Taxation yet again

2011 October 12
by Daniel Lakeland

One of the things that the Occupy Wall Street protests highlights for me is the problem we have with tax codes. I've written on povery traps and tax codes in the past (here and here).

"Progressive" liberal politics asks for a tax code that is "progressive" in other words that taxes people with more income to a greater degree. From previous analysis of a simplified optimal taxation idea this type of policy does, to an extent, fall out of a utility optimization type calculation (though the toy calculation only took into account people's response to taxation in terms of trying to maximize the marginal rate of take home earnings).

One problem with a progressive tax code is that it penalized people who accept fluctuations in their income and people who invest in future income by increasing their education and soforth. Consider a person A who makes $50k / yr every year, and another one B who makes $25k in 3 out of 4 years, and $125k in the fourth year, and therefore averages $50k.

Person A according to 2010 tax tables pays $8688 in tax, and person B pays $3335 for 3 years and $28710 in the 4th year for an average of $9678, about 11% more taxes. Person B typifies a small business owner or a freelance writer or something along those lines, in other words, an entrepreneur who should in theory be encouraged, not penalized! I haven't even taken into account the time value of money which puts person B even farther behind.

Similar effects occur for person C who goes to graduate school in Biology, and works as a Postdoc, and eventually the investment pays off in terms of a job paying say $150k/yr. Compare this person between age say 20 and age 40 to a person D who gets an undergraduate degree in biology and becomes a technician at a biotech and makes say $65k/yr (here we're going to have to use "constant dollars" in other words inflation adjusted, because we're talking about a 20 year time span). Person C makes say $15k / yr for years 20 to 30, and $150k/yr for years 30 to 40. Person D makes $65k/yr for 20 years. Let's use 5% real discount rate, and compare present value of after tax earnings:

Person C: $827k present value (before taxes)

Person D: $810k present value (before taxes)

In theory, Person C, with more education, is slightly better off by age 40 thanks to the investment in education. However, suppose we include the effect of taxes:

Person C pays $3331 for the first 10 years, but $35709 in the next 10 years.

Person D pays $12431 each year.

Person C present value (after tax): $632k

Person D present value (after tax): $655k

Suddenly we're stifling innovation by making a good idea (investment in education and ability to do high paying jobs) into an after-tax disadvantaged strategy. In other words, we're encouraging people financially to stay in middle income jobs.

3 Responses leave one →
  1. Manoel Galdino permalink
    October 13, 2011

    Or you could think the other way around. Imagine there is no progressive tax. Once you are rich, you're less penalized. And this will make richs richer, because they have more money to invest and use scale gains. This will increase inequality and, arguably, the power of rich people to influency politics to favor them.

    There is no free lunch. Or you put your side to favor political equality (democracy in the limit), or to favor investments and growth (capitalism). It's pretty hard to have both.

    • Daniel Lakeland
      October 13, 2011

      Manoel, thanks for your comment. In this post I was simply pointing out one important problem with progressive taxation as we have it now. Given this problem in many ways we are hurting people who are not rich but very much middle class, giving financial incentives to keep them there, something an elite rich group might actually prefer!

      There are definitely problems with eliminating progressiveness entirely, but stay tuned for another post with perhaps a more nuanced approach to dealing with these problems.

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