Illustration by Jarrod Barretto
Economists Can’t Be Trusted on Tax Plans: Laurence Kotlikoff
The presidential campaign has just begun, and it’s already making me queasy. It’s not the smug politicians claiming magical job creation powers or special connections with the almighty. It’s the economists who produce misleading analyses of the candidates’ proposed policies.
Herman Cain’s 9-9-9 tax plan is a case in point. My last column pointed out that his plan would hit the superrich -- those with lots of wealth, but little or no labor earnings -- right in the solar plexus, dramatically lowering their sustainable living standards. The day after the column appeared, the Tax Policy Center, a joint venture of the Urban Institute and Brookings Institution, released a widely quoted study suggesting exactly the opposite.
I’m not surprised. The Tax Policy Center has first-rate economists, but they knowingly use wholly inappropriate distribution analysis also employed by Congress’s Joint Committee on Taxation, the Congressional Budget Office, the Congressional Research Service and the Treasury’s Office of Tax Analysis.
All five groups of tax experts take annual income as a measure of a household’s economic standing and evaluate the progressivity of tax proposals by dividing annual taxes by annual income. This is problematic, in large part because people don’t live for just one year. Their incomes and the taxes on that income change over their lifetimes.
Relying on a snapshot of income alone can be misleading in various ways.
Rich or Poor
First, someone can be extremely rich and temporarily have very little income and thus be treated as extremely poor. If Warren Buffett loses as much money as he makes this year playing the market, his income will be zero and he’ll be classified as dirt poor, even though he has some $50 billion in wealth.
Second, two people with the same lifetime incomes and spending capacity can have dramatically different patterns of earnings over their life cycles. Joe may make most of his money when young, and Sally may make most of hers when old. Should distributional analysis, performed when both are young, treat Joe as rich and Sally as poor, when they actually have the same lifetime resources?
Third, grouping people of different ages together on the basis of income compares apples with oranges. An otherwise broke 65-year-old earning $200,000 a year who is about to retire is in a very different resource situation than an otherwise broke 35- year-old who earns the same amount, but will work 30 more years. The 65-year-old has very low sustainable spending power compared with the 35 year old.
Common sense, confirmed by theory, provides a prescription for evaluating tax burdens. Simply compare each household’s spending power -- the buying power of its remaining lifetime resources -- before and after the proposed policy change. A household’s lifetime resources are current wealth plus the present value of current and future labor earnings.
For example, if we hit Buffett with an immediate 20 percent wealth tax, we know we’ve reduced his lifetime spending power by 20 percent. This is true regardless of whether Buffett intends to spend his money on himself, on gifts to his children or on charities. However and whenever Buffett spends his money, he has one-fifth less to spend.
Now suppose we tax Buffett’s spending power not by taking away any of his money, but by imposing a 25 percent sales tax that raises the prices he, his children and his charities must pay to buy things. This leaves Buffett in the same boat. The purchasing power of his $50 billion drops 20 percent because 20 cents of every dollar Buffett or his beneficiaries spends goes toward taxes and 80 cents goes to consumption. (Note that 20 cents divided by 80 cents equals a nominal 25 percent sales-tax rate.)
So a 25 percent sales tax, which raises the consumer price level by 25 percent, is precisely equivalent to a 20 percent wealth tax. In fact, the timing of the tax hit is identical as well. The moment the sales tax goes into effect, prices rise by 25 percent and the purchasing power of the $50 billion drops by 20 percent.
I’m using the example of a 25 percent sales tax for a reason. The Tax Policy Center says that 9-9-9’s “three taxes combined are equivalent to a 25.38 percent national sales tax.” But the center isn’t going public with the fact that 9-9-9 is taxing wealth by 20 percent.
Instead it’s telling us to locate Buffett in an income distribution table that suggests that people with high income will see their taxes fall dramatically. Or, if we think Buffett’s a low-income guy, at least in the short run, we can place him among the poor and convince ourselves that his taxes will rise. The center’s analysis assumes that the rich spend no money out of the principal of their wealth, so it naturally understates how much sales tax the rich will pay.
This is truly an economic theater of the absurd. Here we have Cain, the darling of the Tea Party, proposing a huge wealth tax, which is a goal of the Occupy Wall Street protesters. We have Cain chastising Occupy Wall Street for demanding what he’s proposing. And we have the Occupy Wall Street folks convinced he’s a capitalist tool.
Some observers, such as U.S. Representative Nancy Pelosi, a California Democrat, will still argue that a sales tax is regressive, on the grounds that the poor spend a larger share of their income. Data on how much households consume, though, are skewed by the fact that millionaires and billionaires who spend a lot out of their wealth can often fall into the low-income category.
The interesting question here is why the congressional agencies, and their copycats, refuse to analyze changes in tax burdens correctly. One answer is that doing so would require admitting they’ve been serving up nonsense for decades. Another is that members of Congress can’t be re-educated. A third is that telling the truth about tax distribution effects would actually lead to consensus on tax reform and threaten plenty of vested interests, including those of the economists who are making a living producing misleading calculations and disserving the public.
To contact the writer of this article: Laurence Kotlikoff at firstname.lastname@example.org.
To contact the editor responsible for this article: Mark Whitehouse at email@example.com.