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Taxes Rates, Tax Brackets, and Thompson
Republican Presidential candidate Fred Thompson earlier this week announced his detailed plan for partially overhauling the federal income tax. His proposal, among other innovations, would allow taxpayers to choose to calculate their federal income tax liability either with the current, six-tier, progressive schedule or with a simplified, two-tier schedule. Incorrectly described by many publicationsincluding USA Today
, The Wall Street Journal
, and the Boston Globe
as a "flat" tax, Thompson's plan would primarily and quite simply reduce the number of tax brackets from the current six to two and drop the highest marginal tax rate on personal income from the current 35 percent to 25 percent.
Although this would, in essence, "flatten" the progressive tiering of the U.S. federal income tax, it is not in any way a proposal to create a "flat" tax; it is, instead, a proposal to move the federal income tax to a straight proportional tax, similar to the sales taxes most states and municipalities impose on purchases of goods and some services.
Technically speaking, a "flat" tax is an absolute amount of money imposed on a transaction: fees for driver's licenses, automobile license plates, hunting and fishing licenses are all examples of flat taxes; so, too, in a broad sense, are traffic fines and other punitive fees.
The term "flat" tax is widely and incorrectly used interchangeably with what is properly termed a "proportional" tax, which is an additional fee or charge calculated as a percentage of monetary consideration transferred in an exchange. Sales taxes are "proportional" because they are calculated as a percentage of a sale. Many municipalities have proportional city income taxes since these taxes are very often assessed as a percentage of taxable income.
The federal income tax is neither proportional nor flat; it is, instead, "progressive" because, as taxable income increases, the percentage of tax assessed on the last dollar of that income increases. Each range of income that is subject to a particular tax rate in the structure is called a "tax bracket." The graphic below, drawn from data available at the Tax Foundation
, illustrates how the number of brackets has varied over the years, reaching remarkable highs of no fewer than 56 in the years 1918 through 1921, 55 in 1932 and 1933, and 50 in 1922 and 1923.
The illustration above clearly indicates that, while the number of tax brackets has varied considerably over the years, there has been a clear, downward trend over the past half-century or so, essentially meaning that the federal income tax, while still progressive overall, has become a proportional tax over much broader ranges of taxable income.
The highest rate at which any given taxpayer's taxable income is taxed in a progressive tax regime is called the "marginal tax rate" for that taxpayer. In the United States, the top marginal tax rate (the highest tax rate at which anyone's income could be taxed) has varied over time. Although the tax system can be fiendishly difficult to describe in numerical summaryespecially with an alternative minimum tax and allowance for different categories of taxpayers, like "heads of household," "married filing jointly," etc.overall, the highest top marginal tax rate the United States ever had was 94 percent during the last two years of World War II. Almost as high was the top marginal tax rate of 92 percent in 1952 and 1953 (again, notably, war years); and the entire period from 1946 to 1963, except for '52 and '53, was marked by a 91 percent top marginal tax rate. The graph below, again drawn from data available at the Tax Foundation
, shows the ups and downs of the top marginal tax rate from 1913, when the uniform federal income tax in its modern form came into existence, through the current year, 2007.
From the graph above, it is clear that the mid-1960s marked the beginning of what would prove to be a long-term, downward trend in the top marginal tax rate, which reached its modern nadir at the very end of the Reagan Administration, when the rate bottomed out at 28 percent. By 1991, during the Administration of George H.W. Bush, it recovered back to 31 percent, and two years later, in 1993, it rose to 39.6 percent, where it stayed until 2001, when tax policy of the George W. Bush Administration and the Republican majority in Congress would resume the long-term downward trend of the top marginal tax rate. As of now, for 2007, the top marginal tax rate stands at 35 percent and will probably remain there for 2008 unless Congress crafts a tax cut for fiscal stimulus because of current economic conditions; but, while the Bush Administration is pressuring Congress to make permanent the tax cuts of 2001
that set in motion the current tax rates, projections of actual tax rates beyond the current year are speculative, at best. Even though the tax cut proposal by Republican candidate Fred Thompson is consistent with the historical trends of both fewer tax brackets and falling top marginal tax rates, the prospect of removing so much potential tax revenue from the U.S. Treasury would face considerable resistance by a Congress likely to remain in Democratic control for the next several years: budget deficits have unambiguously attended lower top marginal tax rates. This can be seen by comparing the chart below, which shows annual federal budget deficits and surpluses from 1962 to 2006, calculated from data made available by the Financial Management Service
of the United States Department of the Treasury, with top marginal tax rates for the same time period, as depicted in the graph above.
In fact, the congressional Joint Committee on Taxation
earlier this year estimated that a plan with major components of a tax regime similar to Mr. Thompson's would create a net loss to the United States Treasury over ten years of about $2.5 trillion. Thompson dismisses such a dire prediction on the usual supply-side economics grounds that his tax cuts would stimulate economic growth and that projections of federal tax revenue losses from tax cuts are often proven in retrospect to have been over-estimated. The graphics presented herein challenge his representation that tax cuts do not exacerbate federal revenue shortfalls.
Mr. Thompson may actually believe the next President of the United States should further erode the ability of the government to pay for its expenditures, thereby compelling the nation to continue borrowing hundreds of billions of dollars every year from foreign interests; otherwise, he may merely be pandering, as so many Republican politicians have for the past three decades, to an apparently insatiable, desperate need for more and more "tax relief" within the ranks of the nation's voters, or at least within the ranks of those who contribute generously to Republican politicians. In either case, Mr. Thompson is rendering evidence that he is not only a strong contender to carry the banner of the Republican Party into the general election of 2008, but also a complete imbecile. That, of course, is a redundancy of qualifications and qualities.
The Dark Wraith will, however, allow voters to make up their own minds as to whether or not they can afford yet another imbecile to occupy the White House so soon.
DW, Please reconsider your decision to allow voters this much leeway again. They're like Michael Jackson; bankrupt, but still buying more monkeys!
With Bill Clinton's two terms showing higher marginal tax rates, I wonder how much the Internet Boom contributed to surpluses, and how lower marginal rate would have affected this.
DW, I could not help but notice that in your third graph, you appear to have used nominal dollar amounts. Perhaps you inflation adjusted the values, and simply neglected to mention doing so. I am not disagreeing with any of your conclusions, but it seems unlike you to use data that is not truly relevant. It would also be interesting to note the trend in deficits/surpluses as a percentage of GDP.
Good morning, Dex.
Actually, the purpose of that third graph was not to show the surpluses and deficits in and of themselves, but rather to qualitatively coordinate the incurrence of surpluses and deficits with top marginal tax rates.
I consider a comprehensive analysis of the relationship between federal surpluses/deficits and marginal tax rates an essential project, and I know very well from working on it that all kinds of difficulties are waiting for me as soon as I start taking erosion of purchasing power into account. First and foremost, while I recognize that virtually no other economist is at all troubled by the matter, I consider the Bureau of Labor Statistics data on inflation to be so tainted by statistical manipulation as to be entirely useless. Speaking from my training as an econometrician, that data manipulation—which has been going on for a number of years, now—renders any results using the data "biased, inconsistent, and inefficient," to use the terminology of econometricians to describe estimators generated from manipulated statistics.
Ignoring for a moment that great big allosaurus sitting in the living room, I can, of course, move into the kitchen and start cooking up some results using the tainted inflation data, and I shall, in the end, actually do this. However, let us consider for a moment what adjustments I should make. If I adjust each year's GDP, I should probably do so using the so-called "GDP deflator"; but that leaves me with the question of what statistic I should use to adjust a given year's deficit or surplus: Should I use the GDP deflator for the year, or should I perhaps use the consumer price index? The CPI would be a poor choice, since government inflows and outflows are affected quite a bit differently by purchasing power erosion than are consumer equivalents (since few households buy things like battleships and occupation forces). The producer price index doesn't give me much comfort, either, since the government doesn't buy at wholesale.
On the other hand, if I were to use the GDP deflator to adjust surpluses and deficits (problematic as that is), and if I were to use the same GDP deflator to adjust GDP, I wouldn't need to use the GDP deflator at all if I were to be calculating deficits and surpluses as a percentage of the incumbent year's GDP, since I'd be using the same deflator in the numerator and denominator, which means they'd be canceling each other out, anyway!
And the problems get brutally weirder when deeper monetary policy effects come into play: they can create what are essentially data "waves" in GDP versus deficits/surpluses (and I'm not even going to try to explain right now what I mean by that, but it's an effect that can make results look really strange unless correction is made for its incidence, which is perniciously not constant through time because of gathering and slackening market elasticities to monetary policy regimes).
You are obviously correct, Dex, to the point that I need to publish a comprehensive analysis of federal deficits and surpluses. It's just that doing such a thing is a whole lot like work, and I prefer to just stare at the project and say to myself, "Yup, I need to get that done."
The Dark Wraith will, of course, get it done.
Good afternoon, Dex.
I have decided I'm going to put some muscle into preparing a fairly short article to publish either late tonight or tomorrow. I will include a graphic showing surpluses and deficits as a percent of GDP, although I'm almost sure that, no matter what I do, I'm going to have some hoehandles publish blog articles assailing my inflation adjustment methodologies.
Whatever. I'm going to try a multivariate regression using lags—at the very least, a one-year lag—to see what happens, but I don't like the lack of data with which I'm working: the deficits have what I'm pretty sure could be characterized as an AR time-series feature because of the way past deficits affect current deficits by way of interest on cumulative national debt. Furthermore, there's quite possibly more than just an auto-regressive behavior: if it's not just the level of the top tax rate, but also the expected stability of it that affects financial planning enough to have a meaningful impact on tax revenues, then this could be more properly modeled, as far as time-series goes, as an ARIMA.
The Dark Wraith should stay light years away from trying to satisfy his intellectual curiosity.
The Dark Wraith should stay light years away from trying to satisfy his intellectual curiosity.
Every so often I get it into my head that I want to study Elvish
. Then after a while I always feel that way, too.
In an unrelated story, yesterday I found this blog:
through Mr Weaseldog. It pretty much blew my mind with how good it is. Perhaps you'll consider adding it to your blogroll.
Good Afternoon, Dark Wraith.
Thank you for this explanation of the mess that is the United States tax code. While reading it, I was reminded of a scene in one of Tom Clancy's books, wherein the Secretary of the Treasury nominee has the entire tax code piled onto a table, causing the piece of massive oak furniture to collapse under the weight. My feelings, as I read through your article, were similar to those of the table - though by the end, I do believe I had a better grasp of the truth of the matter than I did when I began reading.
I am not, nor ever have been, an econometrician (although I have dabbled in house wiring... wait, that's different, isn't it), but my not-so-common sense has always told me that Gummint economic pronouncements are "biased, inconsistent, and inefficient," not to mention a complete load of male bovine excrement. And yet the myths they promote hold power over us all.
Thanks again for edumacating this old dog.
Every so often I get it into my head that I want to study Elvish.
I'm sure there's a place somewhere in 'Vegas that will teach people how to be more Elvish. How to pick out the right shades, get the hair just right, and karate moves while singing.
Let's begin: "Thank yewveramuch." Now repeat.
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