil still has 6 million bucks in his pocket after federal income taxes. Even after state, local, and payroll taxes, Gil is still probably 5 million richer at the end of the year than he was at the start. Don’t feel bad for Gil. And his employee Rich ended up saving four grand!
As for the super-wealthy – the kind that see hundreds of millions of dollars a year (or more), they aren’t going to suddenly become poor. Actually, most of the super rich aren’t earning their money from W-2s. Federal income tax will matter less than corporate taxes and capital gains taxes – which is another topic worth discussing.
But in the meantime, for anyone who managed to stay awake through all of this, I hope it helped explain how graduated income taxes work. A seventy percent tax doesn’t actually mean someone is paying that much in overall taxes. And for those who end up paying close to that, their wealth renders the impact pretty much moot.
Don’t believe the outrage. Don’t believe the exaggerations. A higher top marginal rate isn’t a radical idea. And it’s not going to hurt the economy.