Taxing "The Rich:" Theory v. Practice

This article is from Stone Street Advisors

In 2001, Peter Orszag and Joseph Stiglitz published a short paper wherein they concluded:

...if anything, tax increases on higher-income families are the least damaging mechanism for closing state fiscal deficits in the short run. Reductions in government spending on goods and services, or reductions in transfer payments to lower-income families, are likely to be more damaging to the economy in the short run than tax increases focused on higher-income families.

This is all fine and dandy in the ivory tower (or the White House, as it were to be less than a decade later), but in the realm of reality, theories only get us so far, no matter how seemingly reasonable their basis and underlying assumptions.

Today's WSJ included an essay about the state of The State of California, specifically, its incredible reliance on the very-rich (top 1% +).  Many if not most commentators/politicians/etc seem to think that taxing "the rich" at a (vastly) higher rate than everyone else - especially "the poor" - not only makes perfect sense, but is more than "fair," given the increasingly high % of income accruing to "the rich."  This is all fine and dandy, except:

Nearly half of California's income taxes before the recession came from the top 1% of earners: households that took in more than $490,000 a year. High earners, it turns out, have especially volatile incomes—their earnings fell by more than twice as much as the rest of the population's during the recession. When they crashed, they took California's finances down with them.

The problem with the "fair and equitable" approach is that populism often ignores fundamental economic and financial reality.  In this case, that many of those who make more than the magical ~$500,000 per year do so not from a base-salary, but from bonuses and capital gains, neither of which are very stable, let alone predictable with any real certainty.

The bigger problem is that it's not just California that's significantly dependent upon income taxes from "the rich."  It's New Jersey, New York, Connecticut, Vermont and Illinois, and to a lesser extent, several other populous, economically important states as well.

State income taxes are generally less progressive than federal income taxes, and more than a half-dozen states have no income tax. Yet a number of states have recently hiked taxes on the top earners to raise revenue during the recession. New York, for instance, imposed a "millionaire's tax" in 2009 on those earning $500,000 or more, although the tax is expected to expire at the end of 2011. Connecticut's top income-tax rate has crept up to 6.5% from 4.5% in 2002, while Oregon raised the top tax rate to 11% from 9% for filers with income of more than $500,000.

According to Orszag and Stiglitz, such tax increases for "the rich" were a political and economic no-brainer.  The subjects of these tax increases can afford to borrow money and/or dip into savings to keep-up their pre-tax-increase level of consumption, while those at the other end of the income spectrum spend (virtually) every last $ of income -including if not entirely consisting of government transfer payments - saving little, if anything.  No brainer!

Except, such "analysis" only makes sense in vacuo; When "the rich" become less-so, in a tax regime dependent upon them, it's not just the rich who suffer.

The take-away is that States can't have their proverbial cake & eat it, too.  In times of economic and financial distress, they can jack-up taxes on "the rich," to their hearts' content, but they cannot do so without consequence.  States prosper when the fortunes of "the rich" increase and share in the pain when they decrease.

It seems States not only stick to Orszag & Stiglitz' suggestions, but they seem intent on steadfastly embracing them to the very-end.  Surely, when a State is already over-dependent upon tax receipts from "the rich," the solution is to...increase such taxes even more, right?  Where does it end, though? Round II?  Round III?  Never?

Eventually, "the rich" are going to wise-up and tell the states to piss off, whether by severely decreasing their contributions to Democrats, moving to a lower or no-income tax state, etc.  We're seeing the beginning of this in New York, where many financial employees who made substantial donations to the Democrats are having starting to have second thoughts.  Caterpillar's CEO sent a note to Illinois' Governor last week about the possibility of moving the company to another lower-tax state.

How this will play-out is anybody's guess, but I think inevitably, at least one state (perhaps Illinois or California) is going to be home to an ugly income/tax inequality battle the likes of which haven't been seen in the U.S. for decades if not centuries.


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