Trump wants to cut taxes, and so far his sketch of a plan will cut taxes on the wealthy.
Let's think about this for a minute. We are very near a full employment economy. A caveat here is that wages are not rising like they should at full employment, but if we can keep nudging that full employment threshold there is hope they will rise soon. But the point I want to make here is that cutting taxes when we are so near full employment and when the government budget is still in deficit makes no sense at all.
But if Republicans are foolish enough to ignore their past admonitions against budget deficits (they are perfectly appropriate when the economy is operating below full employment), and want to push for tax cuts, it makes no sense to cut taxes on the highest earners in the economy when they are the folks who have been doing pretty well for quite a long time now. The upper one percent and even the upper 10 percent of earners have garnered more of the nation's wealth over the last several decades. The Congressional Budget Office has studied changes in the U.S. income distribution and concluded, "Rising income inequality was primarily driven by the relatively rapid growth of mean income in the top quintile [top fifth of earners]. The rate of growth in mean income differs across quintiles, with the top quintile experiencing the highest rate of growth over the 1967-2015 period."
So why would you want to cut taxes on the rich, when they have been doing so relatively well? If we were to ignore the budget deficit and cut taxes, we should lower tax rates on the lower part of the income distribution and maybe even raise them a bit on the higher end. Higher rates on higher incomes is what economists call a progressive tax system. And there are reasons why a progressive tax system can be considered more fair. It extracts less important dollars from the private sector.
How much do you think a dollar is worth? Well that's a silly question, you might say, of course it is worth one dollar. But that is not what I mean by what it is worth. I mean how important is a dollar to an individual or family? To explore this question a little more, let's make it $100 per month. And the question to ask is how important is an extra $100 per month to person and her family? Well, if you think about how different people in different circumstances will answer this question, you will probably conclude that it depends. And one of the most important things it will depend on is how many dollars one earns.
Suppose you meet several people who agree to answer your question. One of these earns $3,000 per month after taxes, another earns $6,000 per month after taxes, a third person earns $20,000 per month, and the fourth person you ask has an income of $450,000 per month.
Well the first person, the one who earns $3000 per month, says, "An extra $100 per month, wow that would be $1200 more per year, that would help us a lot." The second person who is earning $6000 per month says, "$100 more per month, that would be nice." The $20,000 per month earner simply says, "Won't make much difference." And the multimillionaire simply stares at you blankly as she opens her purse full of $100 bills, thinking you are seeking a tip for some service you have rendered.
Well this little scenario illustrates that the importance of one more dollar or one less dollar of income depends on how many dollars of income one already has. That last dollar becomes less important the more dollars one already has.
Economists don't like to make these interpersonal comparisons of what a dollar is worth to one individual as opposed to another. What if the millionaire is eccentric enough to get immense joy from seeing her balance sheet increase by $1200 per year, and the fellow earning $3000 per month simply loves a simple life with no complications and cares very little about another $100?
That could happen. But here we want to be practical. We want to judge the fairness of taxes. We would like to design a tax system that extracts the least valuable dollars from the private sector. And on average, an extra dollar of income is more important (more valuable) to those with lower incomes than it is to those with higher incomes. If you believe that, then you should favor a tax system that taxes higher incomes at a higher rate than one that taxes all incomes at the same rate. It goes without saying that a tax system that taxes lower incomes at higher rates than it taxes higher incomes is totally unfair. In the U.S. tax system that sometimes happens, witness billionaire Warren Buffett paying a lower average tax rate than his secretary. (Of course we don't know what tax rate Trump pays on his income because he refuses to make his tax returns public as has other recent U.S. presidents.)
If you accept that proposition about fairness of the tax system, then you should be opposed to a flat tax - a tax that is the same percentage of one's income no matter how high or low that income is - as many conservatives and some Republicans advocate. I'm not sure why many conservatives support a flat tax, because we have never had such a tax, so it is not about conserving such a tax. But let's not get off track here. A flat tax proposal is not close to becoming politically acceptable at the moment. What we are talking about is how progressive is the United States tax system. By progressive we mean by how much higher are average tax rates on higher income individuals.
The U.S. federal tax system is mildly progressive. On average, higher earners do pay higher taxes as a percentage of their income, but it has got less progressive over time. The chart from below shows tax rates on higher incomes today are still higher than on lower incomes. For example the average total (all taxes including income and payroll taxes) tax rate on the top one percent of earners hovered between 40 and 45 percent in the 1950s and 60s. By 2013 it had fallen to more like 35 percent. The average tax rate on the bottom half of all earners has risen almost steadily from about 15 percent in 1953 to about 25 percent in 2013. The U.S. tax system has got less progressive.
In the face of the trend in higher earners taking in more and more of the country's income. The distribution of income in the United States has tilted ever more towards the rich, and in tandem our tax rates have tilted ever more away from the rich. The main reason for this is that payroll taxes for Social Security and Medicare, which fall more heavily on lower incomes, are now a higher share of total federal government revenues. A contributing factor is that corporate taxes which are paid primarily by high income taxpayers are now an ever smaller share of total federal revenues. (see chart below).
Trump's sketch of a tax plan would continue the trend to a less progressive tax system. He wants to lower the top tax rate paid by higher income tax payers, further cut the corporate tax rate that is mostly borne by higher income tax payers, eliminate the estate tax, the tax on inheritances that is mostly paid by high income individuals and families, and eliminate the alternative minimum tax, also paid mostly on very high income estates.
Trump does promise some offsets to these moves, like raising the standard deduction. But nothing in his proposals fully counteracts his moves to make the tax system less progressive.
If Trump wants to look for ways to increase the progressivity of the tax system (he doesn't), one easy way to do this is to offer middle income wage earners a credit against their federal income tax liability for the Social Security and Medicare taxes that they pay. He could also remove the cap that limits the Social Security taxes currently to the first $127,000 in annual income.
But having said all this, now is not the time for tax cuts of any kind. We are very near a full employment economy, and government revenues are not projected to cover government expenditures. A full employment economy is not the time to cut taxes. It will only increase the federal government budget deficit and increase the government debt.
Currently, federal government revenues are about 17 percent of total U.S. income (Gross Domestic Product), while federal government spending is 21 percent of GDP. So to balance the budget, which we should aim for when we are convinced that we are at full employment, say soon after we see labor force participation tipping up and wages rising significantly. It is then that we should either cut government spending or raise taxes a bit, to get the budget in balance. Given, that we have unmet social needs like infrastructure renewal and improvements to education and labor force skills development, it is a modest increase in taxes rather than a tax cut we should be thinking about.
I'll make one caveat to this proposition. An increase in government spending tied to public infrastructure renewable via special infrastructure government bond sales could make sense even in a full or nearly full employment economy. Wise infrastructure spending is an investment that could truly pay dividends in increased productivity and improvement in the life of current and future Americans.
Congressional Research Service on changes in income inequality:
The U.S. Income Distribution: Trends and Issues, Sarah A. Donovan Analyst in Labor Policy Marc Labonte Specialist in Macroeconomic Policy Joseph Dalaker Analyst in Social Policy December 8, 2016
Warren Buffet on his taxes http://money.cnn.com/2013/03/04/news/economy/buffett-secretary-taxes/index.html
Share of federal revenue chart from Slate.com @ http://www.slate.com/blogs/moneybox/2017/08/07/the_history_of_tax_rates_for_the_rich.html
Chart on different federal taxes as a share of GDP