What If the Tax Donkeys Rebel?

October 3, 2017

I would hazard a guess that an increasing number of tax donkeys are considering dropping out as a means of increasing their happiness and satisfaction with life.

Since federal income taxes are in the spotlight, let's ask a question that rarely (if ever) makes it into the public discussion: what if the tax donkeys who pay most of the tax rebel? There are several likely reasons why this question rarely arises.

1. Most commentators may not realize that the vast majority of income taxes are paid by the top 10%--and that roughly 60% are paid by the top 4% of households. (A nice example of the Pareto Distribution, i.e. the 80/20 rule, which can be extended to the 64/4 rule.)

As David Stockman noted in Trump's 1,500-word Airball, "Among the 148 million income tax filers, the bottom 53 million owed zero taxes in the most recent year (2014), and the bottom half (74 million) paid an aggregate total of just $45 billion. So let me be very clear. There was still $4 trillion left in the collective pockets of these 122 million taxpayers — even after the IRS had its way with them!

By contrast, the top 4% or 6.2 million filers paid $802 billion in Federal income taxes. That amounted to nearly 58% of total Federal income tax payments."

2. Few commentators draw a distinction between earned income (wages and salaries) and unearned income (dividends, interest, and more broadly, rentier income streams from the ownership of productive assets.

Here are a few examples to clarify the difference. Let's say a couple earn $300,000 a year--a nice chunk of change, to be sure, but since this is earned income, it's exposed to higher tax rates: 33% and up.

The primary tax breaks available to wage earners are mortgage interest and tax-deferred retirement contributions (IRAs and 401Ks). But there's only so much income that can be sheltered with these deductions. The household earning $300,000 may not own much in the way of wealth, and might even devote much of that income to servicing student loans, paying private school tuition, supporting elderly parents, etc.

If this household is typical, its primary wealth/assets are home equity and retirement funds. A house doesn't generate income, and any income generated by retirement funds is unavailable until retirement age, unless the owners are willing to pay steep penalties.

Now compare the hard-working folks earning $300,000 with a couple who don't work at all, but live off a rentier/investment income of $300,000 annually. Long-time readers know I often distinguish between assets that don't generate income (the family home, etc.) and assets that produce income, i.e. productive assets such as family businesses, stocks, bonds, commercial real estate, etc.

If these wealthy folks are typical, much of their income is taxed as capital gains at 15%, not 35%, and they also avoid the Social Security/Medicare payroll taxes paid by wage earners and the self-employed.

If we separate out these sources of income and types of wealth, we can distinguish two separate classes of high-income taxpayers: those who earn a lot of money and pay a lot of taxes, but who don't get much income from productive assets/wealth. Furthermore, any increases in the value of their primary assets (the family home and retirement funds) are not available in the same way as gains registered in stocks, bonds, and other income-yielding assets.

These high-earners are tax donkeys--they pay much of the nation's income tax but have to work hard for that privilege. While they typically have considerably more wealth than lower income households, their wealth is either inaccessible or unproductive, i.e. doesn't generate income.

The top 9.5% of households are tax donkeys to some degree, while the top .5% are typically rentiers who live very well off the income streams flowing from productive wealth (apartment buildings, ownership of businesses, stocks, bonds, etc.)

At some point, tax donkeys may decide that it's no longer worth it to work so hard, and so they downsize, retire, sell the business, etc.--get out while the getting's good. The average wage earner may reckon that those making the big bucks and paying the big taxes would never stop slaving away because their net income would drop--and who would voluntarily let their income decline?

I would hazard a guess that an increasing number of tax donkeys are considering dropping out as a means of increasing their happiness and satisfaction with life. When the often overworked tax donkeys start bailing out, there may be no substitute source of taxes.

Those who reckon some new tax donkey will quickly take the place of the retiring tax donkey overlook the fact that many are entrepreneurs and/or highly experienced professionals who can't be replaced as easily as a typical salaried person.

Courtesy of my esteemed colleague Lance Roberts, here are some charts that illuminate the widening disparities of income and wealth that differentiate those who pay little income tax, the tax donkeys and those who pay lower rates of taxes on unearned income: (Fed Admits The Failure Of Prosperity For The Bottom 90%):

Family income:

Family financial assets:

Business equity:

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