Inequality and Taxation

It’s not just Occupy Wall Street protesters that are worried about wealth and income inequality. Now people like Bill Gross, manager of the world’s largest bond fund at Pimco, are warning that the problem is making the U.S. less productive.

As noted by Société Générale strategist Albert Edwards, “you don’t have to be a communist to conclude that high levels of inequality not only adversely affects long-term growth, but also increases the economy’s vulnerability to recession.” * * * Wealth and income inequality in America is still getting worse by many measures. — Gus Lubin, Business Insider, November 12, 2013 (here).

Previous posts have established that market economies are unstable, meaning that income and wealth concentrates naturally at the top, and that growth rates decline with growing inequality. Thus, inequality growth and reduced overall growth are “two sides of the same coin.” The neoclassical notion that economies bounce along from one financial crisis to another, recovering toward optimal productivity and “full” employment between crises, is wrong. Rather, there is a gradual, inexorable decline — and the U.S. economy’s decline has been the least gradual in the world. This post and the next will explain how taxation is involved and show how it has been used to engineer the U.S. decline.

The remedy for stabilizing a market, as has long been known, is a system of “progressive” taxation, graduated taxation with the effective rates charged the highest levels of income and wealth sufficiently high to prevent increasing inequality. Progressive taxation both retards concentration and enables government to establish well-being and higher growth throughout an entire economy. This post explores the implications in the United States for growth and inequality of the abandonment of progressive taxation, and the following post explores its implications for the Federal government and the national debt.

The deterioration of the U.S. economy is the worst in the world among developed economies, by far. It isn’t just that the rich here have tended to get rich faster than the rich elsewhere: There has been a huge boost for them established by the reduction of their taxes over a 35-year period. Here is what has happened in the United States:

By 1980, wealth concentration in the U.S. was already substantial, due to the natural operation of the economy. Under the influence of wealthy interests and Milton Friedman’s “free market” philosophy, the Reagan administration began to lower the top rate of income taxation, among other things, making the tax system increasingly regressive. Inequality grew and the rate of growth slowed, both significantly. To maintain a high level of spending, the federal government began to run up the national debt as it continued to reduce taxes at the top, in several precipitous steps.

Instead of taxing rich people and corporations for its revenues, our government borrowed from them, adding still more inequality. After the crash of 2008, although an imminent depression provoked by the Bush tax cuts was narrowly avoided, declining revenues and increasing federal debt continued to hamper the federal budget. Since then, pressure from the political right developed to act “responsibly” and balance the budget, but not by raising the taxes the lowering of which had caused the problem, but by further eviscerating government programs. Such a plan is the height of irresponsibility, for it would further accelerate the already rapid decline and, in the process, eviscerate government. 

Personal Income Taxes

A series of charts will provides the clearest way to focus on the problem. This first chart, published by the Center on Budget and Policy Priorities (CBPP) in April of 2012 (here), shows a long decline in federal income tax revenue from a median-income family of four. The effective tax rate for the median family had declined from 12% in the early 1980s to 6% just before the Crash of 2008:    

Income tax rate US

We would expect federal income tax revenues to decline with a declining economy, but this trend also reflected growing income inequality within the economy, increasing the drag on federal revenues. Wages as a percent of the U.S. economy had also fallen over this same period from 49% to 44%, according to the St. Louis Fed chart presented by Gus Lubin (here):

wages-as-a-percent-of-the-economy

Thus, both wages as a percent of GDP and the average effective taxation of wages declined. Both of these trends can be traced to the growth of income inequality over this period, caused by the reduction of amount of taxation at the top, which of course meant lower revenue contributions from the wealthiest households as well. This next chart from CBPP (here) shows the trend between 1992 and the start in 2008 of the Great Recession in the average tax rate for the highest 400 households by income and the average level of their adjusted gross income:

Income tax rate plus top incomesOver a ten-year period, from 1996-2006, Average AGI of the top 400 taxpayers grew five-fold, yet their average tax rate declined from about 28% to about 18%. This shows the massive tax avoidance at the very top; this is the worst case of a much broader problem: The major decline in the progressiveness of income taxes, the principal control factor for income and wealth distribution, started much earlier (just after 1980) and it redounded to the benefit of far more than the top 400 American taxpaying households. The total impact is enormous: While inequality grew and federal revenues declined, our national debt increased from under $1 trillion in 1980 to over $17 trillion currently, replacing revenue that would have been collected from top incomes and corporations, had the effective federal taxation (of top incomes, capital gains, and corporate earnings) not been substantially reduced.

Income Inequality 

This chart, prepared by Thomas Piketty and Emmanuel Saez (here), shows the changing growth of top 1% income and bottom 99% income together with the trend in the top federal income tax rate:

DP8675b

(Note that the real income per adult of both the top 1% and the bottom 99% are indexed to 1913 = 100; the top 1% level was of course much higher than the bottom 99% level back then. Consequently, the actual difference between income levels is not shown.)

This graph shows that the reductions in the top (marginal) income tax rate immediately resulted in growing inequality, as reflected in the top 1% and bottom 99% income growth rates. This shows a remarkably close correlation between the change in the top marginal rate and change in the top 1% effective rate over the entire 1979-2008 period. Following each tax reduction, income at the top grew at a continuously faster rate thereafter because of the resulting higher concentration of wealth.

The reverse effect on the bottom 99% — the reduced rate of income growth — means that the aggregate rate of growth is somewhere in the middle; the aggregate income growth rate actually declined considerably over this period, as reported frequently on this blog.

The fact that this happened despite steadily increasing productivity explains the high degree of bottom 99% stagnation over the entire period, as shown in the previous post and in this chart (Mother Jones, July/August 2011 issue, here):

change-since-1979-300

It has been frequently observed, recently, that although productivity has steadily grown since WWII, since the start of the Reagan Revolution with the tax reductions for the very rich the top 1% has received an out-sized share of the rewards of increased productivity. We also know from other sources that only the top 10% has seen any income growth at all since 1979, and that since the Bush decline began (with the tax cuts for top incomes) in 2003, there has been no growth except within the top 5%. Since 2010, moreover, there has been no income growth outside of the top 1%. Both the increased rate of income growth at the top and the reduced rate of income growth at the bottom, accordingly, have resulted from the reduction of taxation of income and wealth at the top.

These developments were enabled by the growth of corporate power; individuals on their own could not command such a high level of income growth outside of the capitalist economic structure. Within the corporate structure, the growing spread between CEO pay and average worker compensation in the U.S. is startling. This report from August of 2011 (here) is one of several reporting a huge leap in the spread during the Clinton dot.com era, followed by a decline in the Bush years:

corp disparity-300x251 (1)The chart shows a multiple at 50x at the start of the inequality growth period in 1980, growing to 500x during the Clinton.com boom years before falling off in the Bush recession years. With the record success of the stock market in 2013-2014, these multiples are no doubt rising considerably again. This same source reported this comparison of the U.S. CEO/worker pay multiple in 2011 with that of other countries: 

corp tableThe information on CEO pay, however comprehensive it may or may not be, shows the U.S. to be in a category of its own. This is a graphic illustration of the high level of growing income inequality over the last 3-4 decades.

Corporate Taxes

Corporate CEOs and other heavily invested owners and officers have a great deal of flexibility today in deciding where to locate their operations and where to pay corporate and individual income taxes, if at all. Gone, for the most part, are the days when a company like GE was in integral part of a community (like Schenectady, NY or Pittsfield, MA) by virtue of the location of huge investments in relatively immobile industrial plant. Changes in the nature of work, the installation of massive fiber-optic communications networks, and a well-developed culture of mergers and acquisitions in investment banking, have made it easier for big companies to move around and “forum shop” taxing jurisdictions.   

Currently there is a “race to the bottom” today as states compete in attracting wealth and businesses to locate within their borders. For example, New York State continues to emphasize a program of  reducing the cost of government with strategies for attracting industry and jobs (Governor Cuomo’s “FY 2015 Executive Budget Plan,” here). The General Fund Financial Plan (p. 29), among other things: (a) combines the corporate franchise and bank taxes for “simplification and relief;” (b) reduces the tax rate on net income from 7.5% to 6.5%, “the lowest since 1968;” (c) reduces the net income tax rate on upstate manufacturers from 5.9% to zero, for 2014 and thereafter; (d) announces the elimination over three years of the temporary extension of the “18-a temporary assessment” (funding for utility company regulation) applicable to industrial customers, and acceleration of its eventual complete phaseout, and; (e) increases the exclusion threshold for the estate tax from $1 million to $5.25 million over five years.

Federal taxation of corporations has been declining since WW II, and the effective corporate tax rate has declined more sharply since 1987 (here):

corp tax corporate_profit_1950_2010

It has declined as a percent of GDP (here),

corp tax percent gdp

and very similarly as a percent of all U.S. tax revenue (here):

corp tax percent of total revs

Notably, although the effective corporate tax rate (the percent of profits) has steadily declined since the mid-1980s, corporate taxes bottomed out then as a percentage of all federal revenues, and of GDP, and have remained low.  The implication is that corporate profits have increased substantially as a percentage of GDP, while corporate tax revenues have remained at or near historic lows.

The tax loopholes built into federal laws for major oil companies, and the zero-tax returns of companies like G.E., in 2011, have become infamous. More recently, so have the tax avoidance approaches of major corporations as they “locate” their activities and profits in other countries. Consider these excerpts from a recent report by Flooyd Norris, “Switching Names to Save on Taxes,” New York Times, April 4, 2014 (here):

What was most impressive about this week’s Senate hearing into the way Caterpillar ducked billions of dollars in United States income taxes was the simple strategy involved. There was no subsidiary that somehow qualified to be taxed nowhere, as at Apple. There was no “Double Irish With a Dutch Sandwich,” a strategy made famous by Google in its quest to avoid taxes.

Instead, back in 1999, Caterpillar, helped by its audit firm, PricewaterhouseCoopers, decided that to sharply reduce the American tax on profits from the sale of parts sent from the United States to customers around the world, it had to do little more than take the name of the American parent off the invoices and put in the name of a Swiss subsidiary.

So even though the parts might have never come within a thousand miles of Switzerland, the profits accrued to the Swiss subsidiary. And Caterpillar negotiated a deal to tax those profits well below Switzerland’s norm. Senator Carl Levin, the Michigan Democrat who is chairman of the Senate Permanent Subcommittee on Investigations, put the rate at 4 to 6 percent. That cut the Caterpillar tax bill by $300 million a year. Was that legal? Opinions differ. * * *

What was most notable about the Caterpillar strategy was its sheer lack of creativeness. “This is boring as an intellectual matter,” said Edward D. Kleinbard, a tax law professor at the University of Southern California and a former chief of staff at the congressional Joint Tax Committee. If this strategy is vulnerable to legal challenge, he said, it would largely be because Caterpillar changed its corporate structure to save taxes. Had it had the foresight to adopt the structure decades earlier, the company would be on much safer ground.

Apple, he told me, set up an Irish subsidiary “as soon as it moved out of the garage.” He conceded that was an exaggeration, but not, he said, a large one. Under current corporate tax law, it is easy for multinational companies to park profits in subsidiaries based in low-tax countries. Companies that operate only in the United States find it much harder, although not always impossible, to avoid taxes.

It was interesting that Senator Levin was the only senator who appeared to be exercised over what Caterpillar and PricewaterhouseCoopers had done. “The revenue lost to those strategies increases the tax burden on working families, and it reduces our ability to make investments in education and training, research and development, trade promotion, intellectual property protection, infrastructure, national security and more — investments on which Caterpillar and other U.S. companies depend for their success,” he said. “It is long past time to stop offshore profit shifting and start ensuring that profitable U.S. multinationals meet their U.S. tax obligations.”

Not all the Republicans joined Senator Rand Paul, Republican of Kentucky, in offering an apology to Caterpillar for the existence of the hearing, but they generally agreed that it was proper for a company to do everything it could to avoid paying taxes. None of them seemed interested in the question of who should pay taxes if the companies do not. Nor was there the slightest indication of agreement with Senator Levin that corporate citizens, like individual ones, had an obligation to help pay for their government.

Instead, the preferred cure was to cut the corporate tax rate — now 35 percent, though virtually no multinational company pays anything near that amount. The country must become more competitive in attracting these companies, the senators said.

The current law of the land in America, as I understand it, is that corporations are “people” with constitutionally protected speech. “Money,” moreover, constitutes “speech,” so in spending their money corporations are exercising protected speech, and therefore they can spend their money virtually any way they want without government restraint. Resident “people” do have a legal obligation to pay taxes, but American culture appears to regard tax avoidance as a perfectly understandable, appropriate aspect of legitimate business practice; thus, corporations, whenever they can avoid or circumvent the normal rules of “residence,” legitimately have no obligation to support the operations or infrastructures of nations they inhabit, and whose people they profit from.    

The Shadow Economy

Not everyone sees it that way. The Tax Justice Network (TJN), for example, studies “tax evasion” in “shadow economies” around the world. In its 2011 report (“The Cost of Tax Abuse: a briefing paper on the cost of tax evasion worldwide” (here),  TJN argues that “tax evasion is the illegal non-payment of tax to the government of a jurisdiction to which it is owed by a person, company, trust or other organisation who should be a taxpayer in that place.” TJN estimated the absolute size of a country’s shadow economy, which is the portion of economic activity associated with tax evasion, based upon the country’s own published measure of GDP and recently reported data on the size of shadow economies published by the World Bank:

By the definition used here, economic activity in the shadow economy of a country will be tax-evading. So we next calculate an estimate of the amount of tax lost as a result of the existence of that shadow economy. We do this by looking at how much taxes are on average in the state as a share of GDP, and then apply that same tax share to the shadow economy, to reveal our estimates of lost taxes by state. (p. 2)

On this basis, TJN reported on 145 countries with a total of $61.7 trillion of reported GDP, 98.2% of the world’s total GDP, covering 61.7% of the world’s population. It estimated a world-wide shadow economy of $11.1 trillion which, at an average tax rate as a percent of GDP of 28.1%, resulted in a total tax evasion loss of $3.1 trillion. 

In its table of the ten biggest losers (p. 3) the U.S. ranks first, both in GDP and the size of the shadow economy. Total GDP is reported as $14.6 trillion, the size of the shadow economy is estimated at $1.3 trillion, a the tax revenue lost as a result of the shadow economy is estimated at $337 billion.

Inequality Growth

Corporations are the vehicles of huge incomes. Corporate executives minimize their own tax obligations by arranging corporate payments to them in ways that minimize their effective personal income tax rates. They lobby to create and take full advantage of tax shelters in federal law for the earnings of their corporations and lobby for grants, support payments, and lucrative government contracts. To the extent they can, they “locate” their domestic income in shadow economies overseas to avoid domestic taxation. They negotiate with state governments around the country in a “race to the bottom” to get the most favorable tax treatment they can for themselves and their companies in states in which it is viable for them to locate.

The end result of all of this collective activity is to greatly increase income and wealth inequality, reducing aggregate growth and causing a major decline in the economy of the bottom 99%. Because the collective tax system is regressive — that is it permits substantial transfers of wealth to a small handful of taxpayers at the very top, increasing their net worth by many billions of dollars each year — this is a continuing problem, and it is an accelerating problem with their compounding wealth.

The next post will take a close look at the implications of this trend for the federal budget and the operation of the federal government.

JMH — 4/10/2014 (ed. 4/11/2014)

This entry was posted in - FEATURED POSTS -, - MOST RECENT POSTS -, Decline in America, Economics, Wealth and Income Inequality. Bookmark the permalink.

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