Millionaires and the Income Tax

Two recent stories are interesting as they relate to tax system design issues. How progressive should an income tax be? How does the distribution of income play into this? These questions come up in discussions about what to do with the expiring federal tax rate reductions, whether high state income tax rates drive out millionaires, and how a rate structure affects stability/volatility of the tax system.

An article in the March 26 Wall Street Journal - "The Price of Taxing the Rich" by Robert Frank, includes a description of a California tax problem and the person who used to work for the Legislative Analyst's Office who highlighted it - Brad Williams. He observed that the California personal income tax was volatile because of the nature of the income derived by the high income individuals who were paying most of the tax.

Per the article: "By the late 1990s, Mr. Williams realized that his job had changed. California's future was no longer tied to the broader economy, but to a small group of ultra-earners. To predict the state's revenue, he had to start forecasting the fortunes of the rich. That meant forecasting the performance of stocks—specifically, a handful of high-tech stocks."

Back in the time of the hearings of the Commission on the 21st Century Economy (COTCE), several people commented that it was ok that California's income tax was volatile because it was just tracking the economy. I don't agree with that. I think the structure - with so much collected by a small number of very high income individuals, is too unstable making it difficult for elected officials to balance the budget. Also, the incomes of high income individuals could go down for reasons that do not necessarily mean that California's expenses will decrease.

One solution is to bring more people into the income tax paying system. California did this by lowering the dependency exemption by about 75%. This likely was not the best approach given the weak economy - making low and middle income families pay more income tax. But it happened with what seems to me to be little attention or concern by the larger public.

Another solution would be for a portion of income tax collected to go into a Rainy Day Fund.

Another solution would be to broaden the base of the sales tax to bring in personal services, entertainment and digital items, much of which is consumed tax-free today by higher income individuals. I have written about these topics before - here.

Well, back to the recent articles. The WSJ article notes that some people advocate a flatter rate structure to reduce the volatility of a personal income tax, while others say that is just a tax cut for high income and a tax increase for lower income. That seems obvious. But, can some of the volatility be reduced and a regressive tax reduced by broadening the sales tax base, lowering the sales tax rate and flattening some of the personal income tax, such as what California partly did when it reduced the dependency exemption amounts? It would be interesting to see an analysis of this.

Another design consideration is how progressive the rate structure should be? President Obama has been using $200,000 (single) and $250,000 (married) as the amounts that distinguish the wealthy who don't warrant tax cuts and others who warrant tax cuts. He has also acknowledged that this means that 98% of individuals warrant tax cuts. Within the 2% wealthy group, there is wide disparity of income. An individual making $200,000 is able to live well in any US city and pay taxes. But compared to someone making $1,000,000 or more, these individuals are in much different lifestyles yet could have the same marginal tax rate. Of course, if the higher income individual has mostly capital gain income, at the federal level, that today has a 15% rate rather than a 35% rate on ordinary income.

I'd like to see discussion of whether an income tax rate structure should not lump all of the 2% into the same rate structure, but provide some progressive rates within this group.

Another point that often arises at the state level of taxing the rich is that they will leave the state. That brings up the second recent article on taxing millionaires. This one is from the Huffington Post - "The Millionaire Migration Myth: Don't Fall for This Anti-Tax Scare Tactic" by Carl Davis (3/31/11). The author, a senior analyst with the Institute on Taxation and Economic Policy, notes that this is a myth. He states that often data on decline in millionaires is not that they left the state, but that their income dropped.

He states: "once you scratch the surface of the millionaire migration issue, it becomes abundantly clear that the anti-tax side's claims have no substance. It's long past time to stop letting the millionaire migration myth get in the way of progressive tax reform."

But, myth or not, taxing that group is no reason alone to tax them more. This all needs to be considered within the context of the entire tax structure - whether federal or state. If we look solely at the state income tax and decide to generate revenue by increasing the income tax rate on the highest earners, we miss the opportunity to consider the entire structure and how it all can best meet principles of good tax policy. For example, in California to continue to ignore the very regressive sales tax (with its very high rate and narrow base that exempts a lot of consumption of high income individuals) is a problem. At the federal level to ignore a debate on capital gains rate structure and the Social Security tax (which is the biggest tax expense for many individuals) and focus only on the ordinary income tax rates, misses an opportunity to look at the entire tax structure.

There is a lot to learn from looking at the distribution and range of income levels, what taxes these income groups pay and how improvements can be made to address regressivity, increase equity and not harm economic growth.

What do you think?