NOTE August 8, 2017: The marginal and effective U.S. Tax rates mentioned in this 2011 post have been supported by research conducted by Thomas Piketty (Paris School of Economics), Emmanuel Saez (UC Berkeley and NBER), and Gabriel Zucman (UC Berkeley and NBER). These economic researchers are well-respected by progressives. Data are data, though we differ on interpretations. “Income” vs. “Wealth” presents much of the challenge, as wealth accumulates but is not taxed in the United States. Distributional National Accounts: Methods and Estimates for the United States published July 6, 2017, includes the following table:
As the table shows, the effective tax rate for the top 1 percent peaked at 45 percent of income in 1944-45. Unfortunately, the overall revenue intake of the United States kept growing and the burden has been falling most on the bottom 50 percent. Tax increases on the middle and lower classes reduce potential economic growth since these individuals spend more of their income.
This column is on the misunderstanding of higher federal tax rates, which are marginal and not effective rates. There is a theory, and one that seems to hold in European nations as well as in the United States, that the high-income taxpayers will pay no more than 50 percent of their income to taxes, in various forms. Higher than 50 percent, people find ways to avoid taxes.
Taxes on the Rich Were Not That Much Higher in the 1950s
August 4, 2017
Scott Greenberg
There is a common misconception that high-income Americans are not paying much in taxes compared to what they used to. Proponents of this view often point to the 1950s, when the top federal income tax rate was 91 percent for most of the decade. However, despite these high marginal rates, the top 1 percent of taxpayers in the 1950s only paid about 42 percent of their income in taxes. As a result, the tax burden on high-income households today is only slightly lower than what these households faced in the 1950s.
Original 2011 Post:
There is a “myth” that the economy of the United States chugged along at least in part due to higher taxes on the wealthy in the past. First, this myth, like so many about creating prosperity, ignores that U.S. growth came after two world wars wiped out most of our competitors. Second, the implication is that “the rich” were actually paying 90 percent taxes at some point in history. That’s never been the case.
The U.S. tax system uses an “Effective Marginal Tax Rate” model. The EMTR is applied on ranges of earned taxable income. Each taxpayer pays roughly the same amount on his or her income within these ranges. According to the IRS, the EMTR schedule for 2011 is:
| Tax Rate | Income Range | Taxed |
|---|---|---|
| 10% |
$0 – $8,500
|
$8,500
|
| 15% |
$8,501 – $34,500
|
$25,999
|
| 25% |
$34,501 – $83,600
|
$49,099
|
| 28% |
$83,601 – $174,400
|
$90,799
|
| 33% |
$174,401 – $379,150
|
$204,749
|
| 35% |
Over $379,150
|
N/A
|
Everyone paying income taxes pays the same 10% on his or her first $8,500. So, to calculate a person’s “Composite Real Rate” you must average (in a manner of speaking) what he or she pays in overall taxes on earned taxable income. For example, if you earn $80,000 in taxable income in 2011, your taxes are $16,125.10. That’s a Real Rate of 20 percent. Yes, the marginal rate is 25%, but the Real Rate of tax is weighted towards the 15% bracket.
An income of $150,000 a year? The Real Rate is 24 percent. And that’s not the “real rate” as most of us would think of a “real” tax rate. Why is that? Because taxable income is not even close to what most people actually earn. Earned income and taxable income are two different things in government speak.
So, let’s get more complicated. When there was a 94% top rate in 1944-45, there were so many deductions and exclusions that the taxable income was not comparable to someone’s entire income. First, the top rate started at $200,000, which today is equal to $2,413,059.90 — so the maximum EMTR would apply only to incomes of $2.5 million. But, that’s still taxable income, not earned income.
In 1944, you could deduct business meals, all business travel, all forms of interest payments, and much more. You could even deduct spousal travel expenses on a business trip! (Why travel alone?) Companies could also “loan” or “provide” almost anything to an employee, from an apartment to standard benefits. It was possible to shelter tens of thousands of dollars from taxable income. Three-martini lunches and expense accounts were important realities, skewing tax calculations.
As a result of deductions and exclusions, even the theoretical maximum Real Rate of taxation at 60% in 1944 overstates taxation dramatically. The reality? On earned income, the richest U.S. taxpayers paid close to 40 percent of their earned incomes in taxes in 1944. We simply didn’t count much of the compensation as taxable income.
Allow me to introduce you to Hauser’s Law. Published in 1993 by William Kurt Hauser, a San Francisco investment economist, Hauser’s Law suggests, “No matter what the tax rates have been, in postwar America tax revenues have remained at about 19.5% of GDP.” This theory was published in The Wall Street Journal, March 25, 1993. For a variety of reasons, we seem to balance tax collections within a narrow range.
Since 1945, U.S. federal tax receipts have been fairly constant in terms of Gross Domestic Product (GDP), with taxes ranging from 15 to 20 percent of GDP. The graph is as follows:
When people demand higher taxes on the rich, usually phrased as paying a “fair share,” they are ignoring how our tax system has functioned historically. We could create more brackets, to tax the top 1% at a higher rate once again, but the net increase in tax revenues wouldn’t be dramatic. Why not? Because government spending is near historical highs: we are spending at near-WWII levels. It would be nearly impossible to tax enough to pay the federal bills, and doing so would likely crush the economy.
So, how could we address income inequality if not through increasing taxes? That’s really what people are asking when they demand fairness. The real complaint is the gap between rich and poor. I’ll address that issue in an upcoming blog entry.
[Additional thoughts]
September 5, 2012 at 8:36 PM
The “90%” marginal rate only applied to a handful of people, nowhere near the numbers affected by the AMT and top rates today. You can have a “90% rate” that applies to nobody — I suppose having the rate made someone feel better, but it was meaningless.
From CBS Marketwatch: “The AMT was designed in 1969 to ensure that wealthy taxpayers didn’t use loopholes to escape paying their fair share of taxes. The original target was 155 filers with the then-exorbitant income of $200,000 who avoided paying any federal taxes.”
To clarify, it was 155 families that avoided paying income taxes, despite an income of $200,000. The total filers in the top bracket were slightly more than 1000 filers. But, their effective rates were about 40% according to the data.
Imagine that: 155 filers earned $200,000 at that time. Today, the AMT affects millions of tax filers, because the floor is $75,000 in taxable income. Yet, we don’t seem to be any better off because there are still plenty of loopholes and exemptions for those with less “earned” income.
Bill Gates doesn’t “make multiple billions” in taxable income — I guarantee he keeps most earnings as capital gains, unredeemed stock, and bonuses of various kinds (which are taxed differently). Having an income tax allowed Steve Jobs to have an income of $1/year. Technically, he wasn’t in any tax bracket.
Having 155 families in the top bracket? That was the top in 1969. As rates were lowered, the brackets were also expanded. That’s a very reasonable approach if we insist on an income tax instead of a consumption tax.
The effective rate is what will always matter. And the effective rate seems to be very constant. Therefore, the better solution is closing loopholes, making the tax code simpler and more difficult to abuse. Effective rates still show that people top-out near the 40% range. Maybe there’s a psychological threshold because I’ve seen studies showing the wealthy manage a 40% rate in most of Europe — despite much higher marginal rates.
Behavioral economics do come into play. We’d have to study at which point the behaviors of the wealthy change. It seems to be 40%, but why? Is that the point at which they perceive no more return from government services?
June 1, 2015 at 3:12 PM
None of the 90 percent tax rate discussion is about what businesses pay or don’t pay. The United States corporate rate is among the highest in the developed world, and why companies have become so great at exploiting loopholes. High rate? Low compliance.
The 90 percent discussion is about individual income taxes, nothing more.
As for the 90 percent tax rate even existing, that’s the greater point of this blog post: it never was the real effective rate. We only tax *income* by law and there are plenty of ways to shift income into benefits, bonuses, options, and other forms of compensation. Even the mess we have with insurance (employer coverage) was the result of companies trading insurance in place of increased salaries to workers (as a result of wage and price controls). You tell people “income” is taxed, they shift the money. And, constitutionally, we only tax a person’s income, not his or her wealth. A wealth tax would require a Constitutional change in the United States.
Hauser’s Law seems to apply to taxes. Raise rates, people shift taxable compensation to other places. Taxes remain constant, at about 18 percent of GDP no matter what the rate is. The literature on this is extensive and so far, Hauser’s work has been upheld by newer models. Rates above 20 percent of GDP slow growth. However, tax revenues below 17 percent also do not stimulate growth — proving that there is a narrow range of ideal overall taxation.
October 8, 2015 at 4:22 PM
If we look abroad, we can compare Germany and France, or even the U.S. and Canada. The challenge is discovering what the rates can be without negative effects on the economy. Sadly, we only know when we hit walls if there are consequences.
The sustained growth had too many variables to easily know what role anyone aspect played. We do know that in most ways our economy was a closed system, which it is not anymore. Technology and global trade have changed the dynamics. We don’t know to what extent, however.
The easier evidentiary case for higher costs is to compare high-cost cities to lost-cost cities. New York, San Francisco, and Los Angeles are high cost, with high local taxes, wages, etc. What has happened, curiously, is that these “progressive” enclaves now have the highest inequality measures, too. As costs increased, the middle class left the cities, leaving the poor and the rich, without much in the middle.
The tech companies moved around SF, just as film companies relocated to around LA County. This reduced costs, while still letting the successful enjoy the benefits of living in urban centers. We could see companies (Bob Evans?) move to nearby places with more favorable tax policies and clearer regulation. Simpler regulations and taxes, even at greater face cost, can actually reduce overall costs. (Hence, northern Europe is now ranked as more “economically free” than the United States by some classical liberal economists.)
January 3, 2016 at 2:53 PM
From Bloomberg:
The Internal Revenue Service reckoned that the effective rate of tax in 1954 for top earners was actually 70 percent.
Or lower.
Marc Linder, a law professor at the University of Iowa, has shown that a more comprehensive interpretation of income that includes capital gains suggests the real effective tax rate for millionaires was 49 percent in 1953. The effective rate dropped throughout the decade, reaching 31 percent by 1960.
Additional research finds that from 1958 until 1964, roughly 80 percent of federal income tax came from the 16 to 28 percent bracket. That has fallen, but rate shifts and changing brackets make it difficult to compare brackets over time.
From 1982 on, there hasn’t been a 50% top bracket, for example, so those payers have been shifted to lower brackets. Even at their peak, the 50% bracket was never more than 8.3% of income tax collection, but recall that those individuals paid into all the lower marginal brackets, too.
The 1 to 15 percent bracket has held steady since 1987, when consolidation and changes to code pushed people from higher brackets into this lower bracket exclusively. Changes reduced the number of people paying across the brackets.
Since 1987, a median of 45 percent of taxes have been paid at the lower bracket. However, that has fluctuated wildly. The upper bracket(s) (25 and above) have increased from 7% of tax revenues to roughly a quarter.
The system is so absurd, changing dramatically every five to eight years, that there is no stability in the federal income stream by bracket, only by overall tax income. We keep moving the burden around, never quite content to let to let stay and adjust for inflation.
