This post is part of a larger series.
Income Tax Reform
In a past post, I wrote about income taxes. Here are some basic reforms that would go a long way to reducing income inequality.
1-Federal income tax reform
To simplify the scenarios, let’s take a look again at federal income tax brackets for a single filer as of 2019:
Most people with lower incomes are going to use the standard deduction of $12,200. This means the first bracket really is for individual earners making $12,201 to $21,900.
I advocate that we should not be taxing people earning below income needed for basic necessities. For one, this creates immense hardship for those who are least able to afford their taxes. Second, one major reason taxes are in place is in order to fund government programs for society’s least well off. Why, then, are we taxing people who we would be providing services for? It should be those in wealthier brackets who are funding these programs.
Therefore, we should raise the standard deduction to the threshold of basic income. There are several ways to calculate this. For example, the Economic Policy Institute has a family budget calculator, which shows how much a family needs to earn for their most basic needs within each county or region. The lowest thresholds for a single adult with no children are about $33,000. For two adults with no children, it is about $47,000, and about $85,000 for two adults with two children. An MIT professor has a similar project, with similar results. By this measure, a single adult with no children in Philadelphia needs to earn $26,290 a year, two adults need to earn $40,963, and two adults with two children need to earn $69,059. Note that all of these estimates include tax obligations.
Currently, the standard deductions are only $12,200 for single or married people filing separately, $18,350 for heads of households, and $24,400 for married couples filing jointly or qualifying widows. Let’s make the deductions equal to at least the minimum estimate needed to live for each family type in America’s county with the lowest cost of living. If using this method, we can eliminate the tax expenses line item in the basic cost of living estimates. Using the Economic Policy Institute’s estimate, for example, that would put us at about $27,897 for an individual.
Further, we need to deepen the progressive rate and increase the number of brackets in order to minimize impact on those with lower incomes and increase revenue from those who can most afford to pay taxes. This has the additional effect of decreasing the number of people with very high incomes, since it is discouraged through tax rates.
Taking all of these considerations together, I’ve created one possible alternative. Let’s start with tax brackets. I found data on when in American history income inequality was at its lowest, and then I found the tax rates around that era. I have chosen 1963, since this was a point when the highest marginal tax rate was at its peak when considering periods after WWII. Any date through the 1950s and 1970s would work just as well, though, since this was generally the era when income inequality was at its lowest. Take a look at data from Thomas Pikkety’s global income inequality project to see what I mean:
In this chart, you can see that income inequality reached a peak during the Great Depression, plummeted after WWII, and has been on a steady rise since about 1980. It is now at about the same levels as during the Great Depression. This is why I’ve used tax rates from this low-inequality era as one example of an alternative structure of taxes we could implement.
Below, I have charted our current income tax brackets as compared to the brackets in 1963, scaled to 2013 dollars for easier comparison:
Note two things. First, there were far, far more brackets at that time—24! Today, we only have seven. Increasing the number of brackets, especially at lower income levels, allows us to heighten the impact of a progressive tax. Ideally, we would have a tax rate that increases with every increase in income, but this would be difficult to implement in practice. Having many tax brackets is a practical compromise.
The second thing to note is that the tax brackets are much higher than today’s, especially as income rises to very high levels. The highest marginal tax rates in this era were so high that they effectively set a maximum income. That is, tax policy actively discouraged having an income beyond a certain threshold, rather than encouraging it like today’s tax policy. Additionally, while the first tax bracket begins at 20%, the equivalent of a deduction at that time was also much more generous. Therefore, the impact on lower incomes was far less when compared to today’s tax system.
I am not advocating that we use the exact same brackets as we did in the 1960s. I’m simply showing that the tax structure we had in place back then almost certainly played a role in reducing inequality, and our tax rates today almost certainly play a role in exacerbating inequality. I do not want to propose specific tax rates and brackets, since I absolutely lack this expertise. However, I do want to advocate that we implement a similar system by increasing the number of brackets substantially and increasing the tax rates within brackets substantially, especially at higher incomes.
Next, let’s take a look at deductions. The second part of reforming the federal income tax system is increasing deductions to accommodate for the minimum livable wage. Our current deduction for an individual, for example, is far below this threshold by any measure. Below, I’ve charted a comparison between our current deduction and my proposed deduction based on the Economic Policy Institutes estimates for a livable wage:
You can see that the effect of increasing the deduction is simply shifting the whole tax chart to the right. This has immense benefits for those of us at the lowest income ranges.
Next, I have done the same thing, but for the tax brackets in 1963 to show what this could look like in conjunction with reformed tax brackets:
Combined, this income tax system would achieve the following:
- Raise revenue for the federal government, to be spent on social programs;
- Place no burden on those earning at or below a living wage, minimal burden on those in a middle-income range, and high burden on those in the highest income ranges; and
- Effectively discourage very high incomes, contributing greatly to reducing income inequality.
2-FICA tax reforms
Reforming normal income taxes will help reduce the effects of poverty and inequality, but FICA taxes are just as important. FICA taxes currently disproportionately impact those at the lowest income ranges, because they are effectively flat taxes. In fact, we could even consider the Social Security tax to be regressive, since those above a certain income are not taxed.
The reforms I suggest are to:
- Remove the cap on taxable income for the Social Security tax;
- Make the Social Security tax progressive and bracketed, on par with the federal income tax;
- Make the Medicare tax progressive and bracketed, on par with the federal income tax; and
- Introduce deductions, on par with the federal income tax.
To begin, let’s take a look at the structure of the FICA taxes as they are currently. Let’s keep it to just the rates for an individual filer, to keep it simple:
Social Security tax:
If you are self-employed, here are the rates:
Social Security tax:
Here is a chart of the FICA taxes for an individual, assuming they are not self-employed:
This looks a bit confusing, but that’s only because this is such a strangely structured tax. Basically, it begins as a flat tax until you earn a very high income, then it decreases substantially, and then finally increases slightly at even higher incomes. It is a very crude “U” shape tax. The most significant aspect is that FICA taxes do not account for deductions. So, those who are paying zero federal income taxes because their income is too low are still paying a flat tax of 7.65%, and double that if they are self-employed! The next chart shows the impact of this when combined with federal income taxes, assuming a single filer with the standard deduction:
As you can see, this is a somewhat crude progressive tax, but with a strange chunk taken out of it. The tax rate begins at 7.65%, even if you are earning below the standard deduction. It then increases rapidly, decreases, and then remains generally flat for the remainder of income increases.
What if we reformed the FICA taxes to have a similar structure to federal income taxes? FICA taxes could account for deductions so that they do not disproportionately impact the lowest incomes with a flat tax. And, they could be bracketed and progressive, rather than being a three-bracket regressive tax. Below is an example of what this could look like, compared with our current system. For the sake of example, I have scaled the tax brackets to the federal income tax brackets, with a maximum of the current 7.65%:
You can see that now the FICA taxes look a bit more progressive, following the same pattern as federal income taxes. Again, I want to note that I am not advocating for these exact tax brackets. I am advocating that we implement progressive tax brackets with a deduction accounted for. The exact brackets matter much less than the fact that we implement this structure.
How would a proposal like this play out when we account for federal income taxes? Below, I’ve combined FICA and federal income taxes. I’ve assumed the standard deduction for a single filer, and I’ve graphed both the current system and this potential reform:
That is much better. It is not a drastic change for a reasonable income range for almost every household (under $250,000), and it drastically reduces the impact on lower-income households. Finally, the tax continues to increase after these income ranges, and there is no strange dip caused by the formerly regressive FICA taxes. I advocate for a system like this.
3-State and local tax reform
State and City income taxes also need reform. Like the FICA taxes, they are flat taxes that most heavily impact lower-income households. That needs to change by making the progressively bracketed with deductions, much like with my proposal for FICA taxes.
Recall that the City’s income tax is 3.8809% for residents who work in the City. The State’s income tax is 3.07%. Both of these taxes apply to all incomes and all households, with no deductions. They are a flat line across the board, whereas a progressive, bracketed tax is more like the second half of a logarithmic curve.
Below, I’ve graphed the State and City income taxes. Since that is such a simple graph (a flat line), I’m jumping right ahead to including these taxes with federal income taxes and FICA taxes. Below, I’ve charted the federal income tax brackets, the combined FICA tax brackets, City and State income taxes, and the combined tax brackets. The range goes through $600,000 to show all of the brackets, though most of us are earning well below $100,000:
The graph above is exactly the same as before, but everything is bumped up by the City and State taxes, or another 6.9509%. Now, instead of the lowest income paying a flat tax of 7.65%, they are now paying a combined 14.6009%.
Next, I’ve applied the same method I did to the FICA taxes to the City and State taxes. They are scaled at the same rate as the federal income tax brackets, up to their current level as the maximum. Below is every suggested reform combined for every possible income bracket, so it will be a large income range. Later I will show a zoomed-in version to better show the impact on a normal income range. Take a look at what all of the proposed reforms look like together:
Now it is a progressive tax that accounts for a basic income deduction, and the tax rate increases sharply for incomes above the basic income level. Note that the combined tax rates exceed 100% for the highest income brackets. That is because this is just an example based on the 1963 tax rates—we could lower the federal rates to accommodate for modern FICA and local taxes, or we could give a credit for federal income tax if it would go above 100%. Regardless, the general structure is what is important. Namely, taxes are non-existent for the lowest incomes, moderate for moderate to higher incomes, and very high for very high incomes.
Next, this is the revised version compared with the current system:
Again, you can see that this revised version is much more generous to lower-income households, while continuing to increase the tax rate dramatically at very high income levels. It achieves the goals of a progressive tax.
Finally, here is the zoomed-in version:
Almost all of us are earning far below $250,000, so this is the most relatable chart to look at. In fact, most of us are earning well below $100,000, but I want to show how the two different tax systems diverge for these higher brackets. You can see much more clearly that the current tax system places a high amount of burden on the lowest income households, while my proposed taxes place no burden on these households. Further, our current taxes hardly increase at all for the very high brackets, or even decrease. My proposed alternative structure achieves what a progressive tax should—the rate continues to increase for far higher incomes, because they can most afford to pay.
Some may have a rebuttal that, if lower-income households account for almost all of the households in America, we would be dramatically reducing federal income tax revenues under this revised system. If you are worried about the impacts this system would have on national tax revenue, here is some data to calm those concerns. Below is data from the IRS from the 2016 tax year showing the number of filers by income range and tax revenues by income range. I chose the first bracket where the data was available that is as close to the basic living income of about $30,000 as possible, including the standard deduction for a single filer back then, or $4,050. The other brackets are where the clearest cutoffs were for large groupings of revenue.
As you can see, those earning below $25,000 a year make up a large portion of taxpayers, at 37%. Together with those making under $50,000, they make up more than half of tax payers. People making over $1 million don’t even make up 1%. And yet, those making under $50,000 account for just 6% of tax revenue, while those earning more than $1 million make up one-quarter of tax revenue. The largest amount of revenue comes from the middle to very high income range. Therefore, we can comfortably conclude that my proposed tax changes would not reduce national tax revenue, and would most likely greatly increase revenues.
How to make this happen
Changes to taxes can only happen through the legislatures at every level of government. For federal taxes, Congress will have to write amendments to current tax laws, and the president will have to sign those laws, unless he can be overridden by at least a two-thirds majority. Unfortunately, this is unlikely to happen until Democrats control the presidency and both houses of Congress, and even then it is likely to be contentious. Still, it is worth fighting for, and it is foreseeably possible within the next several years.
The situation is the same at the state level, and perhaps even more difficult. The legislature is controlled by a two-thirds majority of Republicans who are almost all against making the state income tax a progressive, bracketed tax with deductions. Democrats will have to make major inroads into the Pennsylvania legislature, which probably requires reforming gerrymandering—like all of the issues at the state level.
The City of Philadelphia, on the other hand, can do much more immediately. With a catch. Philadelphia can create its own legislation to make its income tax progressive, bracketed, and with deductions, but any such law would require approval from the state legislature before being enacted. This is because the Sterling Act, which allows Philadelphia to pass a broad range of taxes, requires local governments in Pennsylvania to seek approval from the state legislature before taxing anything that the state already taxes, and the state does tax income. While the state legislature may fight this kind of legislation, it is far more likely that local political will is the largest obstacle. There needs to be a movement to elect city council members and pressure current council members to enact this kind of income tax reform.
In sum, we need to reform income taxes at every level to have the following characteristics:
- Progressively scaled, meaning that tax rates are lowest for lower-income households, and increase as income increases;
- Bracketed, with enough brackets to allow for a very strong progressive tax rate;
- With deductions equal to the basic income level for each household type; and
- With an effective maximum income, in order to discourage a certain income threshold and mitigate inequality.
At every level of government, this will take a protracted grassroots movement to elect officials who will vote for this kind of change. In the meantime, we can create a movement to reform the local wage tax.