On Flat Taxes, Reaganomics, Progressivism, and What Capitalism Means

There's a reason people are sympathetic with flat tax proposals. They're simple, and they seem fair.

Economically, this simplicity comes with a big advantage. Everyone knows the U.S. tax code is vast and unwieldy. Each citizen spends far too many hours, which might otherwise be used in productive endeavors, handling their taxes each year. Multiplied across the entire population, that adds up to a tremendous loss -- one both substantial and very real.

And all these deductions and loopholes are disproportionately manipulated by the wealthy, who have the resources and the financial interest to devote to ferreting them out. As a result, many feel that the tax code is a labyrinth that can be navigated only by the rich, who typically pay an effective tax rate that's far less than their stated marginal rate. We've created a vast, opaque, and bureaucratic system that requires huge amounts of time and money to navigate, none of which goes to investing in new businesses or anything else productive. Simplifying the tax code would free up these resources, stop people from gaming the system, and also have unpredictable benefits like lowered stress for the population.

Of course, flat taxes also have a huge disadvantage. The U.S. tax code has always been progressive, meaning that the rich pay far higher percentages of their income -- at least, before all those deductions. In fact, it's far less progressive today than at any other point in modern history. In 2012, the highest marginal rate is 35%, applied to incomes over $388,351 -- not including capital gains, gifts, estates, deductions, etc. During World War I, the top rate was a whopping 79%, on incomes over $5,000,000 ($80.7 million in 2011 dollars). The lowest bracket at that time was only 4% -- far lower than today. The top rate peaked in 1944 at 94%, applied to incomes over $200,000 ($2.54 million in 2011 dollars).

If you think these rates were only due to war efforts, you'd be wrong: in 1954, the top rate was still 91% (still applied to incomes over $200,000, though that had dropped to $1.67 million in 2011 dollars). During the Reagan administration, the top rate dropped, over a series of tax cuts, from 70% to 28%, and by the last cut, this rate applied to everyone making over $29,750 ($56 thousand in 2011 dollars) -- the lowest, most anti-progressive top bracket in U.S. history.

The top U.S. tax bracket (marginal rate) by year.

A few things are worth noting immediately about these statistics, besides the obvious fact that the U.S. tax code has always been progressive -- and historically, far more progressive than it is today. The first is that the top bracket, until Reagan, was set at far greater levels than it is today. This is important, because it essentially means that there's a flat tax above this level, beyond which everyone's treated the same. The highest bracket peaked in 1936 at $80.7 million in 2011 dollars. This compares to today's highest bracket of $379,150. In other words, the more filthy rich you were in the past, the more likely you were getting hit with a higher rate. Today, someone making $1,000,000 or even $100,000,000 is treated just like someone making $379,151. There's no additional tax penalty above that top bracket, and that has a lot to do with how the very top American earners have grown disproportionately with the rest of us.

Also, there used to be a lot more tax brackets than there are today. That's another feature of progressive tax codes, because it allows for more gradations based on income. The first permanent income tax, in 1913, had seven brackets. In 1917, there were 21 brackets. This increased to 55 brackets in 1932. From 1942-1981, including the entire post-war period until Reagan, there were 24-26 tax brackets. That's was cut down all the way to two brackets in 1988, and it's since increased back to six. Still, that's an incredibly low number, and multiple tax brackets allow for a nice progressive gradation, rather than suddenly hitting people with far greater taxes when they hit certain thresholds.

For some, this progressive quality to the U.S. tax code, present all along and mostly far greater than today, is unfair. It certainly seems so, superficially, when one hears that someone making $379,150 will pay 35%, compared to the lowest tax bracket of 10%. Many right-wingers have called this "redistribution of wealth." Which, of course, it is: that high rate of 35% allows for the low rate of 10%, which helps the poor.

What everyone seems to miss, while complaining about "redistribution of wealth," is that the alternative is basically unthinkable. It's been this way since the first permanent income tax in 1913. The progressive tax code helps with income inequality, by not taxing the poor at the same rate as the rich. The poor save a little on taxes, and that means that they'll have a better quality of life. The little the poor are taxed means a lot more to them, since they're trying to make ends meet, than the high rates do to the rich, who have far more money to spare.

Progressive tax policy also allows for upward mobility. America's proud of the American Dream, in which people can rise from poverty into great wealth. That happens far more rarely today in the U.S. than almost ever before, and the U.S. is now lagging behind perhaps 10 other nations in upward mobility. (The exact number of other nations depends on the study and the method of its calculations.) The bottom line is that America's now lagging behind other nations in, of all things, the American Dream.

That's not merely an emotional argument. It's also an economic one.

Reaganomics, then a fringe idea dismissed by the Republican establishment, centrally believed that the economy was stimulated best by giving more money to the rich, because the rich are the ones who do the hiring. Give more money to the rich, and they'll use that money to hire more people.

Or so the theory went. But it hasn't worked, no matter what Republicans claim. In fact, the economy has grown at a slower rate, since Reagan began radically diminishing the progressive features of the tax code. True, the economy took off under Reagan, especially at the end of his first term. But that came as part of a recovery from a recession, in which the economy was undergoing a natural upswing as part of normal business cycles. By the end of Reagan's anti-progressive reforms, the stage had been set for the recession under Bush, which included a massive bailout of the Savings and Loans.

That natural recovery after recession, under Reagan, has confused matters ever since. But Reaganomics got a second go -- albeit a less extreme one -- under George W. Bush, and the result was a period of slow growth that should have been much faster, followed by the disastrous collapse of 2007 and 2008.

This gets us into why Reaganomics doesn't work. It presumes that the rich, given more money, will invest that money in ways that "trickle down" to the rest of the population. And certainly, this happens to some degree. But most of the rich already have more than enough money and ability to borrow to fund their plans to finance business expansion. And if the rich put that money under the mattress, or into overseas operations, it doesn't produce any American jobs. Most of that added money to the rich ends up getting put into financial investments, as the rich try to earn a return on all this money. This could be stocks, which supplies extra money to companies, which in turn might get invested. But supplying the rich with giant pools of money that crave somewhere to go is also a dangerous thing, because it creates demand for investments beyond the traditional stocks and bonds. Thus, the growth in hedge funds and bizarre financial instruments that ended up packaging mortgages into bundles that could be traded and insured -- which helped contribute to the 2007-2008 crisis.

In short, creating giant pools of money seeking investment opportunities can produce all kinds of unexpected and destructive side effects, which we've painfully and recently seen can wreck the global economy. And very little of this goes into creating jobs, much less manufacturing or anything beyond moving money around.

Now, consider the alternative: making the tax code more progressive. Instead of using tax reforms to give huge amounts of money to the already privileged few, we give far smaller amounts to a far greater number of people. We don't know that the rich will use their windfalls to employ more people. But we do know that those struggling to make ends meet will spend the dollars they get. This doesn't directly employ anyone, but it's spread throughout the economy. It goes to pay for delayed home improvements, for dinner at local restaurants, for extra Christmas gifts, and for making payments on credit cards.

So if what we want is to create incentives for increasingly bizarre financial investments, Reaganomics is a great idea. If what we want to do is to increase sales to U.S. businesses across the board, trusting consumers to make the best decisions about which products and services are worth their dollars, progressivism is where it's at. It's actually far more likely to unleash the magic of capitalism than lining the silk pockets of the super-rich.

That's not to say that tax relief for the rich and for businesses has no positive effect, merely that helping the poor and middle-class is a lot more direct way of stimulating the economy. And it has the added benefit of being more humane, because those small amounts can make big differences in the lives of struggling people.

This is actually an entirely intuitive result. The #1 reason why people aren't buying more isn't that the stores need more money to employ more people and get new products out. It's that the consumers don't have enough money to spend.

If you trust capitalism, you trust consumers, over time, to choose the stores and the products that deserve to succeed or fail. Giving consumers more money gives them more ability to pick these winners and losers. Giving more money to the game's current winners -- the rich -- isn't remotely as good at encouraging future winners. If you've got a new product, you should want customers empowered with the money to buy it, not a governmental stimulus based on the success of your last product.

It's here that income disparity becomes far more than a theoretical or moral argument. As income disparity becomes more extreme, the poor and increasingly the middle class can lose their ability to purchase goods and services. That means that businesses increasingly don't have customers -- the one thing a business absolutely needs. Sure, businesses catering to the rich might continue to thrive -- as they have, in the current economy. But all the other businesses feel the pinch, as their customer base feels the pinch.

There's one other thing to consider, when it comes to the argument that "redistribution of wealth" is somehow anti-capitalistic. Capitalism works best when people have equality of opportunity. That's why we break up monopolies: the capitalistic game breaks down, when someone has a monopoly that's powerful enough to prohibit competition, because it's competitive forces that make capitalism work. If someone can't get an innovative product to market, we all suffer. Equally, we want innovative Americans to have the economic freedom to create new products and new businesses. We don't want our young innovators trapped in a cycle of poverty, because they'll spend all their time trying to survive, rather than having the time and the financial freedom to experiment with a new product or service or business model.

Nothing represents a worse loss to a capitalistic economy than a kid who might build the next Apple or the next Google instead trapped in a cycle of minimum-wage jobs, toiling for 60 hours a week to support himself and exhausting his mental and physical energy simply to pay the bills. I'm not saying that he shouldn't have to work while putting together his potentially economy-changing innovation, but he shouldn't have to work so hard, and in such a hopeless cycle of debt, that he never ends up innovating in the first place.

A progressive tax structure isn't punishing success. No one's going to fail to implement a great business idea because he might, if successful, have to pay an extra five percent in taxes. This extra revenue should go to pay for the costs of capitalism's playing field, such as the roads and police and schools and trash pick-up that allow businesses to transport goods, their employees to be literate, and their customers to get to stores. This extra revenue should also go to leveling the playing field of capitalism, so that customers have a little more money to spend, and thus vote with their dollars for the businesses that deserve to win or to lose. And this extra revenue should also go to creating the circumstances by which the next guy with a great business idea has a shot at implementing it, so he too can become successful.

So a progressive tax structure is indeed "redistribution of income." But it's not really a Robin Hood-like, quasi-socialist scheme. It's actually thoroughly capitalistic. It's part of the cost of maintaining capitalism. And without it, just like without the breaking up of monopolies, capitalism itself can grind to a halt, descending into a system of haves and have-nots that not only slows the economy (because customers have less money to spend) but also deprives that economy of the wonderful free-market innovative power lying unharnessed in those have-nots.

Of course, anything can go too far. I don't think anyone credible wants a return to a 94% tax bracket. We certainly don't want a tax code that's so progressive that it paralyzes businesses that become successful. Or removes the incentive for successful people to try new things and grow more successful. No one sane would wants that.

But we also can't afford, as believers in capitalism, to have anything other than a progressive tax structure.

And if you look at the rise of income inequality in the United States, it's clearly tied to the current economic downturn. True, there's instability and fear in the marketplace, which can cause businesses to play it safe. That's all the more reason not to infuse businesses with cash, because this uncertainty about the future will prevent them from hiring as much as they otherwise might. The key is to get consumer spending up, as fast as possible. Only this will reassure businesses: if business picks up, hiring will follow. The reason consumer spending has been so sluggish isn't because the average American is hoarding his money, the way the banks are, in response to this uncertainty. Most consumers don't have this luxury. The reason is because they don't have enough disposable income, and that's intimately related to income inequality. The most direct way to help the economy is to get cash into consumers' hands.

This need for a progressive tax structure is the reason why a flat tax would be a disaster. It might seem fair. It might seem like a pure, capitalist approach -- a level playing field. But it's not. It's profoundly anti-capitalist.

Yet there's no denying, as previously explained, that simplification of the tax code would also be good for a capitalist economy. A streamlined tax code would eliminate the loopholes that pervert capitalist decisions, encouraging behavior that wouldn't make sense normally. It would also cut down on the time and money spent navigating the tax code, energies which should be available for proper capitalist endeavor.

What's needed, then, is a radically simplified tax code -- but one that's at least as progressive, if not more so, than what we have now.