In a recent blog I touched on taxes. This week in the macroeconomics course I teach, the textbook turned to taxes. It touted the conventional belief that taxes are mostly progressive. That provoked a bit of discussion in class.

A further exploration demonstrates that taxes are typically regressive. They impose a higher cost as a share of income on lower to upper middle class households than they do on the wealthy. This applies to income taxes, sales and consumption taxes, excise taxes and especially property taxes in their various forms. 

First, let us define regressivity and progressivity. We adhere to a popular misconception that we all share equally in the burden of supporting government. We believe that, since it may be very painful for a poor person to pay a tax, while a rich person can do so without sacrifice, the poor should pay a low tax rate and the wealthy a higher one. This is called tax progressivity - the tax rate rises progressively as income rises. In fact, taxes are regressive in that the tax burden of the poor as a percentage of their income is typically higher than that of the wealthy, especially he very wealthy. 

The conventional wisdom is that the income tax schedule is progressive because higher tax brackets have a higher marginal tax rate. One’s tax rate does not apply to all their income, though. The first bit of income, up to the standard family deduction of about $30,000, using the baseline of a family of four, is income tax-free in the U.S. The next bit of income, from $30,000 up to $50,000 is levied a tax rate of 10%. That rises to 12% for income above $50,000 until it reaches the next threshold of almost $120,000. The rate takes a big jump to 22% for income in excess of $130,000, all the way up to about $230,000. Then, the increases are slow - 24% from about $230,000 to $430,000, and 32% for all income earned above about $430,000, once that tax-free first bit to $30,000 is considered.

The schedule shows that, for those who earn income from working, the schedule seems pretty progressive up to a household income of about $230,000, but is much flatter for earned income beyond that. The tax code essentially loses its progressivity for the upper end of the middle class.

It is said that the middle class pays the most taxes. How is middle class defined? It is the middle 50% of households ranked by income. Currently that omits 29% of households with an income lower than about $70,000 for a family of four, and extends to those with an income up to about $220,000.

Once this upper threshold  of the middle class is met, the tax rate increases very slowly. In other words, income tax progressivity applies primarily to the middle class, but not the wealthiest 20% of society. 

Even this analysis is qualified, though. It only applies to earned income. The tax code defines earned income as derived from a job or self-employment earnings. It does not apply to income from many forms of dividends or capital gains. The tax rate on most U.S. and some foreign company dividends for many of those with income beyond the middle class is only 15%, and rises to 20% only for those making about $310,000 per year, all the way up to Elon Musk. The same formula applies to capital gains. Since the top 20% of income earners are often able to derive a good bulk or all their sustenance from such “unearned” income, they in effect pay a tax rate that is lower than much of the middle class. 

But wait. It gets worse. That assumes that the increase in wealth each year by the top 20% is considered unearned income. If most of that income is in the form of a rising value of their investment portfolio, as is for a hedge fund manager, an investor, or Elon Musk, this increase in wealth is not considered income. It could be taxed someday, maybe, if the investment asset is sold. In the meantime, someone can borrow against that collateral for a nominal interest rate and live off the borrowings tax-free. Someday, perhaps far off into the future, these investments may be sold, and the tax bill is due then. 

Of course, I’d far prefer to pay taxes someday far off into the future for income I generate today. And even such paper wealth may avoid taxes upon one’s death, if it does not exceed the estate-tax-free threshold of about $20 million. 

As a consequence, the very wealth often pay little or no taxes. One of the wealthiest Americans, Warren Buffett, complained that it does not makes sense he pays less taxes than his secretary. 

Some people argue that we should replace the regressive income tax with a consumption tax. Such an elaborate version of a sales tax is even more regressive. 

A consumption or sales tax only taxes the amount you spend each year on food, goods and services, etc. It typically excludes housing, but is at a constant rate for all other purchases. 

Such a tax primarily burdens lower income households because they must devote most all their income to sustain themselves. Were a consumption tax be applied broadly, we’d need a federal tax rate of about 20-25%. In effect, the lowest income households would pay a tax of about 20% on their income, but someone who manages to save or invest half their income would pay only a 10% tax. Elon Musk receives an income of perhaps $25 billion per year from various sources, but actually lives quite modestly, beyond the occasional jet-setting that is perhaps paid by his businesses as an expense. I doubt he actually consumes more than ten times what you and I do in goods and services annually. That would convert to a .0004% tax rate as a share of his income, even if it might convert to a 10% tax rate for many in the middle class. Consumption taxes are highly regressive. 

A similar problem arises with property taxes. As we discussed in a previous blog, a property tax is a somewhat unusual wealth tax. It is an annual tax, for local government and schools, that is levied against not what you own in your home but also the share the bank still owns if you have a mortgage. Since home equity is the single largest category of savings for most Americans, it ends up being a rather burdensome wealth tax. 

Nationally, property taxes cost an average of 1.38% of one’s assessed property value. In the town I live in, it is twice that, and in the small city next door, it is almost three times that rate. At three times the national rate, one is essentially paying the entire value of their home every twenty five years in taxes. 

The median household income in the U.S. is about $75,000, while the median home value is about $425,000. If a median household is assessed a 4% tax on the value of a median home, that tax is 23%, which is higher than the marginal tax rate for anybody in the lower income or middle class, and is far higher than the average federal income tax rate for the vast majority of Americans. 

This tax is especially burdensome on the lowest income households since they otherwise pay little in federal income tax. Even if they rent, their landlords pay the value of their rental in property taxes, and you can be assured that cost is passed down to the renter. 

Certainly the wealthy have bigger and more expensive houses. Someone with ten times the median income may live in a house worth $1 million or perhaps $2 million. A 400% higher home value, when compared to an income ten times the size, results in a property tax burden of about half that which a median household may pay, as a share of income.

This trend is magnified as income rises further. For $25 billion of income that someone like Elon Musk may earn, they would have to live in a home worth more than 330,000 times the median home value to pay the same proportion of their income in property taxes as does a median household. That is equivalent to a $140 billion home. President Trump claims that his Mar–A-Lago home was worth only $1 billion, which is about four times higher than the most valuable home in the U.S. and more than the value of the Mona-Lisa. He pays a little more than $500,000 in taxes there each year, which is less than 40 times what I pay, for a home claimed to be worth 2,000 times what mine is worth. Very high income communities pay a very much lower property tax rate than is owed in more modest towns, which worsens the regressivity of property taxes even more. 

In essence, the ultra wealthy pay almost nothing in property taxes as a share of their income, while for many households it represents their largest or second largest tax burden, ranging from about 7% to more than 20% of their income. 

This is in no way a condemnation of those who work hard and are rewarded for it. I have great admiration for the engineering prowess of my fellow Queen’s University alumnus, Elon Musk, even if I wish he developed more Canadian-like manners. Certainly, he pumps a lot of what he makes into new ventures that have revolutionized our economy and stand to continue to do so. I also admire Warren Buffett, although his wealth is not from making things but from being clever in the pieces of paper he buys. If he can avoid paying billions in taxes each year because of the way the tax code has evolved, he is not generating jobs because of his stock buying. Instead, the tax code reduces the number of jobs created because middle income households must pay more in taxes rather than spend it on goods and services that actually grow the economy. 

Instead, this is more of a comment on the fact that our tax codes that were once progressive have morphed into placing the greatest onus on the middle class and the greatest burden on those least able to afford it. This shift is job- and growth-destroying rather than creating. We can stick to the conventional wisdom that the tax code is progressive, but in fact that denies an inconvenient truth. Some communities are discussing the repeal of property taxes, perhaps over their regressive qualities. That may address one issue, but without a commensurate decrease in government spending, taxes will rise elsewhere, maybe not is such a regressive form, but most all taxes are regressive in that the share of income and wealth creation that is siphoned off in taxes falls proportionately more on the middle class and lower income households than on the wealthiest citizens.