Why Rich People Benefit the Most from Tax Breaks
March 12th, 2009 . by economistmomI like Matt Miller’s point on the Daily Beast today about why rich people should just relax (already) about the Obama budget proposals to raise their taxes–in particular the proposal to partially fund the health reform reserve fund by capping itemized deductions:
Republican ire isn’t really directed at Obama’s call to let the Bush income-tax cuts for the top expire. After all, Obama campaigned on that idea, it won’t take effect until 2011 (when the economy will presumably be past the worst), and we know from the boom of the 1990s that a top marginal rate of 39.6 percent puts no brake on entrepreneurship and growth…
No, their real pique is reserved for Obama’s plan to limit the value of the itemized deductions top earners take for mortgage interest and charitable donations. If the president aims to “punish success” in this way, Republicans say, and use the proceeds to help fund liberal dreams like universal health care, then as a matter of principle they must fight with everything they’ve got. According to the New York Times, Democratic tax chieftains Max Baucus in the Senate and Charlie Rangel in the House actually agree with the GOP here…
[E]veryone has gotten confused. The headline “Obama Proposes to Keep Subsidizing John Thain’s Mansion More Than John Thain’s Cleaning Lady’s Home” would more accurately describe what he’s doing. A closer look should reassure the GOP and Democratic tax writers that under the Obama plan, America’s top earners, far from being punished, will still retain their traditional place at the top of Uncle Sam’s housing and charity dole.
Let the mortgage deduction illustrate the point. Under Obama’s proposal, top earners will be able to deduct mortgage interest only at the 28 percent rate, not at the 35 percent rate (or the 39.6 percent rate, once Bush’s tax cuts expire). What does that mean exactly? Today, every $1,000 in mortgage interest (or charitable gifts) generates $350 in tax savings for top earners; under the new plan, the tax savings would be only $280.
To be sure, this represents a sudden and disorienting loss for top earners, who were accustomed under the previous regime to having their taxes cut even during a time of war. But here’s the comforting part: That $280 per $1,000 mortgage subsidy is still a lot more than the $150 subsidy per $1,000 that millions of middle-income homeowners in the 15 percent bracket enjoy. And it’s an infinitely bigger federal housing grant than the zero awarded by Uncle Sam to the masses of Americans who rent (or who will shortly, once they’ve been thrown out of their homes)…
Yes, rich people benefit the most from the holes that are poked into the tax base, whether those holes be deductions or outright exemptions (a prime example being the exemption for employer-provided health care, the largest tax preference in the federal tax system), because rich people face the highest marginal tax rates. (We have a progressive income tax system.) It does seem pretty counterintuitive or nonsensical–that we purposely choose a tax system that taxes higher-income households more heavily (as a share of their income), yet we somehow end up passing out subsidies through the tax system in precisely the opposite way. I think this is just one of the many reasons to give us pause about our government’s tendency towards tax expenditures as a (sneaky) way of increasing government subsidies.
Matt’s story about how the marginal tax rate schedule determines the distribution of the benefits of the itemized deduction reminds me of a frequent misconception about the benefits of lower-bracket marginal rate reductions. President Obama is proposing to let the Bush (2001) marginal tax rate reductions at the top end of the income distribution expire as scheduled under current law (at the end of 2010). He’s not proposing to raise the lower-bracket marginal tax rates; in fact, extension of the “middle-class” components of the Bush tax cuts will require new legislation to do those parts of the Bush tax cuts all over again. And with those “middle-class” (lower-bracket) rate reductions, even top-bracket households benefit, because all top-bracket households are still taxed at those lower rates for at least a portion of their income. In fact, when you reduce a marginal tax rate in a lower bracket, anyone whose income is fully above the top end point of the bracket (i.e., any rich person) receives a bigger dollar benefit from that rate reduction than anyone whose income falls within the bracket (i.e., any lower-income person).
When rich people pay the most in taxes, they benefit the most from tax cuts. Don’t like that result? Then stop spending federal dollars through the tax system. Start using the tax system for what it was intended: to raise revenue.
Madame,
If I understand your reasoning you are essentially advocating disallowing all deductions, except business expenses on the Schedule C. Am I understanding correctly? No state tax deduction? No charitable or mortgage deductions at all?
That would be a pretty hard sell for a Democrat, since most of her or his constituents are from relatively high-tax, high real estate value states. They would be severely encumbered by such a change.
It would be hard for a Republican, too, because her or his supporters would say “Hey, you’re raising taxes!”
One certainly can’t argue with it from an equity standpoint; much “charitable” giving from the wealthy is to arts organizations which are able to sell their seats for a lower price, so the donors get a direct return. A good portion of the rest of “charitable” giving goes to mega-churches which increasingly resemble entertainment conglomerates with highly paid CEO’s with a DD instead of an MBA.
So it is a very interesting proposal. From a Libertarian perspective, why should an atheist or agnostic be forced to subsidize the giving of an acolyte of a church that probably despises her or him. Why should people in low-tax Mississippi subsidize the government of the State of New York or (gasp!) California!
However, practically speaking it’s little more than a Red Herring. Way too many powerful constituencies benefit from the current system. Even the “flat-tax” advocates won’t touch the third-rail of charitable donations.
Well, I’m suggesting we should give up all deductions and replace them with either credits (which do not give bigger subsidies to higher-income, higher-bracket households), or with subsidies done through the spending side of the budget (which could be even better targeted to give even larger subsidies to lower-income households).
The headline “Obama Proposes to Keep Subsidizing John Thain’s Mansion More Than John Thain’s Cleaning Lady’s Home” would more accurately describe…
Um, no, no true. Does one really imagine Democratic politician Charlie Rangel is trying to protect John Thain’s mansion deduction? Interest on only $1 million of mortgage principal is deductible, and that doesn’t come close to covering Thain Manor.
OTOH, a two New York City public school system teachers (or therapists, or social workers) with seniority married to each other make >$200,000 (school system salaries in the suburbs are much higher — the underfinancing of our public schools is an interesting story, for another time) which is in the 33% tax bracket (especially so if they have more income from their summer jobs, investments, etc.) and so they would have their mortgage interest, charity, etc, deductions reduced — and New York politician Charlie Rangel might be reacting to that.
In NYC and various other parts of the country the 33% tax bracket is entirely the hard-working, middle-class bourgeoise. And Rangel, Schumer, Hillary (when she was here) and the other NYS Democratic politicians respond to any attempt to cut their constitutents’ tax deductions strongly!
So Thain, the evil banker, who doesn’t deduct but a bit of his mortgage, is invoked by Miller as a disingenuous red herring. Miller should be saying: “The upper middle class — and not so upper in some areas, even public school system employees in New York State — should be happy to lose deductions for their homes…” But don’t think NYS’s Democratic politicians are going to swallow that so glibly as he proposes it. (A coming problem for Democratic unity.)
And that of course is only the beginning. For Miller himself has said Obama’s proposal is only the start of the tax increases — “feed the beauty”, give the public “free” deficit-financed new government spending now, and they’ll have to pony up the tax increases to pay for it later. (If one wanted to try to think up something more duplicious and fiscally irresponsible than the Republican tax cuts, well, this idea is it.)
When rich people pay the most in taxes, they benefit the most from tax cuts. Don’t like that result? Then stop spending federal dollars through the tax system.
It’s a remarkable thought that those who pay taxes are the ones who benefit from tax deductions.
Of course, if one really doesn’t like that fact of life for some reason, one must be sorely troubled by the fact that the higher tax rates go, the more unavoidable tax deductions become. The pressure to increase them rises with the square of the increase of the tax rate, and all that. Nobelist William Vickery — and old school true liberal — came out for a flattish tax rate system long before today’s conservatives did after showing how in the old really high top-tax-bracket days, the richest paid lower effective tax rates than the less rich, because of all the deductions and preferences the high rates created.
So the simplest and only workable remedy for this injustice is to limit the degree of progressivity in the tax rates.
To say “the rich” (including our NYS middle class and public school employees) should pay “more” as their “fair share”, for all we hear it, is rather subjective and unscientific.
Objectively, and empirically, how much should “more” be to be “fair”? Define that amount and we can get to it! Right now about 40% of households pay no federal income tax and “the rich” pay total tax that is about double in proportion to their share of total income. Should it be 2.5 times, triple, 3.76 times? Let’s specify an actual number, with some justification.
Whether a tax system can objectively, empirically, become too progressive is an interesting question.
As one example to consider, right now in NYC all of 1/2 of 1% of taxpayers, 19,387, pay 40% of the city income tax, collected in a city of 8 million residents.
And of course, right now, over Bloomberg’s objection, the city’s Democratic political establishment and all the unions are demanding a new “millionaire’s tax” on that 1/2 of 1%, to close the city budget gap without the other 99.5% of the city paying it.
But is that really a good progressive idea? Does one have to reach very far to find reasons why it might be a bad idea, both fiscally and politically?
When California built its tax base on the fortunes of the Silicon Valley billionaires, and then the tech bubble imploded, did the state’s finances ever recover? … If Bloomberg decides to retire and move to Connecticut to reduce that 1/2 of 1% paying 40% of the city’s income taxes by just one person, how many hundred thousand sales tax collections will that offset? … Did de Tocqueville observe that Democracy can survive until the majority realize they can live at the expense of the minority?
If Matt Miller really believes a new government spending programs will benefit the middle class, why shouldn’t he honestly say: “So you middle class voters who are getting this benefit should be happy to pay for it, in taxes up front! With nothing added to the deficit.” Does he instead prefer “feed the beauty & the deficit” and “tax the rich” rhetoric because he’s afraid the voters don’t agree with him — and he wants those programs in spite of that fact?
I’ve felt this way instinctively, but have never really understood the mechanisms behind why the rich benefit most from tax breaks.
Madame,
Thank you for being brave enough to make a genuine clarification for an idea that may get LOTS of brickbats. I think the answer to the question why the system rewards in a regressive way when it penalizes in a progressive direction is having the deduction system rather than dollar value credits buys upper middle class support for the progressive revenue side.
Democrats have to get their campaign contributions from somewhere; traditionally the Republicans have the small business community and corporate management sewn up. So Democrats have had to rely on public and charitable sector employees and patrons. Most of the highly paid members of those groups live in the high-tax high value northeastern and west coast states. The public sector folks might not defect to the Republicans if their contributions were no longer deductible, but the arts patrons certainly would.
Although your proposal is clearly economically more efficient, I fear that right-wingers would use the replacement of deductions with credits it to bludgeon the progressive revenue system. We would then have a political system even more completely dominated by rich families, multi-mansion CEO’s and whiny franchisees.
Just as an aside, if Jim Glass will remember it was Proposition 1 which eviscerated California’s tax base not some left-wing plot. Once property taxes could no longer be increased on owner-occupied homes except at the time of a sale, the state had no alternative to increasing sales and income taxes — which it has done — and/or to decrease state spending, which it has also done, unfortunately mostly on education and infrastructure.
I learn so much by reading your blog!
I love how any talk about tax rates stirs up the unfortunate “working poor” i.e. more than $250k per annum, of the teachers and firefighters in NYC. Yes it’s expensive to live there. Get over it. It ’s expensive in a lot of places. Try living in the DC metro area on SS alone like my elderly aunts. Try living at the federal poverty level anywhere in the country.
I get that they work hard in NYC for their money, but they also seem to really like a fine whine to go with all of their meals.
“I love how any talk about tax rates stirs up the unfortunate “working poor” i.e. more than $250k per annum, of the teachers and firefighters in NYC. Yes it’s expensive to live there. Get over it.”
Your task is to tell Democratic politicians like Charlie Rangel, Chuck Schumer, Hillary (while she was here), et. al., to “get over it” and vote to cut back itemized deductions that are much more valuable to their Democratic constituents in high cost of living states — which are thus high tax bracket for average real income states, which makes their deductions much more valuable to average people there — than to persons in low cost of living, low tax bracket states.
For instance, think how unfair the federal deduction for state and local income taxes is! It’s worth a huge amount to many middle class voters in high state tax states like NY, Mass, Calif — but worth little to nothing to persons who live in states with low cost of living and little or no state income taxes.
Surely, under the “fairness” argument this should be the first tax deduction progressive Democrats should want to repeal….
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Good luck on your task — be it convincing them to cut back this or any other major itemized deductions.
Here’s the dilemma: The higher the tax rates you impose, the greater the pressure to create deduction and preference “exceptions” to the tax, both on the economic merits and on the politics.
For instance, during all the history of the nominal 70% and 90% top tax brackets there were huge exemptions for capital gains and other investment income, so no rich person ever paid anything like a real 70% or 90% rate, both because (1) if the bulk of investment income was really taxed at 70%-to-90% rates the economy would collapse, so major exceptions were economically necessary; and (2) the payoff of to investors of lowered rates was huge, so Congressmen could collect huge payments (via campaign contributions and otherwise) by selling them, which they are happy to profitably do.
The only time ever in history without major tax preferences for investment income that paid off hugely for the rich was after the Reagan 1986 tax reform that reduced the top bracket rate to the lowest ever, 28%. Which also greatly reduced deductions of all kinds generally. Since then rates have been going up and deductions and preferences have been steadily coming back.
Saying “I want higher tax rates with fewer deductions and tax expenditures” is like saying “I want a magic aqueduct in which water will flow uphill”. Water flows downhill. If you want fewer deductions and tax expenditures and a broader tax base you want lower tax rates.
Take your choice, one or the other: Higher rates with more deductions and preferences, lower rates with less of them.
As a second point … where is the logic behind the claim that tax expenditures (deductions, credits, other tax preferences) are somehow less fair, less efficient, and less worthy than cash expenditures?
Both are enacted into the budget in exactly the same way by Congress in its wisdom — by majority vote after full due consideration.
If Congress is assumed wise, fair and efficient in its cash expenditures, so we can safely trust it to ramp up the spending budget in coming years, why should anyone consider it unwise, unfair and inefficient in its tax expenditure budget? (Charlie and Chuck would disagree with that idea!)
And if Congress is unwise, unfair, and inefficient in its tax expenditure budget, why would one assume it to be any less so in its cash expenditure budget?
The Concord Coalition provides a more informative discussion of this than the latest spin from Greg Mankiw as I argue here:
econospeak.blogspot.com/2009/03/obama-budget-mankiw-rehashes-old-spin.html
This discussion sidesteps the question of whether we should make the tax system more progressive — by either or both raising the marginal tax rates for the wealthy and reducing the value of their deductions. This assumes that the wealthy should pay more because they are lucky or fortunate and should subsidize, through payments, those who are less lucky or fortunate. This isn’t the case, for the most part.