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Diminishing Marginal Tax Sensibilities

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It's the one year anniversary of the Occupy Wall Street movement, and so it seems like a good time to revisit the old issue of tax policy, wealth redistribution, and everyone paying their "fair share," whatever the hell that is.

The first concept everyone needs to be aware of for creating a sensible tax policy (and just in general, because it's an important concept) is diminishing marginal utility. Long story short, the more you have of something the less valuable the next unit of that thing is. If you're really hungry and I give you a hotdog, that hotdog is going to be really satisfying. If I give you a second it might be good, but not as good as getting the first was. If I give you a third you're going to start feeling quite full and derive little pleasure if any, and by the time I force the fourth down your throat you're going to be sick and yacking hotdog all over the other guests at the picnic.

Same goes for money. The first $20,000 you earn goes to paying rent and basic utilities. The next $20,000 gets you into a less dangerous neighborhood, basic cable, and some fresh produce every once in a while. The next $20,000 (taking you from $40k to $60k) buys you an upgrade to your car and the start of some retirement savings. Going from $1,000,000 to $1,020,000 buys you less value than that second hotdog. This value is what econ types call "utility."

Utility is important because money is just an intermediate step. Money has no value on its own, and is only valuable for the utility it gives. Now let's set that concept aside for a moment and look at one of the more popular tax reforms being proposed.

The flat tax would give everyone the same tax rate, say 20%. Proponents consider it fair because everyone is taxed at the same rate, and that sameness makes it "fair." And in their defense, proponents of the flat tax do typically include a standard deduction, somewhere in the $30,000 ballpark, so that the very poor don't pay anything, and the tax is slightly progressive. As you can probably figure out though, if the burden on the very wealthy drops and the burden on the very poor drops, it's the people in the middle who are left holding the check. Suddenly this doesn't seem quite so fair.

And the reason it doesn't seem fair is diminishing marginal utility. Being taxed 20% hurts someone earning $60,000 a whole lot more than someone earning $600,000 and the person earning $6,000,000 probably sees no drop in standard of living at all. They're paying the same rate of dollars, but very different rates of utility. The $60k earner may be losing 10% of all his utility, the $600k earner perhaps 1% and the $6000k earner loses somewhere in the realm of 0.0001% of his total utility. Thus the tax is only flat in terms of percentages of dollars, but not in terms of actual lost value.

 

Before deciding what would be a fair rate, we also need to consider that the federal government's taxing and spending tend to fall into one of two purposes. The first is simply that the country has bills to pay and someone has to pay them. We need roads and a military and the post office, and then are left to answer who should pay for these things. The second purpose is wealth redistribution and social welfare.

The big tickets on the social welfare side are Medicare, Medicaid, and Social Security, which account for 43% of the national budget. There are some other social redistributive type things elsewhere, but the bulk of the remaining 57% is in the first camp of regular type bills to pay.

The top 10% of earners pay 50% of federal taxes. The next 10% pay another 15.3%. The bottom 10% pay 1.1% of taxes. The 11-20th% pick up another 5%, and the 21-60% range pay 9.6%. The bottom 60% are paying a total of 15.7%.

The leadership of the Republican party would argue that the rich are paying far more than their fair share. They're paying 500% of their share, while the bottom 60% are paying only 26% of their share. And those Massachusetts Obama Socialists want to raise their taxes!

Applying what we know about diminishing marginal utility though, we can see that this argument has little merit. The very rich pay almost nothing in terms of lost utility while the middle and lower-middle class are getting gouged. A sensible tax policy would have the rich (the top 20%) paying all of our non-redistributive bills. That's the top 20% picking up 57% of the budget that isn't Medicare, Medicaid, and Social Security. On top of that, they also have to pay their share of the redistributive bills, which is another 8.6% of the budget.

Now we get in to the part that's actually controversial. How much more of the redistributive bill should the top 20% pick up? This is certainly ripe grounds for debate, and without the computing power of the CBO it's hard to tell where exactly to draw the line, but it seems sensible to say that the poor ought not to be the ones funding the poor tax. If they had the money to fund social welfare programs they wouldn't need the social welfare programs. If we call the poor the bottom 20% and hand off their share of the burden to the top 20%, the top 20% are now paying a total of 74.2% of taxes. That might seem insane of terms of GOPish "fairness," but it's rather hard to argue against if the question is "how much is this hurting you?" It's hurting the wealthy almost not at all.

On the other hand, we can look at who's gaining under the system. We have shifted an extra 8.9% of the federal budget onto the shoulders of the top 20%. With this amount we can eliminate all taxes for the bottom 20% (6.1%) and still have some left over for the upper-lower and middle classes. The remaining 2.8% would reduce the tax burden of the 21-60% range by 29.2% (2.8 divided by 9.6, if you didn't follow that math).

The poor see their already minimal tax burden eliminated, and the upper-lower and middle class see their taxes drop by about a third.

You may recall hearing on the news that even if we taxed the rich at a 100% rate we still couldn't pay our bills. That's because the rich were defined as just the very top 1%, and those claims looked just at earned income, and not capital gains which is the bulk of their income. But what would this tax policy mean for the bills of the rich? Do they even have enough money to pay?

Currently, the top 20% pay around 25% of their total income to the federal government. This model would increase their burden by 13.6% ((74.2-65.3)/65.3, again if you don't get the math). The top 20% would instead have to pay about 28.4% of their income to the federal government, far short of the doomsday 100% rate. And just to be clear, that a 28.4% effective rate, not the marginal rate.

 

Class warfare! Socialism! Right?

No.

The policy isn't derived from a desire to screw the rich or to make everyone have equal incomes. The policy comes from two principles. First, that non-redistributive bills should be paid in a manner which causes the least total loss of utility to the country. We have roads to build and it just makes sense to take the money from someone for whom the money is an abstract concept his accountant informs him of every quarter rather than the person who without that money can't pay to fix his car or take the kids out to a movie once a month. We have bills to pay, and we're paying them in the way that causes the least total collective harm. The second principle is just that the top 20% should pay the redistributive share of the bottom 20%, and yeah, that is a bit socialist, but an extremely weak form of socialism that people in a decent society should be ashamed to argue against.

Also, putting all that extra money into the hands of the poor and middle class would stimulate the fuck out of the economy. So there's that.

[Read more from The Robot Pimp]


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