Rangel's Mangled Tax Tangle
The House of Representatives Ways and Means Committee Chairman Charles Rangel has introduced a proposal to re-tax the rich
November 1, 2007
Fred Foldvary, Ph.D.
Economist

The House of Representatives Ways and Means Committee Chairman Charles Rangel has introduced a big reform of the personal income tax. This begins a debate on tax reform which will continue until the end of the ozo (2000-2009) decade.

Past errors in tax policy are now maturing into such severe tax tyranny that it threatens a tax revolt unless changes are made soon. The Alternative Minimum Tax was enacted in 1969 as a second method of income tax calculation. Rich folks were getting away with paying little tax, using deductions, credits, exemptions, and shelters to avoid paying taxes. The AMT was supposed to tax the rich by eliminating these tax loopholes.

But the geniuses who authored the AMT did not index the tax brackets for inflation. So now the AMT is increasingly hitting many middle incomes. If nothing is done, the AMT will become a huge tax increase on the middle class and also make tax calculations more complicated.

The Rangel reform would eliminate the AMT. It would also increase the standard deduction, reducing taxable income for those who do not itemize tax deductions. The bill would also increase low-income tax credits and give more money to poor folk whose taxes are less than the credits. The top tax rate on corporate profits would drop from 35 to 30.5 percent, but some deductions would be eliminated.

To make up for the tax reductions, the bill would increase the tax rate on the rich by four percent. That would apply to income above $150,000 for single and $200,000 for married couples paying jointly. The extra tax rate, which some have called the biggest tax increase in US history, would be 4.6 percent for joint incomes over $500,000. Those with incomes over $1 million would be hit by an average tax increase of over ten percent.

Tax reform will become a major campaign issue in 2008. If Congress and the presidency are controlled by Democrats, there would most likely be a tax change similar to the Rangel bill. Democratic candidates wish to terminate the Bush tax cuts of 2001 and increase taxes on the rich. Republican candidates will attack the Rangel plan as a steep tax increase that would reduce entrepreneurship and investment.

The 2001 Bush tax cuts will terminate in 2010 if nothing is done. The top marginal tax rate, the tax on extra income, would jump back up to 39.6 percent. Including all its changes, the Rangel bill would then put the marginal tax rate on incomes over $500,000 at 48%. It would be the fourth highest marginal tax rate among developed economies.

Economic decisions are made "at the margin." People look at the extra costs and benefits of doing something, and if the net income after taxes is too low, they don't work or invest as much. The historical evidence is that rich people care about taxes - one does not get to be rich by not caring about money. They will respond to a big tax increase by saving and investing less, by shifting enterprise to less risky ventures, and by putting more money in tax shelters or lower-taxed business. For example, if corporate tax rates are much lower than personal tax rates, rich folks will create corporations and shift into to corporations. Such shifts reduce, rather than increase, total tax revenues. The tax increase will be counter-productive.

A tax on the enterprise of the rich is a tax on the wages of the poor. The tax increase reduces economic growth and productivity, reducing the growth of wages. Perhaps an invention that would have greatly reduced pollution will not be produced because the gains are now too low. Quantum leaps in technology and opportunity that would have taken place do not happen, and we will all be worse off.

The waste caused by taxes, which economists call the "deadweight loss" or "excess burden," increases by much more than the increase in the tax as the total tax amount rises. A four percent increase may not seem like much, but on top of the existing taxes, the vibrant invisible hand of the entrepreneur will be replaced by the cold dead hand of the tax. The deadweight loss of the tax is itself a tax whose rate could be even large than the 4.6 rate on income.

Advocating a particular tax reform implies rejecting all other possible tax changes. An alternative to an increase in marginal tax rates would be for the federal government to levy taxes on all pollution. An environmental or green tax would have no deadweight loss, as it reduces the social cost of pollution and makes consumers pay the social cost of their purchases. It taxes a bad, pollution, rather than a good, enterprise and investment.

So why is a pollution tax being rejected in favor of higher tax rates on the wealthy? My guess is that welfare-state liberals (WFLs) don't like it when entrepreneurs to make a lot of money. These WFLs could decrease income inequality without any excess burden by shifting taxes from labor to land values, as much of today's inequality come from unequal land tenure. But WFLs refuse to do that tax shift. So it is not even inequality they don't like. They just don't like it when successful entrepreneurs get rich. Why else reject efficient taxes on land and pollution?

Unfortunately, "conservatives" are almost as tangled as the WFLs. "Conservatives" seek to maintain the pollution and land subsidies and privileges of the rich. They will attack the Rangel tangle without proposing the efficient and equitable remedies.

Oh, what a tangled mess we weave when mangled taxes we conceive!

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Fred Foldvary, Ph.D.
Economist

FRED E. FOLDVARY, Ph.D., is an economist and has been writing weekly editorials for Progress.org since 1997. Foldvary's commentaries are well respected for their currency, sound logic, wit, and consistent devotion to human freedom. He received his B.A. in economics from the University of California at Berkeley, and his M.A. and Ph.D. in economics from George Mason University. He has taught economics at Virginia Tech, John F. Kennedy University, Santa Clara University, and currently teaches at San Jose State University.

Foldvary is the author of The Soul of LibertyPublic Goods and Private Communities, and Dictionary of Free Market Economics. He edited and contributed to Beyond Neoclassical Economics and, with Dan Klein, The Half-Life of Policy Rationales. Foldvary's areas of research include public finance, governance, ethical philosophy, and land economics.

Foldvary is notably known for going on record in the American Journal of Economics and Sociology in 1997 to predict the exact timing of the 2008 economic depression—eleven years before the event occurred. He was able to do so due to his extensive knowledge of the real-estate cycle.