One of the fundamental assumptions about modern statecraft is that the tax system should be progressive. A progressive tax system is one that takes away a greater proportion of income from individuals and households with higher incomes, and a smaller proportion from those individuals and households that have lower incomes. Political debates, particularly in Britain and the United States, focus on what the top rate of income tax should be. The debate often divides on partisan grounds, with one side seeking an increase in tax revenue, and the other seeking to eschew ‘tax cuts for the rich’. In Britain, the tax rate on incomes over £150,000 was increased from 40% to 50%, effective from April 2010, one month before the General Election, and then lowered to 45%, effective from April 2013.
The case for progressive taxation is usually made on fairness. There are four types of fairness under consideration: benefits of government protection, the ability to pay, the marginal utility of money and income inequality.
Benefits of Government Protection
The argument is that taxes are paid for state protection and services, and since people with higher incomes have more to lose, they benefit disproportionately from these protections, and so should pay a disproportionate amount in taxation. Whilst this argument is initially intuitive, the perforation of property rights actually harms all citizens. Firstly, being unable to keep money from voluntary transactions deeply harms those people with no or little property, as they cannot effectively improve their situation. Secondly, having only a little property means that individual is much closer to losing absolutely everything. Thirdly, wealthy and high-income households can use part of their wealth to pay for the services that a government bereft of taxation is unable to, or when the state refuses to uphold its promised protections. Private security can be a major part of expenditure, for both wealthy individuals and corporations. Even public property, such as museums, may be protected by private security guards. According to the Guardian, the oil corporation Shell spent over $383m in three years defending its staff and installations in Nigeria. Fourthly, the argument implicitly assumes that thieves and invading armies seek to rob mostly from wealthy households. The only income distribution a thief cares about is the one going from one person to themselves. The perforation of property rights would not just affect the current allocation of property, but it would also damage the accumulation of property once the state failed to enforce those rights. Property rights benefits everyone within the society that enforces them, not just the already wealthy. These rights also benefit those people with little or no property themselves, as it ensures that the income they do gain legitimately is not taken away.
Moreover, the government is not solely in the business of defending property. It should also defend its citizens in a plethora of other ways, such as protections for individuals against vindictive bodily harm, and to their life. There can no cause for progressive taxation here, as a person with high income is no more deserving of the protection of their life and body, nor gains a disproportionate amount from such protection, than someone with a lower income. To use the phrase held within the United States Declaration of Independence, the costs of defending each citizen’s “life, liberty and the pursuit of happiness” are essentially the same.
Another variant of this argument is that rich people have enjoyed the benefits of our society, and so owe a debt to that society, which must be paid in higher rates of taxation. This extra tax burden must extend beyond the use of roads and other infrastructure, which is usually paid for by user-based taxation, such as vehicle excise duty and fuel duty taxes. If wealth came to these people through illegitimate means, then the state would normally act to take such wealth away in fines. Hence, wealth has usually to come to higher-income individuals through voluntary exchanges, such as the purchase of goods and services that are created and provided by themselves or their companies. These goods and services have undoubtedly improved the lives of their purchasers, since they voluntarily exchanged money for them. It is a strange assertion that a person owes a ‘debt’ to a group of people after using their own time and efforts to create and distribute something those people desire.
Ability to Pay
This argument for progressive taxation states that taxes must be paid, and so taxes should be levied upon the people with the greatest ability to pay such taxes, that is, those individuals and households with the highest incomes. This argument fundamentally misunderstands the method by which government accrues taxes. A government can only set specific rates at which to levy taxation; it does not have complete control over the revenue raised by those taxes. Governments raise taxes from the incomes of individuals, the rolling profits of businesses and the sales of goods and services. The revenue from each of these taxes are dependent are the amount of money that individuals earn, what the profits of each business is in a given year, and how many goods and services are bought and sold by people. These amounts are not pre-ordained, and may change due to the levels of taxation. The argument assumes that the government decides to raise a certain amount of revenue from the economy, and so the government can elect precisely who this taxation falls upon.
Marginal Utility of Money
The next argument relies on the marginal utility of money: taxation is a sacrifice; this sacrifice should be shared equally amongst the citizens. As a person with a high income receives less satisfaction from each extra unit of money than a person with lower income, an equitable sacrifice requires that such taxation be progressive. This argument directly counteracts the first argument made for progressive taxation; taxes are primarily seen as a burden, and not a charge from which specific benefits are derived. Whilst the theory of marginal utility is well-founded, that receiving £1 on top of £1,000 is less satisfying to a person than receiving £1 above £100, progressive taxation is not an immediate consequence. For taxation to be properly based on sacrifice, it would be necessary to know whether receiving £10 or £100 on top of £1,000 produced a similar satisfaction to a further £1 when the person only has £100. Also, it would require that this curve of marginal utility was similar for all citizens. However, there is much variation between human beings – some people prefer to gain more money in order to spend it, others wish to gain more money in order to save it for future expenditure, and others wish to work the hours only necessary for them to fully enjoy their non-working hours. There would be great difficulty in drawing each citizen’s marginal utility curve, as it would change throughout their life, and be based entirely on personal notions of satisfaction. The variation means that the marginal utility curve is subjective, and so cannot form the basis for a taxation system that uniformly applies to all citizens.
One of the most alluring and persistent arguments for progressive taxation is its inherent ability to reduce income inequalities within a society. When Britain and the United States are compared to other countries, the main comparison of inequality is incomes before taxation. These income statistics invariably exclude state subventions and employer benefits, such as health insurance, which is very common in the United States. The exclusions have the effect of greatly exaggerating the differences of the actual well-being of people within each country. The UK government currently spends about £213.6bn on direct transfers to its citizens, meaning that any comparison of incomes before taxation and these transfers is invariably under-reporting the spending capacity of some citizens, whilst over-reporting the spending funds of others. If the well-being of the citizenry is the prime concern, then it is consumption capacity, not income inequality, should be the focus of our attentions. Thus, arguments from income inequality necessarily assume that the higher rates of income taxation on larger earners will generate more tax revenue for the government to distribute to its poorer citizens. Merely taking a disproportionate amount of money from some higher-income individuals does not improve the lives of all citizens.
Rates and Revenues
Beyond the theoretical justifications for progressive taxation, the true test of its validity is the amount of tax revenue it raises, and whether such taxation fulfils its guiding purposes. The main source of taxation in the United Kingdom is the income tax, which collected £152.6bn in the financial year 2011-12, out of £570.4bn total taxes. Income tax represents 26.8% of the British government’s collected taxes. The actions of individuals are not predestined, and so people will react to different tax rates. It may be that greater tax revenues are taken through a lowering of tax rates. John Maynard Keynes said on taxation: “Nor should the argument seem strange that taxation may be so high as to defeat its object, and that, given sufficient time to gather the fruits, a reduction of taxation will run a better chance than an increase of balancing the budget.”
There is much evidence that the higher rate of taxation, usually called the marginal rate of income tax, may be so prohibitive as to actually reduce the total tax revenue. The top 1% of earners in a country usually receives a gravely disproportionate amount of attention from journalists and politicians. In 1979, Chancellor Geoffrey Howe slashed the top rate of income tax from 83% to 60%. Prior to this cut, the top 1% of taxpayers paid only 11% of all income tax. By 1988, this value had grown to 14%. Nigel Lawson further cut the top rate of income tax, from 60% to 40%. By 1997, the share of income tax paid by the top 1% soared to 21%. According to the BBC, this value had escalated again to 24.1% by 2009. The comparison is between statistical categories as opposed to actual human beings, and note that the UK tax system recognised households for taxation before 1999, thereafter it only taxed individuals.
There are four instances in the United States that such reductions in the marginal rate increased the total amount of taxation, and heavier burdens were carried by the upper categories of income earners: the Harding-Coolidge tax cuts, the Kennedy tax cuts, the Reagan tax cuts, and the Bush tax cuts. In first of these tax cuts, American economist Thomas Sowell explains in his booklet “Trickle-Down” Theory and “Tax cuts for the Rich” that during the 1920s, Treasury Secretary Andrew Mellon had sought to lessen the tax burden on households with lower incomes, and thus wanted to gain more tax revenues from America’s rich. A marginal rate of 73% had been justified by World War I, but Congress had also established tax-exempt securities, which were used by rich people to avoid that 73% rate. Secretary Mellon wanted Congress to extinguish what he termed the “evil of tax-exempt securities”, saying that: “It is incredible that that a system of taxation which permits a man with income of $1,000,000 to pay not one cent to support his Government should remain unaltered.” Congress refused, so Mellon then argued a lower marginal rate would be more effective in obtaining revenue. In 1921, the US federal government collected just over $700m in income taxes, of which 30% was paid by people making more than $100,000. Following diminutions in the top rate from 73% in 1921 to 24% in 1929, when the US federal government collected in excess of $1,000m in income taxes, where 65% was paid by those on the highest rate – those people making over $100,000. In 1916, there were 206 individuals declaring an income over $1,000,000. By 1921, there were now just 21 people declaring such an income. By 1925, the population of declared $1,000,000 earners revived to 207.
Despite these facts, reducing marginal rates is repeatedly referred to as ‘tax cuts for the rich’, even though the aim is for ‘the rich’ to bear a greater burden of income tax. Sharply progressive income taxes, with very high marginal rates, appear destructive to the justifications of progressive taxation, namely ensuring taxation is mostly paid by the higher earners within society. There is little disagreement over whether there should be a progressive tax system, as even the flat tax proposal is actually a progressive tax – there are two tiers, with one tier of income at a 0% tax. Income taxes, however, are only one facet of the British tax system, and ‘sin taxes’, such as the duties on tobacco and alcohol, are regressive in nature. National insurance, a second income tax, is also deeply regressive. It is questionable that, overall, the British tax system is truly progressive. Flatter taxes, with a more grounded upper rate, would be simpler and be capable of increasing tax revenue. An elevated marginal rate may have so few people paying it that it becomes merely symbolic. If taxes truly are a burden, then the hollow gestures of super taxes actually necessitate even heavier taxation on individuals and households lower down the pay scale. Since sharply progressive taxes are often defended on the basis of reducing income inequality, the advocacy and opposition of these taxes are now fought over the very purposes of government.