IRS 1040 with cash

The problem with progressive tax rates – those which scale with income – is not that they don’t work, but that they are poorly understood. This is a complex subject, but a few simple points can be made which might serve to start a fresh conversation on them.

First off, discussion of higher taxes on the rich comes across to many Americans as penalizing success, which seems unfair. I can understand the sentiment, but I think it is misplaced, and the reason is that low tax rates on the rich have been shown, again and again, to lower incentives for hard work, for investment, and for growth! If you want to reward success, you need first to encourage success, not actively discourage it. The current system is creating a virtual feudal aristocracy, and is just bad capitalism.

What happens when you raise taxes on the wealthy, especially in the form of high marginal tax rates? That depends on a lot of other policy factors, like controlling capital flight or buy-backs (as through tax penalties) and whether rewards for investment in the real economy are given (as through tax deductions). But done right, the result is always the same – higher wages for workers, faster growth rates in the real economy, and a higher standard of living.

To give a basic example, let’s consider the logic a given large business might follow. With low taxes on the rich, there are few reasons not to give large salaries and bonuses to top executives, and since the people making the decisions are rewarding themselves, it is understandable that they would do so! Once this process starts, it rapidly spins out of control, as businesses compete with one another to offer the most generous packages at the top. In the 1960s, pay for CEOs was twenty times the pay of the average worker in that business, which is a fine wage to reward their expertise, and created a lot of millionaires. But today the figure ranges from 300-400 times the pay of the average worker!

But what happens when you put in large marginal tax rates? It removes the incentive for those large salaries entirely! Why pay out a huge bonus when Uncle Sam would just take it? So… go figure… they don’t give out those huge bonuses any more! This leaves more money in the enterprise to be invested in growing the business and paying the workers higher wages! This is, in fact, exactly what happened when we created the middle class in the first place, and what continues to happen in the rest of the developed world. Creating a disincentive for those massive pay-packages directly raises wages for everyone else.

The massive income inequality in the United States is not just a moral problem, as liberals often discuss it. The disparities directly impact the entire economy, harming growth and investment, producing stagnant wages for ordinary people, and driving down the American standard of living. We went from first in the world when we had such a tax policy to between 16th and 17th place today. Isn’t it time we made the economy work for everyone again?

Photo credit: Chris Potter via ccpix (CC BY 2.0)