High earners right to feel lonely at the top

Feeling lonely, are we? Tax week can do that. And if you're paying high rates of income tax, that sense of tax isolation isn't mere paranoia. You are isolated.

Fewer than two in a hundred filing households have income sufficient to bring it anywhere near the top statutory rate of income tax rate of 39.6 per cent. Because of deductions, an even smaller number of people actually end up paying at this high level. You and every one else at the executive meeting may be forking over half your money to Washington and your state capital. But you are a tiny crowd.*

That, however, doesn't mean you are shouldering a small tax burden. On the contrary. Today, Americans as a group pay more taxes than they ever have before, both nominally and as a share of the economy. And top earners are responsible for supplying a greater share of that overall obligation.

In 1998, the last year for which complete data are available, the top 1 per cent of earners paid 34.55 per cent of all individual income taxes. This is up from a 19.05 per cent share for the group in 1980. The top 5 per cent of earners paid more than half of all income taxes in 1998, up from about a third of the total obligation in 1980.

Meanwhile, at the bottom end of the income scale, things have changed as well. The bottom 50 per cent of earners now pay only 4.23 per cent of income tax. And several tens of millions of households, nearly all of them with incomes under $40,000, pay no income tax at all. He ain't heavy, indeed.

What happened? Well, the low end of the scale is relatively easy to explain. Under the Earned Income Credit, many workers have zero tax liability and get cash back. The idea of this negative income tax is to encourage work and discourage the dole. But the EIC sure skews the tax picture. And higher up? Here the answer is that Washington has taken a hammer to the old progressive rate structure, rebuilding it several times in recent decades.

Imagine a set of stairs. Increases in income drive taxpayers up the steps to new and higher brackets. In the late 1970s, the trip up was short and steep. It wasn't long before taxpayers got to the top step, or bracket, of 70 per cent (50 per cent on labour income). This tax experience was similar to the one that obtains in the UK today. Any number of modest earners reached the top bracket. In America, inflation made the trip particularly fast and brutal. Today, the American tax stair looks different. The summit isn't so high, the nominal top rate being 39.6 per cent. And it takes a longer time to get there - the steps themselves are big ones. Singles and married couples have to have $288,350 in adjusted income to reach the top bracket. Brackets are indexed, so those have to be real dollars.

These changes were engineered by two sets of carpenters. The first set, the supply siders in the administration of Ronald Reagan, figured that lower rates would inspire entrepreneurs to work harder on the Treasury's behalf. The supply siders were right, as it turned out. Productive workers did work more when rates came down, so they paid more tax. This is why you'll never hear President George Bush label supply-side ideas "voodoo", the way his Dad did.

The second set of carpenters came in the 1990s. These were the folks in the Bush and Clinton teams who knew that they could get away with raising the top rate from 28 per cent, to 31 per cent, to 39.6 per cent as long as the new punishment hit only the slimmest minority of taxpayers. They were also right.

All of which goes a long way to explain why Dubya is finding his income tax cut a harder sell than Mr Reagan found his in his day. It is pretty ironic: supply-side tax cuts are more challenging because supply-side theory has worked too well.

Not to say that all is dark for high earners at the end of the tunnel (or top of the staircase). For while lawmakers in the 1980s and 1990s managed to disenfranchise those with high amounts of earned income, they didn't do the same for the crowd with unearned income, such as interests, dividends and capital gains. And rentiers, once relatively scarce, have become an electoral powerhouse. These days, about half of Americans own some form of stock. Which is why the Bush administration may end up playing midwife to a capital gains cut, even though that was not part of the plan as conceived back in Austin.

* Tax masochists may refer to IRS's regular Statistics of Income Bulletin Series (http://ftp.fedworld.gov/pub/irs-soi/98hiinco.pdf PDF).

© Copyright 2001 Financial Times

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