The Increasingly Risky Federal Income Tax Portfolio

Many people are aware that over the years upper-income people have been paying an increasingly large share of federal income taxes. One consideration is determining someone’s “fair share” of the tax burden. For example, (all data taken from this web site), in 1980 the top 1% of income earners paid 19% of all income taxes. By 2007 the top 1% paid more than 40% of all income taxes.

Similarly, the top 5% of income earners paid 37% of all income taxes in 1980, and 61% in 2007. The top 25% paid 73% of all income tax payments in 1980 and 87% in 2007.

I will leave it to others to decide if these tax shares are fair. Another concern, which I will set aside for the moment, is that if a minority of taxpayers are paying virtually all taxes (the bottom 50% paid less than 3% of all federal income tax payments), it’s easy for the majority at the bottom end of the income distribution to want more federal spending, because other people will be paying for it.

Something I haven’t seen discussed is that incomes at the upper end of the income distribution tend to be more volatile. Wages don’t fluctuate as much as investment returns, bonuses, commissions, and so forth that make up a larger share of the incomes of upper-income people. So, as we increasingly move toward taxing the rich, the tax portfolio of Uncle Sam becomes increasingly volatile.

While the Obama administration is interested in taxing high-income people more, such a move will make the tax system increasingly dependent on the condition of the economy. When high-income people are taxed more, tax revenues will go up more in a boom than they would with a tax system that spread the burden out more, and will decline more when the economy is sluggish, as it is now.

Many of President Obama’s policy proposals would have negative impacts on economic growth, ranging from his health care initiatives (partially passed this year), his energy policies (which face an uphill battle at the moment), his redistributional policies (including the extension of unemployment benefits), and his regulatory initiatives (such as the recently-passed financial regulations). Setting aside whether they are in any larger sense desirable policies, one thing they will do is reduce tax revenues by more than if the tax burden were more evenly shared.

As the president proposes placing an even larger share of the income tax burden on upper-income Americans, this, in concert with his other policies, will have a negative impact on aggregate revenues collected. The president claims to be concerned about the looming future deficits, but his policy proposals suggest otherwise.

Back in 1980, when the top 1% of income earners paid 19% of total income taxes, the highest marginal income tax rate was 70%. Now, the highest rate is 35%, and the share of taxes paid by the top 1% is more than double what it was in 1980. Higher tax rates on upper-income taxpayers don’t necessarily bring in more revenue.

Tax volatility like this has been referred to as an “automatic stabilizer,” designed to slow the economy down as it grows, and stimulate it during downturns (with “automatic” tax reductions). If the economy starts to recover, do we really want to slow that recovery down? And on the other side, it should be obvious that increasing tax rates won’t “stabilize” a sluggish economy.

There are many reasons I have seen mentioned to oppose the tax increases President Obama proposes as the Bush tax cuts expire at the end of 2010. One I haven’t seen mentioned is the increased volatility this would induce in aggregate income tax revenues.