In America today there is a widespread belief within the upper classes that the Income Tax is unfair to rich people. I’d like to explain why, from an economist's POV, this belief is utter nonsense. In plain language...
Rich people get the idea that high tax rates are unfair to them when they 1) think about the total number of dollars that rich people are handing over to the government, and then 2) imagine what that money could buy in the marketplace at current prices.
When they add up all of those un-bought possessions in their minds, it leads them to the conclusion that the Income Tax forces wealthy people to give up a lot when the government sends them a very large tax bill on their very large incomes.
So are they right? Do very high income tax rates impose a very large sacrifice on rich people?
For the answer, we need only to reflect on the last time that Congress decided to dramatically increase the top marginal rates that the richest of Americans were required to pay on their incomes.
HISTORY TEACHES
The year was 1932, in the depths of the Great Depression. At that time Congress increased the Income Tax’s top marginal rate from 25% to 63%. Fours years later, it was raised again to 79%.
Just how bad did it get for the country’s millionaires, once the government started to take huge amounts of money away from them? Answer: they got along just fine.
When we look at what actually happened to rich people at the time, it becomes clear that dramatically increasing the tax obligations of these people did not actually inflict any kind of real suffering on them at all.
In the years that followed the 1932 tax hike, none of the mansions, or the yachts, or the beachfront property disappeared. Throughout the Great Depression, rich people still owned all of the economy’s luxuries and they continued to enjoy them fully.
They may have had fewer disposable dollars to throw around than they used to, but that just meant that they were able to get all the luxuries that the economy produced at lower prices.
You see, in spite of the much larger tax bills they were paying, rich people still had the highest disposable incomes in the land, and in a market economy, that’s all the money you need to claim the scarcest luxury goods & services that the economy brings to market.
Why this is true is something that becomes apparent once you’ve learned a thing or two about how market economies determine prices.
MARKETS DETERMINE PRICES BY AUCTION
Any competent economist will tell you that the marketplace sets prices by auctioning the scarcest goods & services to the highest bidders. The auction process we see in most markets is different from the one we observe at Sotheby’s, but the results are the same.
The essential element driving the process is the freedom sellers have to charge the highest price for their products that they think the market will bear. With extraordinarily few exceptions, this is precisely what sellers in competitive markets always do.
If sellers become aware that---for whatever reason---supplies of the product they sell will soon be in short supply relative to demand, they will immediately raise their prices. They understand that, given the anticipated shortage, many people will be willing to pay a higher price for the product rather than do without.
How high will the price ultimately go? That is what the auctioning process ultimately determines.
A seller starts off by trying to guess the highest price she can charge while still being able to sell all of her product(s). If her guess is too high, product will remain on the shelf unpurchased.
But if instead she finds her products are ‘flying off the shelf’ at the original price she set, she will increase her prices further to see what happens. If they are still flying off the shelf, she will proceed to raise them again.
The price she charges will continue to go up until sales slow to a trickle and products remain on her shelves unpurchased. When this happens, the she will then lower her price just enough to move the product off the shelf, but no lower. Equilibrium---for the moment---is achieved.
In this markets’ method of auction, sellers try to guess the winning high bid in advance, ask for it up front, and then allow potential buyers some time to respond. Potential buyers only participate in the auction if they believe they can afford the winning high bid that the seller/auctioneer has set.
In a free-market economy, prices are always going to go as high as they can possibly go, limited only by the number of $$ that potential buyers have available to them. That is why the scarcest luxuries always end up in the hands of those who possess the most disposable dollars because sellers are always going to do their best to price everyone else out of the market.
It is a process that is every bit as effective as a Sotheby’s auction at delivering the scarcest goods & services generated by the economy to the highest bidders.
PURCHASING POWER IN MARKET ECONOMIES
From this explanation of marketplace dynamics we derive a supremely important economic truth: purchasing power is not determined solely by the number of dollars you have. What determines your purchasing power is the number of dollars you have compared to everyone else.
The purchasing power of your disposable income is ultimately determined by its ranking within the hierarchy of all disposable incomes. Those who have more disposable dollars available have a higher ranking than those who have fewer. The higher your ranking, the more able you are to ‘outbid’ others for the scarcest luxury experiences.
One principle stands out above all others: whenever a household experiences an increase its disposable income, its purchasing power will either increase, decrease, or not change at all depending on what has happened to the disposable incomes of all other households.
- Your household income may increase next year, but that seemingly happy development would only provide your household with an increase in purchasing power if your gain in $$ earnings is exceptional (e.g., you win the lottery, or land a much better paying job).
- If the only reason your disposable income increases next year is because you and everyone else got a nice tax cut, then none of you is going to experience an improvement in your ranking within the hierarchy, and that means none of you will see an improvement in your purchasing power (as a consequence of the tax cut).
- A third possibility: your household income increases next year at a time when everyone else’s is going up more. In this case, your household’s purchasing power would actually decline, even though your nominal income had increased, because your ranking within the hierarchy would decline relative to everyone else.
- Yet another possibility: your household’s disposable income declines next year, but because everyone else’s disposable income declines even more, you actually end up experiencing an improvement in your purchasing power.
With a more sophisticated understanding of purchasing power in market economies, we are able to see why it is indeed a fact that dramatically increasing the income tax ‘burden’ that rich people are expected to shoulder for society does not actually impose any kind of material sacrifice on them whatsoever.
Decreasing the number of dollars that rich people have available to spend does not decrease the quantity of luxury experiences that are brought to market. They will still be marketed to the same people and they will still be sold to the same people once the price drops to a level that rich people again perceive to be affordable.
In the real world, nothing changes.
And thus the fear that rich people have always had of deprivation and unfair treatment via the Income Tax has never had any basis in reality. It turns out that they have feared the specter of steeply progressive income taxes, not because they are evil, but because they have simply never understood the nuances of marketplace dynamics.
SO HOW DOES THIS AFFECT OUR PERCEPTIONS RE: TAX FAIRNESS?
In the world of Public Finance and Taxation Theory, it is simply not possible to conceive a method of taxation that is more fair than one which actually preserves the purchasing power, the material possessions, the privileged lifestyles of the economy’s richest participants.
And yet, though the Income Tax is ideally fair in its construction, there are still some important fairness issues that rich people need to be concerned about.
There is, for example, the high likelihood that if the Income Tax’s top marginal rates were made much more steeply progressive during a Bernie Sanders administration, certain disreputable individuals would feel inspired to defy the supremely virtuous intent of the Income Tax by acting to enhance their own disposable income rankings at the expense of all other rich people.
Which is to say they will seek to cheat, lie, or otherwise game the system that has been set up to calculate the government’s share, often by not reporting all of their sources of income. If/when they do such things at the same time the majority of rich people are following the rules they would indeed be able to improve their rankings within the hierarchy of all disposable incomes.
But here’s the thing: if everybody were to follow their example, then none of them would be able to improve their rankings. In order for these scoundrels to truly benefit as they desire, they need for most rich people to play by the rules while they are cheating.
That’s the funny thing about morality. Moral behavior is---by definition---behavior that would make everyone better off if everyone behaved the same way. Immoral behavior is behavior that would make everyone worse off if everyone behaved the same way.
So if you are a rich person who has come to realize that the income tax is indeed the fairest method of taxation you could ever hope for, it does not mean that all of your concerns about fairness have gone away.
It simply means that you need no longer be an unwitting dupe manipulated by sycophants and political opportunists into wrongly blaming 1) the Income Tax itself, and/or 2) the Federal Government as the ‘victimizers’ who threaten you with unfair treatment.
The people who are actually trying to victimize you with unfair treatment are those ‘other’ rich people out there who don’t want to play by the rules, rules that are set up to protect all rich people from any loss of purchasing power in the marketplace.
How then should Good Rich People respond to this kind of unfairness/victimization?
I would suggest that they 1) stop giving money to the idiots who are currently demonizing the Income Tax, and then 2) join together with other Good Rich souls out there to put pressure---both politically and otherwise---on the Bad Rich to abandon their stupid-selfish behavior.
And they might also want to consider voting for Bernie Sanders…
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Explanatory Note: I’ve been re-writing a lengthy article on my website re: the Progressive Income Tax for a while and I thought I’d run this draft by the Kos community to see what kind of a response it would get. It seems like the kind of content that economic progressives and Bernie Sanders would have a particular interest in...
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FYI, in a previous diary, I presented a version of this message in the voice of Bernie Sanders that I thought he could include in his stump speech...
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