Higher Taxes, Lower Pre-Tax Incomes?

In Wednesday's post, I debunked Beale's Law. Beale's Law reflects the pseudo-scientific economush advocated by the political left and political right. It provides that "income inequality levels inversely track the top tax rate--as the rate increases, income inequality decreases." Sounds like physics, right? But a close look at the numbers demonstrates that income inequality levels do not track "inversely" to the tax rate.

I'm not picking on Professor Beale. She is a bombastic advocate on behalf of the political left, which provides some counterweight to her counterparts on the political right. When it comes to data manipulation for political purposes, the right and the left are engaged in a long-running tug of war. They both abuse statistics and economic common sense to influence public opinion in the short term. It's great sport for incumbent politicians, blogging left-wing academics and Washington lobbyists. Not so great for the country in the long run.

As I said on Wednesday, this is all about political expedience: fitting complex economic issues into a simple box for widespread consumption by the relatively unsophisticated masses. But enough on data manipulation. One more question about Beale's Law while the topic is fresh.

Pre-Tax Income vs After-Tax Wealth

Beale's Law posits that income inequality is inverse to tax rates. Imagine that we plot a curve with the pre-tax incomes of the lowest-earning taxpayers on the bottom left, and the highest-earning taxpayers on the top right. Beale's Law predicts that, when top tax rates are high, the curve will "flatten out." Conversely, when top tax rates are low, the curve will "steepen up." Put another way, the difference between the pre-tax incomes of the top 400 taxpayers and the bottom 400 taxpayers should decrease as tax rates increase. And vice versa.

My last post demonstrated that Beale's Law doesn't apply in the real world. It reflects ideological and political wishful thinking, not an interpolation of real-world data. However, I remain puzzled by the logic underlying the pseudo-science. Specifically, I find it puzzling that the political left attempts to link the pre-tax income gap to the top tax rate.

The data indicate that we have a pre-tax income gap and an after-tax wealth gap in our country. I follow that increasing tax rates may "flatten" the after-tax wealth gap. If we taxed the highest-earning taxpayers at 90% marginal rates, we would diminish their ability to accumulate wealth.

In response, many of those individuals would ramp up tax sheltering activity -- shifting taxable income into non-taxable perks, relocating to lower-tax jurisdictions, etc. Longer term, such a policy would drain the wealth controlled by the richest Americans. We wouldn't necessarily observe a "redistribution" of wealth. There is no reason to expect an increase the wealth of the bottom 50% of taxpayers or bottom 400 individuals. But the curve plotting the difference between the top 400 wealthiest individuals and the bottom 400 individuals would likely flatten over time, because the wealthiest individuals would become less wealthy and/or relocate to lower-tax jurisdictions.

The fact that we could flatten the after-tax wealth gap does not mean that we could also flatten the pre-tax income gap. In 2010, LeBron James, Chris Bosh and Dwayne Wade signed $100+ million, six-year contracts with the Miami Heat basketball team. If the top tax rate were, say, 70%, would we expect that James, Bosh and Wade would have signed for less money? Or is the theory that higher tax rates at the top would support higher government spending and thus "trickle up" into higher wage rates across the board?

It's very difficult to identify any logical nexus between higher top tax rates and lower pre-tax income inequality. But no surprise -- as noted, Beale's Law is ultimately about ideological and political wishful thinking.

Buffett on Taxes ... Again

For the umpteenth time, Warren Buffett has petitioned Congress to raise tax rates on "millionaires and billionaires."

In a New York Times editorial published August 14, Buffett makes the following recommendation to Congress:

I would leave rates for 99.7 percent of taxpayers unchanged and continue the current 2-percentage-point reduction in the employee contribution to the payroll tax. This cut helps the poor and the middle class, who need every break they can get.

But for those making more than $1 million — there were 236,883 such households in 2009 — I would raise rates immediately on taxable income in excess of $1 million, including, of course, dividends and capital gains. And for those who make $10 million or more — there were 8,274 in 2009 — I would suggest an additional increase in rate.

I'm weary of Buffett's lectures on tax policy. One week, he lectures Congress to raise taxes on "millionaires and billionaires." The next week, he lectures President Obama for scapegoating the private jet industry. (Note that Buffett's company, Berkshire Hathaway, owns NetJets, a business-jet operator.) He occasionally makes a valid point, but advocates of Big Government ignore the nuances and use Buffett as the poster boy for Big Taxes on everyone.

A few observations on Buffett's tired refrain:

[1] Buffett's main concern is the preferential tax treatment of capital gains. I'm sympathetic to the argument, but that's a topic for another day. My problem with Buffett is that his focus on capital gains obscures a more pressing issue: our tax system is fundamentally broken.

Imagine a patient in critical condition in a hospital emergency room. Buffett is like an orthopedic surgeon, anxiously fluttering around the ER doctors while fretting over a manageable knee injury. Sure, the knee injury will require treatment. But we need to stabilize the patient before we treat the knee. We need comprehensive tax reform, and the taxation of capital gains should be part of that reform process. Buffett's focus on capital gains recognized by "millionaires and billionaires" puts the cart before the horse.

[2] Buffett thinks that dividend and capital gains tax rates should be higher for "millionaires and billionaires." How about a compromise position? In connection with fundamental tax reform, why not "phase out" the tax preference for dividends and capital gains in excess of $1 million? That seems to me a kind of rough justice. Although Buffett might be open to such a compromise, President Obama is focused on class warfare for political purposes.

[3] Buffett would "leave rates for 99.7 percent of taxpayers unchanged." This is a repudiation, not an endorsement, of President Obama and other left-wing policymakers who sweep households with $250,000 in adjusted gross income into the same category as "millionaires and billionaires."

[4] Although Buffett repudiates the central strategy in President Obama's class warfare playbook, expect the media and left-wing policymakers to focus on a more general narrative: billionaire Warren Buffett as the poster-boy for Big Taxes on everyone.

[5] I keep waiting for Buffett to put his money where his mouth is. Nothing prevents Buffett, Bill Gates, or any other "millionaire or billionaire" from making a large "donation" to the federal government, or state government(s), or local municipalities. However, Buffett has pledged most of his personal fortune to charitable foundations. Kudos to Buffett for the philanthropic gestures, but the call for Bigger Taxes is starkly hypocritical. If Buffett believes that politicians are good economic stewards, why did he allocate most of his personal fortune to charitable foundations rather than writing a big check to the IRS?

Message to Buffett: more action ... less talk.