Don't believe the hype: Obama's not Robin Hood

Lori Montgomery’s nice piece in the The Washington Post this morning described how some congressional Democrats want to use the looming tax increases on high-earners to help redress income inequality in the U.S. But would these tax hikes matter very much?

There are two issues to think about here. The first: Would relative after-tax incomes change a lot if the Bush-era tax cuts were extended for low- and moderate-income taxpayers but allowed to expire for the highest-earners? The second is what would the government do with the extra revenue it receives if those top-bracket tax cuts do expire? Would it necessarily spend the funds in a progressive way?

The answer to the first question is "less than you might think." The answer to the second is "no."

Here are some numbers to help you think about the effect of taxes on incomes:
First, there is no doubt that incomes have risen much faster for the highest earning one percent of households than for the rest of us. According to the Congressional Budget Office, between 1979 and 2007, average pre-tax income for the top one percent more than tripled--from $550,000 to nearly $1.9 million. By contrast, average pre-tax income for those households in the middle 20 percent of income rose by only about 20 percent--from $54,000 to $64,500.

But how much did taxes affect incomes of the wealthy? The CBO numbers give a rough idea, and you might be surprised by the answer. From 1979 to 2007, after-tax income for those top-earners rose from $347,000 to $1.3 million—a rate of increase that wasn’t much different than before they paid taxes.

The pattern changed somewhat, however, after the 2001 and 2003 tax cuts. For those top-earners, average pre-tax income rose from $1.5 million in 2000 to $1.9 million in 2007, an increase of about 27 percent. But from 2000-2007, their after-tax income increased from about $1 million to $1.3 million, a hike of about 30 percent, largely because Congress cut their average federal tax rate from 33 percent to 29.5 percent. Thus, those Bush-era tax cuts did play a part in boosting after tax-incomes for high-earners. But for the most part, those folks got rich thanks to the money they made, not from the taxes they saved.

And remember that President Obama’s proposal to extend the tax cuts for income under $200,000 (or $250,00 for couples) would still increase after-tax incomes for the highest earners by about 2 percent--relative to all the tax cuts expiring.

Btw, for those middle-income households, after-tax income rose from about $50,000 in 2000 to $55,000 in 2007, an increase of about 10 percent. Their average federal tax rate was cut from 13.5 percent to 13.1 percent.

But keep in mind that the CBO calculations show the direct impact of tax payments (as well as federal income transfers such as Social Security) on income. They exclude a potentially more important factor—how the tax laws helped high-earners make their money in the first place. For instance, a lot of folks got very rich in the real estate business over this period—an industry fueled by tax subsidies. And few politicians are talking about addressing those tax code issues.

Finally, let’s take a quick look at what government would do with those tax revenues, and whether higher taxes on the wealthy would generate more progressive spending. This is very hard to know, but my guess is that it would not.

Here’s why: The biggest government programs—defense, Medicare and to a lesser degree even Social Security-- are not aimed at the poor. Many other subsidy programs, both those administered through the tax code and those designed as direct spending, tend to be regressive. For instance, the biggest beneficiaries of farm assistance are agribusinesses, not family farmers. The big winners from the home mortgage deduction or the exclusion for employer-sponsored health insurance are higher-earners, not the middle-class households.

Quantifying all this is not simple, but I certainly wouldn’t assume that more tax revenues will equal more spending on the poor or middle-class. And even if it did, the amount of increase would be pretty small.

Bottom line: The Democrats are right that income inequality is a problem. But they are wrong if they think that letting the 2001-2003 tax cuts on high-earners expire will do much to solve it.

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