A Deficit Too Big to Live With

May 22, 2011 at 3:07 pm | Posted in Banking, Economy, Politics, Taxes | 1 Comment

A few weeks ago at Rotary we were talking politics. (Our discussions sometimes get heated, but never discourteous: they’re a good model for the rest of the nation to emulate.) Somebody asked me how much money the top 2% make—the ones liberals want to tax more. So I did a little research, which turned into a whole lot of research. Most of the statistics I found were less than objective, less than adequate, and difficult to understand: I’m no statistician. Eventually I found some numbers I could both trust and figure out, and the following article is the result.

Most people agree: the deficit is too big. We have to do something about it, and the politicians are making loud noises about how to fix it. They have politicized the discussion beyond all belief, which guarantees that any “solution” they come up with will be a disaster.

The sad fact is that solving the deficit problem is going to require sacrifices from all of us: we’re all in the same boat; it’s sinking, and we must all help to bail.

Sensible, precisely directed spending cuts will help reduce the deficit, but they won’t eliminate it, nor will they achieve objectives like repairing crumbling infrastructure, reducing dependence on fossil fuels, or adding the huge numbers of jobs we need to get the economy back on its feet. Draconian cuts to needed programs won’t help either: in the long run they’ll destroy our economy and our people.

Well if you can’t solve the problem by cutting government spending, how can you solve it?

By increasing government revenue.

One approach we ought to take is to eliminate tax loopholes. The tax code could be vastly simplified to ensure that every individual, household, and corporate entity pays a fair share. Some deductions ought to remain, because they encourage behavior we want to encourage. Charitable giving is an example. Others, like the mortgage interest deduction might be phased out over the next several decades, but slowly, because the mortgage interest deduction is a huge factor in many families’ financial security.

Another approach is to increase the tax rates. Doing so would have an immediate effect, yet could be designed make the comfortable and wealthy contribute more, while minimizing the sacrifices made by those who can least afford to sacrifice. Some of you will recoil in horror: “Redistribution of wealth!” you will scream. Perhaps, but we need to increase revenue to reduce the deficit, and some of us can well afford to provide more revenue, while others cannot.

Who? Let’s take a look at how wealth and income are distributed and at how we are taxed.

Economists define wealth as being equivalent to net worth. A person’s wealth is the sum of the values of his or her marketable assets (like real estate, stocks, and bonds) less the value of his or her debts (like mortgages, and credit cards).

2007 is the latest year for which good numbers are available. In a paper titled Wealth, Income, and Power, Professor G. William Domhoff of the USC Santa Cruz Sociology department says that in 2007 the top 1% owned 34.6% of all privately held wealth, and the next 19% owned 50.5%. Remember the 80-20 rule? Well the wealthiest 20% owned 85% of the wealth, leaving only 15% for the bottom 80%! (The amount of wealth held by the top 20% is shown by the red and green areas of the chart combined.)

If that comes as a shock, don’t feel lonesome: a 2010 study showed that most Americans, regardless of income level, gender, or political affiliation, have no idea what the distribution of wealth is. If you’re ready for another shock economist Edward Wolff estimates that since 2007 there has been a 36.1% drop in the wealth of the median (middle of the middle class) household, while the wealth of the top 1% dropped only 11.1%

Wealth and income are two different things: income is money earned from work (wages and salaries) and from wealth (dividends, interest, rents, and royalties).

Looking at income gets us to the question I was asked at Rotary: “How much money does the top 2% make?” The answer is…I dunno. But I do know this: in 2009 the top 5% averaged $295,388 in income. In 2007 it was $287,191.

In the table below, the top 5% is included in the top 20%. That is, in 1983, the 20% with the highest incomes earned 45.1 percent of the aggregate income and the rest of us earned 54.9%. (Also note that we’ve added a year not included in the wealth chart.)

Income distribution is important because income taxes are the biggest source of government revenue. Our Federal Income Tax system (like most) is progressive, meaning that the richer you are the higher your tax rate. The theory is that the richer you are, the more of your income you can afford to pay in taxes. The chart below shows how much people paid in taxes (Federal, state, and local) as a percent of their income. Our system, when you count all taxes, is mildly progressive—until you get to the top 10%, where it flattens out. Then it becomes regressive: the top 1% (who held about a third of the wealth) paid a smaller percentage of their income.

They paid less because, as you can see from the blue areas on the chart, state and local taxes are regressive, meaning that the poorer you are the more of your income goes to these taxes. The problem is that the less income you have the more of it you need.

The chart below is another way to look at how income—and tax liability—are distributed. The lowest 20% earned about 3.5% of the aggregate income in 2010, and paid about 2% of the taxes. The fourth 20% earned 19% of the income and paid 19% of the taxes. Only the top 20% paid a larger share of taxes than their share of income, with the top 1% earning 20.3% of the aggregate, and paying 21.5% of the taxes.

I’ve been told, by my conservative friends, that 47% of the population doesn’t pay any taxes. Well that’s a great number to feel outraged about, but it’s not quite true. According to Congress.org, the number came from a study done by the nonpartisan Tax Policy Center. The study does estimate that 47% of U.S. Households did not pay any Federal Income Tax in 2009. 85% of them, however, paid payroll and Medicare taxes, and of the 6% who did not, most are elderly or very poor. Fair enough: they can’t afford to both pay taxes and eat, so let them eat. Over the years, the Congress has consistently ensured that the poorest Americans don’t have to pay taxes.

In a “normal” situation, that is when we don’t have huge deficits, the effects of our tax policy are reasonably fair, except for the regressive State and local taxes. I think the tax code ought to be simplified drastically, and many loopholes, subsidies, and entitlements eliminated. But the simplification needs to be done carefully, so that our tax system continues to encourage socially useful behavior and doesn’t impose an unfair burden on those who are already suffering. And we should change the tax rates appropriately. What is appropriate? Let’s look at some history.

The first Federal income tax was imposed during the Civil War, but was repealed afterwards. The current system was enacted in 1913, and the chart that follows shows how the top tax rate has changed over the years.

The table will make more sense if we add some historical events:

Between 1914 and 1918 the top tax rate shot up to nearly 80% to pay for World War I. After the war the rate came down, but in 1929 the stock market crashed, ushering in the Great Depression. The top tax rate started going up again to pay for President Hoover’s attempts to improve the economy, and then for President FDR’s New Deal. Then, between 1941 and 1945, the top rate soared to over 90% to pay for World War II.

It stayed up there until 1968, paying off the war debt, and paying for the Marshall Plan and other forms of foreign aid. But (believe it or not) dropped during the Viet Nam War! It has continued to decline since then even though we spent huge amounts of money fighting the Persian Gulf War, beefing up internal security after the 9/11 attacks, and fighting wars in Afghanistan and Iraq.

There’s a pattern here: raise taxes to pay for wars and economic disasters. That technique worked for 60 years after the income tax started. Then we got the idea that we could pay these extraordinarily large expenses without extra revenue and our top tax rate is lower than it has been since 1928! We also have a deficit so big it’s incomprehensible, and an economy that totters along like a drunk navigating between curb and gutter.

We’re not going to get out of this situation by cutting spending, even if we use a dull axe and turn the whole middle class into a lower class. That strategy would turn us into a Third World country and probably a wholly-owned subsidiary of the People’s Republic of China.

We need to raise taxes. How much? I don’t know, but it’s clear that our government needs a lot more revenue to do what it needs to do. The lower income people among us are teetering on the edge of total financial disaster, and much of the middle class is close to disaster as well. We need to continue the programs that are keeping those people going, and we need to require that those who can afford to pay do so. We must make our Federal Income Tax system fiercely progressive and a whole lot simpler.

The boat is going down, and we’re all going to sink together, so pay up or start swimming.

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