Con­fus­ing wealth and in­come

The Washington Times Weekly - - Commentary - RICHARD W. RAHN

Which of the fol­low­ing fam­i­lies is “richer”? The first fam­ily con­sists of a wife who has re­cently be­come a med­i­cal doc­tor, and she makes $160,000 per year. Her hus­band is a small busi­ness en­tre­pre­neur who makes $110,000 per year, giv­ing them a to­tal fam­ily in­come of $270,000 per year. How­ever, they are still pay­ing off the loans the wife took out for med­i­cal school and the loans the hus­band took out to start his busi­ness, amount­ing to debts of $300,000. Their to­tal as­sets are val­ued at $450,000; hence, their real net worth or wealth (the dif­fer­ence be­tween gross as­sets and li­a­bil­i­ties) is only $150,000.

The sec­ond fam­ily con­sists of a trial lawyer who took early re­tire­ment and his non-work­ing wife. They have an an­nual in­come of $230,000, all of it de­rived from in­ter­est on tax-free mu­nic­i­pal bonds they own. How­ever, their net worth is $7 mil­lion, con­sist­ing of $5 mil­lion in bonds, a mil­lion­dol­lar home with no mort­gage, and a mil­lion dol­lars in art work, home fur­nish­ings, au­to­mo­biles and per­sonal items.

The sec­ond fam­ily is clearly far bet­ter off fi­nan­cially than the first fam­ily, yet many in the U.S. Congress, in­clud­ing Sen. Barack Obama, want to in­crease taxes on the first (and poorer) fam­ily and not on the wealth­ier fam­ily. They have mis-de­fined “rich” by con­fus­ing a flow (in­come) with a stock (real net as­sets), and thus come to the wrong con­clu­sion. They want to tax those (who make more than $250,000 a year) who are try­ing to be­come rich, while pre­serv­ing the sta­tus for those who al­ready have wealth.

In­creas­ing taxes on those 2.3 mil­lion Amer­i­can house­holds who earn more than $250,000 per year is fool­ish and de­struc­tive for sev­eral rea­sons. It re­duces the in­cen­tives for highly pro­duc­tive peo­ple to spend years in school ob­tain­ing needed skills, and then work hard in pro­duc­ing goods and ser­vices de­sired by their fel­low cit­i­zens. It en­cour­ages the mis­al­lo­ca­tion of pro­duc­tive re­sources by en­cour­ag­ing peo­ple to find ways to min­i­mize the tax bur­den rather than to use their la­bor and sav­ings for the high­est and best use. It re­duces the mo­bil­ity of fam­i­lies up and down the in­come scale, and freezes the ad­van­tages of those who have sub­stan­tial in­her­ited wealth (e.g., the Kennedys, Ker- rys, Pelo­sis, etc.).

Those who want the “rich” to pay more or “give back” not only con­fuse in­come with wealth, but also fail to un­der­stand life cy­cle mo­bil­ity, and the ef­fects of tax­a­tion and in­come re­dis­tri­bu­tion pro­grams on “dis­pos­able in­come.” Many peo­ple, when they are young (in­clud­ing the av­er­age grad­u­ate stu­dent), would be classified as poor in terms of tax­able in­come. Most peo­ple have a sharp rise in fam­ily or “house­hold” in­come af­ter they grad­u­ate from school, and many of th­ese en­ter the def­i­ni­tion of “up­per in­come” in their for­ties and fifties, but af­ter they re­tire, their tax­able in­come of­ten drops to the point where they are con­sid­ered mid­dle in­come, even though they may have more than a mil­lion dol­lars in net as­sets. In­come dis­tri­bu­tion is most of­ten de­fined by “house­hold” in­come as con­trasted with in­di­vid­ual in­come. Most low-in­come “house­holds” con­sist of sin­gle (of­ten young) in­di­vid­u­als, while most fam­i­lies with more than one in­come earner are higher in­come “house­holds.” The fact is there are about 4 times (8.9 mil­lion) as many house­holds that have net as­sets of a mil­lion or more than there are house­holds that earn more than $250,000. And many of the high-in­come house­holds do not have a mil­lion dol­lars in net as­sets.

Many politi­cians and me­dia peo­ple con­fuse tax­able in­come with dis­pos­able and in-kind in­come. Be­cause of the highly pro­gres­sive in­come tax sys­tem, (97 per­cent of in­come taxes are paid by the top 50 per­cent of in­come earn­ers and the top 1 per­cent pays 40 per­cent of the tax, de­spite hav­ing only 20 per­cent of the in­come), the dif­fer­ence in high-in­come and low-in­come fam­i­lies in af­ter-tax in­come is far less than pre-tax in­come. In ad­di­tion, there are many gov­ern­ment wel­fare and sub­sidy pro­grams for low-in­come peo­ple that are not in­cluded in many of the stan­dard def­i­ni­tions of in­come.

Given that high mar­ginal tax rates on in­come are coun­ter­pro­duc­tive, some have ar­gued for a wealth tax, but that doesn’t work ei­ther. A wealth tax mainly taxes pro­duc­tive cap­i­tal, thus re­duc­ing job and pro­duc­tiv­ity growth, and it also en­cour­ages peo­ple to move their wealth to other coun­tries and/or en­gage in ex­trav­a­gant ex­pen­di­tures — as the French have found out, much to their re­gret.

Mr. Obama also says that he wants to in­crease the cap­i­tal gains tax. Many peo­ple have times in their lives when they reap a sub­stan­tial cap­i­tal gain from the sale of a farm or small busi­ness or a va­ca­tion home, etc. If they re­ceive a cou­ple of hun­dred thou­sand dol­lars or more from the cap­i­tal gain, they ap­pear to be “rich” in that year, ac­cord­ing to Mr. Obama’s def­i­ni­tion, even though they may have an av­er­age yearly in­come of less than $100,000 and net as­sets of less than a half-mil­lion dol­lars. They will not only be taxed at a higher rate, but if the as­set has been held for many years and has grown in value no faster than inflation, they will be taxed on imag­i­nary in­come, and may well suf­fer a real loss — which is not only eco­nom­i­cally de­struc­tive but im­moral.

Those who con­fuse tax­able in­come with wealth are guilty of both sloppy use of lan­guage and sloppy think­ing. Is it pru­dent to trust the writ­ing of the tax code to a group of sloppy thinkers?

Richard W. Rahn is a se­nior fel­low at the Cato In­sti­tute and chair­man of the In­sti­tute for Global Eco­nomic Growth.

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