I just heard the sound bite again on a Sunday morning talk show: “The wealthiest Minnesotans pay only 9 percent of their income in state and local taxes while middle-income wage-earners pay 12 percent.”
Those numbers are accurate. They come right out of the Minnesota Tax Incidence Study, a biennial report of who pays how much in state and local taxes. And the Minnesota report even earns the kudos of center-right economists for its intellectual rigor and clear statement of assumptions and limits — a rigor and integrity lacking, however, when tax burden percentages are tossed out as disembodied “facts.”
Among many relevant but ignored economic issues affecting interpretation of the Tax Incidence Study, three stand out.
First, the Tax Incidence Study is a snapshot of income distribution at a specific point in time and does not consider the significant changes in income that occur over a person’s lifetime. Consequently, the study implies more income inequality than is reality over a person’s working life.
A report provided by the U.S. Treasury Department found that more than 50 percent of taxpayers were in a different tax bracket (higher or lower) at the end of a 10-year study period than at its beginning. Although an insignificant percentage in the lowest tax bracket made it to the top bracket in just 10 years, only 33 percent remained in the lowest bracket — and 32 percent elevated themselves to the 15 percent tax bracket.
Likewise, a small percentage of those who in Year 1 were in the 28 percent tax bracket and above dropped to the lowest income levels. However, after 10 years, a significant percentage of once upper-income earners were in the 25 percent, or middle income, tax bracket. Over the 10-year timeframe, income levels trended toward the middle-income tax brackets.
Discounting income mobility ignores the impact of taxes on the ability of people to both pay back debt they incurred in low-income-earning years and save for later, low-income-earning years. Legislating people into a higher tax bracket punishes education, saving and upward mobility.
Take the case (reported by Yahoo News) of Van Moore, who graduated from optometry school $150,000 in debt. His first job brought in less than $20,000 a year. Then he made $50,000 for several years, all the while paying on his student loan, which still carries a balance. Now he is making just above $250,000, the arbitrary dividing line between “the rich” and the rest of us. A higher tax penalizes Moore for borrowing money in his low-income years to educate himself so he could earn more in the future.
A second misuse of the Tax Incidence Study is making it a barometer of “ability to pay.” The measure of income is very important to creation of a meaningful tax incidence study. The Minnesota study uses Federal Gross Income as its measure of income because the law requires that it use “the broadest measure of income available.” Using a broad-based definition of income and a narrow definition of tax liability skews the study findings to appear more regressive than the tax system actually is.
My colleague at the Minnesota Free Market Institute, economist King Banaian, suggests two ways to eliminate that problem. One could deduct federal tax payments from federal gross income, or one could calculate the tax incidence including federal taxes paid (neither technique currently allowed by the state law mandating the Tax Incidence Study). The law notwithstanding, the combined federal, state and local tax system is progressive. The Congressional Budget office calculates the effective federal tax rate is only 4.3 percent on taxpayers in the bottom 20 percent of income earners, but 25.8 percent on taxpayers in the top 20 percent of income earners.
A third issue: Even accepting “fairness” as the overriding objective, the progressive solution of higher state income taxes actually increases, not decreases, the pre-tax income gap.
“Fairness” in the perfect progressive world means middle- and upper-income earners each pay 12 percent of their incomes in state and local taxes. Of course, some rich guy paying 12 percent doesn’t reduce the out-of-pocket tax burden on a middle-income person, but progressives aren’t talking effective taxation; they’re talking “fairness.” Here’s what really happens.
A uniquely skilled individual commanding a high salary can work just about anywhere he chooses. The mobile worker, the kind who pays the most taxes, will gravitate to where his net income, not gross income, is highest. To lure and keep highly productive individuals in Minnesota, Minnesota employers, including school districts looking for superintendents and universities seeking nationally known professors, must pay higher gross salaries to compete with low-tax states.
Higher salaries for those already earning top dollar don’t just increase the salary gap; they contribute to higher consumer prices and lower wages for non-mobile workers — the rest of us. When a company pays top-earners more to compensate for high tax rates, it means fewer dollars available to pay the rest of a company’s employees, further increasing the real wage gap irrespective of what the Tax Incidence percentages indicate. Is that really “fair”?
Bottom line, there are tradeoffs between a tax system based on economic principle, tax burden and efficiency objectives and a tax system motivated by distributional effects and equity objectives.
The public would be better served understanding and debating those tradeoffs than by class-baiting Sunday morning sound bites.
Craig Westover is a contributing columnist to the Pioneer Press Opinion Page and a senior policy fellow at the Minnesota Free Market Institute (mnfmi.org). His e-mail address is westover4@yahoo.com.
This commentary originally appeared in the St. Paul Pioneer Press, Friday April 24. 2009.
[...] I noted in a recent Pioneer Press column [...]