Policy Review, April & May 2011, No. 166

8/7/2019 Policy Review, April & May 2011, No. 166

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THE INEQUITY OF THE PROGRESSIVE

INCOME TAX

KIP HAGOPIAN

A SMARTER APPROACH TO THE YUAN

CHARLES WOLF, JR.

AMERICAS FADING MIDDLE EAST INFLUENCE

SHMUEL BAR

THE EUROPEAN UNION GOES EAST

BRUCE PITCAIRN JACKSON

ALSO: ESSAYS AND REVIEWS BY

JOSEPH BOTTUM, LIAM JULIAN, DAVID SHORR,PETER BERKOWITZ, HENRIK BERING

April & May 2011, No. 166, $6.00PO

LICYReview

A Publ icat ion of the Hoover Inst itut ionstanford uni vers i ty


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the hoover institution was established at StanfordUniversity in 1919 by Herbert Hoover, a member of Stanfordspioneer graduating class of 1895 and the thirty-first president ofthe United States. Since 1919 the Institution has evolved from a

library and repository of documents to an active public policyresearch center. Simultaneously, the Institution has evolved into aninternationally recognized library and archives housing tens ofmillions of books and documents relating to political, economic,and social change.

The Hoover Institutions overarching purposes are:

To collect the requisite sources of knowledge pertaining toeconomic, political, and social changes in societies at home

and abroad, as well as to understand their causes and conse-quences

To analyze the effects of government actions relating to pub-lic policy

To generate, publish, and disseminate ideas that encouragepositive policy formation using reasoned arguments andintellectual rigor, converting conceptual insights into practicalinitiatives judged to be beneficial to society

To convey to the public, the media, lawmakers, and others

an understanding of important public policy issues and topromote vigorous dialogue

Ideas have consequences, and a free flow of competing ideas leadsto an evolution of policy adoptions and associated consequencesaffecting the well-being of a free society. The Hoover Institutionendeavors to be a prominent contributor of ideas having positiveconsequences.

In the words of President Hoover:

This Institution supports the Constitution of the UnitedStates, its Bill of Rights, and its method of representative

government. Both our social and economic systems are basedon private enterprise from which springs initiative andingenuity. . . . The Federal Government should undertake no

governmental, social or economic action, except where local government, or the people, cannot undertake it forthemselves. . . . The overall mission of this Institution is . . .to recall the voice of experience against the making of war,and . . . to recall mans endeavors to make and preserve

peace, and to sustain for America the safeguards of theAmerican way of life. . . . The Institution itself mustconstantly and dynamically point the road to peace, to

personal freedom, and to the safeguards of the Americansystem.


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POLICYReviewAPRIL & MAY 2011, No. 166

Features

3 THE INEQUITY OF THE PROGRESSIVE INCOME TAX

Working harder and paying more

Kip Hagopian

29 A SMARTER APPROACH TO THE YUAN

Avoid the rush to rebalanceCharles Wolf, Jr.

41 AMERICAS FADING MIDDLE EAST INFLUENCE

Speaking softly, wielding no sticks

Shmuel Bar

53 THE EUROPEAN UNION GOES EAST

A patient policy of long-term partnership

Bruce Pitcairn Jackson

Books

65 BEING T.E. LAWRENCE

Joseph Bottum on Hero: The Life and Legend of Lawrence of Arabia

by Michael Korda.

70 BETTER BRAIN SCIENCE

Liam Julian on Moonwalking with Einstein: The Art and Science of

Remembering Everything byJoshua Foer andThe Most Human Human:

What Talking with Computers Teaches Us About What It Means to Be

Alive by Brian Christian.

76 POWER AND ARROGANCE

David Shorr on The End of Arrogance: America in the Global

Competition of Ideas by Steven Weber and Bruce Jentleson.

82 THE GOLDSTONE MESS

Peter Berkowitz on The Goldstone Report: The Legacy of the Landmark

Investigation of the Gaza Conflict edited by Adam Horowitz, Lizzy

Ratner, and Philip Weiss.

88 HOW PEACE GETS MADE

Henrik Bering on How Wars End by Gideon Rose.

A Publ i cat i o n o f th e Ho o ver I nst i tut i o nstanfo rd uni vers i ty


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PO

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Class Wars: A Parable

Once upon a time in the land of America, there lived tripletbrothers named Tom, Dick, and Harry Class. They were 45

years old, had virtually the same aptitude (skill), and were

raised in the same home. Each was married and had two chil-

dren. All three were employed as carpenters making $25 per

hour, working 50 weeks a year.

While they were almost identical in most respects, they had somewhat dif-

ferent preferences and values. For example, Tom, who worked 20 hours a

week, had a different work ethic from his brothers, Dick and Harry, whoeach worked 60 hours per week. Neither Toms nor Dicks wives worked,

while Harrys wife worked 40 hours per week as an office manager making

$50,000 per year (the same hourly rate as her husband). Tom and Dick

The Inequity of the

Progressive Income TaxBy Kip Hagopian

Kip Hagopian was a co-founder of Brentwood Associates, a California-basedventure capital and private equity firm. This essay is an abridged version of a paper which is available in its entirety and for comment atwww.kiphagopian.com.

April & May 2011 3 Policy Review


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4 Policy Review

spent all of their income, and were relying on Social Security to take care of

them when they retired. Harry and his wife, on the other hand, saved most

of her after-tax income over many years, gradually accumulating

$300,000. They invested this money in bonds and real estate that produced

$25,000 a year in interest and rental income. This was the income of each

family:

FamilyTom Dick Harry

Work hours per Week: 20 60 100

Annual Wages

Husband: $25,000 $75,000 $75,000

Wife: 0 0 50,000Investment Income: 0 0 25,000

Total Income: $25,000 $75,000 $150,000

Despite their different priorities, the Class families were close; so much so

that when a new housing tract was developed in their community, they each

bought an equal-priced home on the same private street. Theirs were the

only houses on the street.One day the brothers decided to pool their funds for the purpose of

improving their street. Concerned about crime and safety, and desirous of a

more attractive setting for their homes, the three families decided to: install a

gate at the streets entrance to deter burglars; add lighting for safety and

additional security; repave the streets surface to repair damage; and install

landscaping to beautify the approach to their homes. The work was done

for a total cost of$30,000.

The brothers were quite happy with the outcome and felt the $30,000was a worthy expenditure given the benefits provided each family. But when

it came time to divide up the bill, the problems began.

Harry thought it would be simple to divide the bill. Since the benefits to

each family were equal, each brother should pay one-third, or about

$10,000. But Tom and Dick objected. Why should we pay the same as

you? they said. You make much more money than we do. Harry was

puzzled. Why is that relevant? he asked. My family makes more money

than yours does because my wife and I work long hours and we earn extra

money on our savings. Why should we be penalized for working and sav-

ing? Harry looked at Tom and said, Im no smarter or more talented than

you are. If you and your wife worked harder and saved more you would

make as much as my family does. To which Tom replied, I dont work

more because I value my leisure time more than I value money. And I dont

save because I prefer the gratification of consumption today more than I will

when Im too old to enjoy it. Tom was adamant. How could Harry, who

was clearly rich, ask him to pay the same amount, when it was obviously

harder for him to do so?

Kip Hagopian


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Dick thought for a moment, and then said, Ive got an idea. Our aggre-

gate income is $250,000, and $30,000 is 12 percent of that amount. Why

dont we each pay that percentage of our income? Under that formula, Tom

would owe $3,000 , I would owe $9,000 , and Harry would owe$18,000. Since I make three times as much as Tom, I would pay three times

as much. Harry, who makes twice as much as me and six times as much as

Tom would pay two times as much as me and six times as much as Tom.

No, said Tom. No? Dick and Harry responded in unison. Why

not? What do you propose instead? asked Harry. Tom was ready with his

answer. Paying the same percentage of our income is not fair. Instead,

Harry, you pay $23,450; Dick, you pay $6,550; and I will pay nothing.

This is the only fair division. Dick was surprised at how completely arbi-trary this proposal was. He was also surprised at how disproportionate it

was, but since his suggested share was significantly less than under his own

proposal, he didnt object. Harry, however, was stunned. You call that

fair?! I make only two times as much as Dick, but you want me to pay

three-and-a-half times as much as he does. I make six times as much as you

but you expect me to pay almost 80 percent of the total cost while you pay

nothing. And this is despite the fact that each of us is receiving the exact

same benefits. Where did you get such a crazy idea? he asked. From noless an authority than the federal government, said Tom as he pulled out a

gray booklet. Its all right here in the irs tax tables. Under the current tax

code, here is what each of us paid in income taxes last year:

Family

Tom Dick Harry Total

Income $25,000 $75,000 $150,000 $250,000

Taxes Paid

1

0 6,550 23,450 30,000Effective tax rate 0% 8.7% 15.6% 12%

By an amazing coincidence, our total taxes paid were exactly equal to

the $30,000 expended on our street improvements. This is the progressive

income tax system all U.S. taxpayers live under, and I dont see why the

Class families should be different. In fact, I believe all future pooling of

funds should be divided in this way. Im in, said Dick. So, by a vote of

two to one, the cost of the street improvements was divided as follows:

Tom Dick Harry Total

Dollars $0 $6,550 $23,450 $30,000

Percentage 0% 21.8% 78.2% 100%

April & May 2011 5

The Inequity of the Progressive Income Tax

1. The tax figures were calculated by The Shapiro Group, a Los Angeles tax accounting firm. The mar-ginal rates and brackets are those applicable for the 2010 tax year. These figures are for illustration pur-poses only. They do not include the effect of certain tax credits (which some would consider transfer pay-

ments) that exist in the law. If these credits were included, Harry would pay a tax of$22,600, Dickwould pay a tax of$3,700 and Tom would receive a refundof$7,100.


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6 Policy Review

Also by a vote of two to one, all future pooling of funds was to be divided

up the same way.

Like all parables, the story of the Class brothers is designed to

illustrate a moral principle. In this tale, Harry is required to pay a

disproportionate amount of the cost and value of the benefits he

derives from his mini-society, simply because his family works harder

than the families of the societys other members. The moral question is: Is

Harry being treated fairly? If not, how should this affect our thinking about

progressive taxation?

In the United States, the payment of taxes is effectively a pooling ofmoney by the nations citizens to fund the services of government. These

services include, but are not limited to: the national defense, infrastructure,

the judicial court system, police and fire protection (delivered at the federal,

state, and local levels), education (delivered at the state and local level), the

general administration of government, and support for truly needy citizens.

Deciding how much money should be appropriated for this pool and how

it should be spent is almost always a subject of contentious debate. The

same is true when deciding how taxes should be apportioned. As to the lat-ter, the debate inevitably devolves into an argument over fairness and eco-

nomic efficiency.

The primary source of federal tax revenues (excluding Social Security and

Medicare taxes) is a progressive tax on the earned income of individuals.2

This essay will make the case that the progressive income tax is plainly

inequitable. It will also review the alternatives to progression in an effort to

identify the most equitable (or least inequitable) tax system.

Factors that determine income

Americas free enterprise system provides an environment

in which the substantial majority of its citizens can realize their

fullest earnings potential. Within that environment, individual

economic outcomes are the product of a combination of three elements:

aptitude, work effort, and choice of occupation.

Aptitude.3 For the purposes of this essay, aptitude is broadly defined asthe capacity to produce, or to earn income. For the most part, it comes from

Kip Hagopian

2. There are several other types of taxes levied by federal, state, and city governments, including taxes oncapital gains, dividends, estates, sales, and property. These tax systems are outside the scope of this essay.

3. As defined here, the term aptitude is similar to but distinct from other terms used in the literature todescribe capacity to earn: 1) endowment, which, in this context, is synonymous with genetic inheri-tance and is, therefore, too limiting; 2) faculty, which, like aptitude connotes capacity to earn, but is

also used in the literature to describe financial wherewithal; and 3) ability, which, like faculty, is usedto describe either capacity to earn or financial wherewithal.


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circumstances of birth and is distributed unequally. Aptitude may be derived

from innate talents (cognitive, musical, artistic, athletic, etc.) or physical

attributes (appearance, dexterity, possession of senses, etc.). Or it may be

acquired from lessons learned from parents and other life experiences.Aptitude emanating from circumstances of birth (either innate or acquired)

can be significantly enhanced by individual effort applied to strengthening

ones skills (see Work Effort below). Aptitude is measured from low to

high in accordance with the monetary value placed on it in the marketplace.

This is a measure of earning power and is not in any way an indication of an

individuals intrinsic worth as a human being. For most people aptitude is

the most significant determinant of income. But it has to be understood as

capacity; aptitude does not produce income until itis combined with individual effort.Work effort. For any given level of aptitude and

occupation, work effort plays the decisive role in

determining income, and in many cases may result

in persons with lower aptitudes earning more than

their higher-aptitude peers. For the purposes of this

essay, the term work effort includes not only the

number of hours worked, but also the intensity ofthe effort applied during those hours. As notedabove, it also includes work effort applied to

strengthening ones skills.

At every level of aptitude and in every profession,

whether the pay is in salary or hourly wages, there

are workers who outperform their peers in each

hour worked. They do this by performing tasks more quickly; focusing on

the tasks more intently; finding and completing additional tasks that need tobe done; and using some of their leisure time practicing or training to

become more skilled. These people get more raises, larger bonuses, and

more promotions than their peers. Thus, greater work effort can produce

higher income whether the person is paid by the hour or earns a salary.

In addition to producing higher income in its own right, work effort

applied to strengthening ones skill resulting in learned or enhanced

aptitude can make a substantial contribution toward increasing income.

The rough carpenter who spends nights and weekends developing the

skills necessary to qualify as a more highly valued finish carpenter will

move up the wage scale by doing so. Professional athletes, musicians,

singers, and other performers can enhance their innate aptitudes substantial-

ly through extensive practice, and a great many are renowned for having

done so. A classic example is Hall-of-Famer Jerry Rice, who is generally rec-

ognized as the best wide receiver in nfl history. He was one of the highest

paid players in pro football for twenty years, an achievement largely credited

to his intense practice and workout regimen. Perhaps the most effective way

of enhancing aptitude is through increased study in school. Whether it is

April & May 2011 7


Paying the same

percentage of

our income is not

fair. Instead,

Harry, you pay

$23,450; Dick,you pay $6,550;

and I will pay

nothing.


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8 Policy Review

grade school, high school, vocational school or college, for any particular

tier of aptitude, those who study the most almost always get the best grades,

matriculate to the best colleges, and secure the best jobs.

Choice of occupation. Choice of occupation is also important in deter-mining income. Had Bill Gates decided to finish Harvard and become a highschool math teacher, he almost certainly would have been successful, but he

would not have become a multi-billionaire.

Earned income is determined by a mix of the three factors described

above, and the relative contribution of each varies by individual.

Understanding the primary determinants of income and the implications of

each for tax policy are essential to designing the most equitable tax system.

Surprisingly, the literature contains only infrequent and oblique references tothis crucial aspect of tax theory.

Alternative income tax systems

There is a consensus among economists and tax theorists that the

best tax system is one that strikes the optimum balance between

economic efficiency and equity. An efficient tax system is one thatdoes the least to distort the allocation of resources in the economy, thus

maximizing overall production. Accordingly, taxes that might alter con-

sumer or investor behavior should be eschewed. As to equity, there is virtual-

ly unanimous agreement among scholars that the tax system should be

fair. Unfortunately, there is great disagreement as to which system best

meets this criterion.

There are basically four systems of income taxation described in the liter-

ature:A per-capita, or head tax, which would require each person to pay hisor her per-capita share of the costs of government. (Technically a per-capita

tax is not an income tax, but it is almost universally accepted as the most

economically efficient tax system.)

A proportionate or flat tax, which would tax each dollar of income ata single rate. Embodied in virtually all proportionate tax proposals is a sub-

stantial broadening of the tax base through the elimination of most tax

deductions, credits, and preferences, which has the benefit of simplifying the

tax code and reducing the cost of compliance. The purest form of this sys-

tem is a single-rate tax levied on all earned income from the first dollar, but

different variations on this theme have been proposed.

A degressive tax, which is a proportionate tax only on income above acertain threshold or exemption. The exemption makes the system progres-

sive, but typically much less so than a system of graduated rates.

A progressive tax, which taxes incremental income at higher marginalrates as income rises, resulting in an increase in taxes as a percentage ofincome as income increases.

Kip Hagopian


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Each of these systems will be examined as part of the analysis of progres-

sive taxation.

The case for progression

Progression has been in use somewhere in the world for

more than two thousand years. And it is safe to say the debate on

its merits goes back just as far. At present, the substantial majority

of nations employ some form of progressive taxation.

The first time a federal income tax was imposed in the United States was

in 1861 as a means of financing the Civil War. The tax rates were decreasedafter the war and the income tax was allowed to expire in 1872. The con-

cept of an income tax was legally quite controversial; so when a new income

tax was levied in 1894, it was challenged in the courts, and in 1895 was

found to be unconstitutional. It was not until 1913, with the ratification of

the 16th Amendment to the Constitution, that the first constitutionally sanc-

tioned income tax was enacted (which, incidentally, was progressive).

Throughout history, many arguments have been advanced both for and

against the progressive income tax. One of the most comprehensive exami-nations of the subject in the 20th century was a book published in 1953

and reissued in 1963 , The Uneasy Case for Progressive Taxation, byProfessors Walter J. Blum and Harry Kalven of the University of Chicago

Law School. This book is an exhaustive review of the prior literature on this

topic, interspersed with the authors own analyses and critiques of the argu-

ments presented. In their words, the book is, an effort to explore what

might be called the intellectual case for progression.4 Another particularly

useful source of information and analysis was a book-length article pub-lished in 1908 in the American Economic Association Quarterly,Progressive Taxation in Theory and Practice, by the noted economist and

tax historian, Edwin R.A. Seligman.5

According to Blum and Kalven, the most rigorous analysis of progres-

sion came only after the idea had become a political reality . . . whatever the

reasons, it is clear that the political history affords little insight into the mer-

its of the principle of progression.6

The arguments in supportof progression tend to fall into three main cate-gories:7 economic efficiency, fairness, and reduction of income inequality.

April & May 2011 9


4. Edward Blum and Harry Kalven, The Uneasy Case of Progressive Taxation (University of ChicagoPress, 1953).

5. Edwin R.A. Seligman, Progressive Taxation in Theory and Practice (Princeton University Press, 1908).

6. Blum and Kalven, 14 .

7. Some advocates of progression argue that a progressive income tax is needed to offset the putativelyregressive nature of the payroll taxes that fund Social Security and Medicare. The conflation of these

revenue streams is ill-conceived, inasmuch as each has a different purpose. Income taxes are used to funda broad range of government services as described above, while payroll levies are collected for the express


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Economic efficiency. The argument is that progressive taxation increasesworker productivity, yielding greater economic efficiency and higher aggre-

gate incomes. The study of the impact of tax policy on economic efficiency

and growth has for centuries been a fertile ground for economists, who haveproduced numerous analyses on the topic without reaching clear consensus.

Since the focus of this essay is on the issue of tax equity, the economic effi-

ciency arguments will not be discussed beyond noting that logic and the

weight of empirical evidence appear to favor less progression rather than

more.

Fairness. The argument for progressive taxation on fairness grounds hasthree main strains.

The benefits principle. Taxes are payments made in return for govern-ment services and protections. People with higher incomes have dispro-

portionately more to lose; therefore, they should pay disproportionate-

ly more for the protections afforded them by government;

Sacrifice theory and the marginal utility of money. Taxes are a burdenon society that should be shared in an equitable manner. Burden is

defined as the sacrifice made by the individual when he or she pays

taxes. Since the marginal utility of a dollar declines as income rises,higher-income people should pay enough more in taxes to equalize

their sacrifice relative to the sacrifice of lower-income peers.

Ability to pay. A fair tax system is one in which those with the greatestability to pay should pay the most.

Reducing Income Inequality. In this view, inequality is a social injusticethat can be remedied or mitigated by a progressive tax system. It is often

proffered as an argument for basic fairness, but since proponents haventunited around a specific principle of fairness in its support, we will consider

it separately.

We will now examine each of the three fairness arguments in detail, then

turn to the question of income inequality.

The benefits principle

The benefits principle of taxation holds that the government

provides benefits to its citizens that should be paid for in taxes by

each beneficiary in accordance with the value he or she receives

Kip Hagopian

purpose of providing income supplements and medical care during retirement. More specifically, SocialSecurity levies are a form of forced savings, and Medicare levies are effectively prepaid medical insurancepremiums. Neither of them finances government services per se. Since Social Security benefits when paidout are tied to the aggregate amount paid into the system by each beneficiary, it is inaccurate to call thelevies regressive. In the case of Medicare, the amount paid into the system is proportionate to income

while the benefits (paid health care) are essentially the same for each beneficiary; consequently, the systemis redistributive.

10 Policy Review


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from government services. As a basic foundation for taxation, the benefits

principle also called give and take or quid pro quo has probably

received more examination and comment than any other. As we will see, the

statement of the principle payment of taxes in return for benefits lendsitself to widely varying interpretations.

Historically, the use of the benefits principle to advocate progression

relied on the protection theory of benefits, which asserts that the govern-

ments primary function is the protection of property. The theory focuses on

income as property, and analogizes the protections of government to an

insurance company that insures property against loss. Those who cite pro-

tection theory as an argument for progression assert that individuals with

higher incomes should pay a disproportionately greater share of the cost ofgovernment than lower-income individuals because the higher-income groupwould have disproportionately more to lose if the protections of government

were withdrawn. Implicit in this interpretation of the principle is not just

that the value of benefits received from the government increases as income

increases, but that it increases more rapidly than the rise in income. As wewill see, the statement of the principle payment of taxes in return for ben-

efits lends itself to widely varying interpretations.

When examined carefully, the protection theory interpretation of thebenefits principle falls short in five different ways.

First, the basic premise of the protection theory is flawed. Government

protections extend to much more than property. The Founding Fathers made

clear their vision for America in the Declaration of Independence when they

spoke of the unalienable rights of all Americans to life, liberty and the

pursuit of happiness. There is no basis for believing that a low-income per-

sons life is worth more or less to an individual(as contrasted with an insur-

ance actuary, an economist, or a jury assessing damages in a wrongful deathcase) than the life of a high-income person. The same is true for liberty and

the pursuit of happiness. The American military and other protective agen-

cies and institutions of government exist to protect and preserve these rights

for all Americans equally, regardless of how rich or poor they are.

Second, there is no persuasive support in the literature for the claim that

higher-income people derive a disproportionately greater value from govern-

ment protection of property than lower-income people. Some progression

advocates have argued that government exists in large part to protect rich

people from poor people, while poor people need no such protection. Thus,the value of the rich persons protection is disproportionately greater than

that afforded the poor. Perhaps this was true centuries ago in some feudal

nations, but it is not now and never has been generally true in the United

States. Others argue that insurance is priced according to risk as well as

value, implying that high-value property is at greater risk of loss. While this

notion has conceptual merit, it does not follow that property owned by

high-income people is at greater risk than property owned by low-income

people. In fact, the rich are more likely to engage in self-protection (e.g.,

April & May 2011 11



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12 Policy Review

build protective walls, install security systems, hire guards, etc.), which

would result in reduced, not greater, risk. Seligman, Blum and Kalven, and

others have examined the property protection arguments for progression

and dismissed them as either untenably weak or without merit.Third, this interpretation of the benefits principle overlooks the principle

of marginal utility. If, as virtually all economists agree, the marginal utility of

a dollar of income declines as income increases, then people would place a

lower value on protecting their income as it rises. To accept protection theo-

ry as an argument for progression, one would have to assert that each addi-

tional dollar of income earned is worth more than the previous dollar ofincome, which is nonsensical.

Fourth, even if the protection argument had merit, it would, at best, arguefor a proportionate rather than a progressive tax. To argue otherwise

requires a belief that the price of property insurance increases faster than the

value of the property (in this case, income), which is observably untrue. If the

insurance analogy were applied, those with two times as much income or

property would pay two times as much tax, which would be proportionate,

not progressive. Its no accident that historically almost all exponents of

benefit theory employed it to support proportion as against progression.8

Fifth, the analogy to an insurance company is specious. The costs of themilitary and police and fire departments are not equivalent to property and

casualty insurance, in which the policy is priced in accordance with the value

of the property insured. There is no material difference in the cost of protect-

ing persons with high incomes or high-value property than that of persons

with low incomes or low-value property. (In fact, the cost might be less,

since persons with high income tend to reside in low-crime areas.)

Accordingly, there would be no difference in the cost of these protections

based on property value. Thus, under the protection theory, the fairest taxsystem would more logically be per capita.

A second interpretation of the benefits principle, and one that appears

clearly to have more substance and more scholarly support, is that govern-

ment benefits redound roughly equally to all people regardless of their

income. More specifically, and as noted in the preceding paragraph, the value

of benefits relating to life, liberty, and the pursuit of happiness, including the

protection of property, is essentially the same for all citizens. Thus, each per-

son should share the costs of government equally, in which case the fairesttax would be per capita. This is essentially what Harry proposed to hisbrothers as the fairest way of dividing the costs of their street improvements.

There is yet another interpretation of the benefits principle that is

arguably superior to the others, because it comes closest to placing a true

value on the benefits of government. This interpretation posits that the ulti-

mate benefit of government is the overall well-being each person derives

from its services.

Kip Hagopian

8. Blum and Kalven, 38 . .


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The Class Wars parable imagined a society in which all of the members

had the same aptitude. But in the broader society, aptitudes are distributed

widely and unequally. This changes the picture substantially, as we can see

by means of a simple thought experiment: Assume the societys populationhas a normal (bell curve) distribution of aptitudes. Assume also that all of

the persons in this society work exactly the same number of hours and at

exactly the same intensity, resulting in incomes that correlate closely with

aptitudes. In this hypothetical situation, and within each occupation,

incomes would vary across a distribution curve almost identical to the apti-

tude curve. Accordingly, persons with more highly valued aptitudes would

earn more income than their lower-aptitude counterparts, and thus derive

greater value from government. It follows, therefore, that, all things beingequal, higher-aptitude people should pay more in taxes than lower-aptitude

people not because they have more to lose (or to protect), but because

they receive greater value from their government. Blum and Kalven touchedobliquely on this concept when they noted:

Another approach [to the benefits theory] is more ingenious. It is found-

ed on a double assumption: first, that the well-being of men, while not

caused by the government, is dependent upon it in that government is a

necessary condition for its existence; second, that the only aspect of well-being which is measurable is wealth or income and that it is therefore

appropriate to take either of these as an index of the benefits flowing

from government.9

It is noteworthy that this ingenious approach is entirely consonant with

the greater-value interpretation of the benefits principle.

The greater-value interpretation of the benefits principle is at odds with

the cost-sharing concept described above (which suggests a per-capita tax),inasmuch as it argues that higher-income people should pay a higher price

for their benefits because they have received greater value from their govern-

ment, largely because of a more highly valued aptitude (which is a gift at

birth) or some other good fortune. The merit of this notion can be inferred

by imagining that aptitudes could be purchased on the open market. If such

a thing were possible, it is certain that the more highly valued aptitudes

those that would produce higher incomes would be bid up to amounts in

excess of the per-capita cost of government.

But how much more should higher-income people pay? The major fallacy

in the use of the benefits principle as an argument for progression is the

implicit premise that the value of government benefits increases more rapidly

than income. Under the greater-value theory, since income a proxy for

well-being is what each individual receives from the economic system,

income is a reasonable measure of the value each individual receives from

government. It is reasonable to conclude, therefore, that the fairest tax sys-

April & May 2011 13


9. Blum and Kalven, 37 . .


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14 Policy Review

tem is one in which each person pays tax in proportion to his or her income.

It makes no difference whether the income is derived from aptitude (as

defined), financial windfalls, random events, or privilege. In all of these

cases, the tax should be levied in proportion to the value of the benefitsreceived. Thus, a person who earns 10 times as much income as another

would pay 10 times as much tax, while someone making 100 times as

much would be taxed 100 times as much.

A new and important contribution to the debate over fairness emerged in

the mid-19th century when proponents of proportionate taxation realized

there were both practical and intellectual reasons for exempting a portion of

income from taxation. The practical reason was simply the futility of taxing

that portion of a persons income that was needed for survival. To do sowould be self-defeating, since the hardship imposed would deprive the state

of production. The intellectual basis for the exemption, from the point of

view of the state, emanated from the notion that income needed for subsis-

tence constituted an expense of production, while income above this amount

was surplus or clear income, i.e., net of production costs (an insight

attributed to the economist David Ricardo). From the point of view of the

taxed, government benefits only have real value when the taxpayer earns a

surplus of income over what is needed for subsistence. Most scholars whosupported a proportionate tax system concluded that taxing only clear

income was both practical and fair to both the individual and the state. This

enhancement to the benefits principle, which introduced a mild degree of

progression by comparison to a pure proportionate tax (a tax from the first

dollar of income), became known as a degressive tax. It is important to

note that, among the proponents of the degressive tax, there was clear con-

sensus that the income exempt from tax should be set no higher than the

level of subsistence. To do otherwise would be arbitrary and in the opinionof many, inequitable.

The greater-value interpretation of the benefits principle stands as a rejec-

tion of a per-capita tax system and as a compelling case for either a propor-

tionate or a degressive system.

Sacrifice theory and the marginal

utility of money

Sacrifice theory is perhaps the most historically prominent and

persistent argument in favor of progressive taxation. Stated simply,

the theory posits that the fairest tax is one that extracts from each

taxpayer an equal or proportionate sacrifice. The theory rejects the quid-

pro-quo notion that taxes are remitted in return for government benefits and

instead treats taxes simply as a burden that must be shared in the most equi-

table way. Sacrifice theory is dependent upon the economic principle that

Kip Hagopian


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holds there is a marginal-utility curve for money to the effect that the more

money one earns, the less utility (or satisfaction) will be derived from the last

dollar earned. Thus, if you plot a chart in which the vertical axis is units of

marginal utility a person gets from money, and the horizontal axis is theamount of money the person earns, the curve will eventually have a down-

ward slope. A downward slope indicates, for example, that an incremental

$1,000 has greater utility to a person earning $10,000 a year than it has

to someone earning $100,000.

The economic principle of marginal utility on which sacrifice theory

depends is sound. However, there are several difficulties with the sacrifice

theory itself that render it untenable as an argument for progression.

First, the basic premise of sacrifice theory is conceptually flawed. Thenotion that taxes are simply a burden that must be tolerated rather than a

payment for benefits raises the question: Why would the citizens of a democ-

racy vote to impose taxes on themselves if they did not expect benefits in

return? And if the government does provide benefits (which of course it

does), why would the payment of taxes be considered a sacrifice rather than

a fair payment for value received? Did the Class brothers not receive benefits

from their street improvements? If they did, what would be the logic of a tax

based on proportionate sacrifice rather than one based on shared cost orvalue received? On conceptual grounds alone, sacrifice theory appears to be

a very weak foundation for tax policy.

Second, the validity of the theory depends on more than just the existence

of a downward sloping marginal-utility curve. For progression to be justified

under a theory of equal sacrifice, the curve must not only decline, but

decline more rapidly than income rises. In the view of British economist

Arthur Pigou and others, there is no way to prove this is true:

All that the law of diminishing utility asserts is that the last 1 of a1000 income carries less satisfaction than the last 1 of a 100 income

does. From this datum it cannot be inferred that, in order to secure equal

sacrifice . . . taxation must be progressive. In order to prove that the

principle of equal sacrifice necessarily involves progression we should

need to know that the last 10 of a 1000 income carries less satisfac-

tion than the last 1 of a 100 income; and this the law of diminishing

utility does not assert.10

Seligman credits the Dutch economist A.J. Cohen-Stuart with debunking

the notion that there is a universal marginal-utility curve that dictates pro-

gression. Here Seligman quotes Cohen-Stuart: It is perfectly possible . . . to

construct tables [curves] which lead not to progression, but to proportion

and even to regression.11

April & May 2011 15


10 . Arthur C. Pigou, A Study in Public Finance (Macmillan, 1951), 85-86. .

11 . Seligman, 219..


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16 Policy Review

Third, the sacrifice argument for progression is dependent upon the addi-

tional assumption that the marginal-utility curves of all persons are essential-

ly the same. While it is well accepted that marginal-utility curves will eventu-

ally slope downward, it is by no means true that all curves have the sameslope. In fact, in comparing the marginal-utility curves of Tom, Dick, and

Harry Class, there are any number of reasons why Harrys marginal utility

curve might decline less steeply than Toms and Dicks. Imagine, for exam-

ple, that Harry has a learning-disabled son who needs costly special educa-

tion, or that Harrys wife has an illness that requires expensive medication

not covered by insurance. Or perhaps Harry has an obsession with saving

enough money to send his two children to the best private secondary schools

and universities. Now consider Toms and Dicks situation: Knowing thatHarry is the most industrious of the brothers and was unlikely to need their

help, Harrys parents made it clear that when they died they would leave all

of their rather significant estate to the less industrious brothers, leaving

nothing to Harry. In this event, Toms and Dicks marginal-utility curves are

affected by their knowledge that they dont need as much income to secure

their future. Thus, Toms and Dicks marginal-utility curves may have steep-

er downward slopes than Harrys, even though Harry earns much more

income. Seligman calls this the very core objection to sacrifice theory:The imposition of equal sacrifices on all taxpayers must always

remain an ideal impossible of actual realization. Sacrifice denotes some-

thing psychical; something psychological . . . Two men may have the

same income, which they may value at very different rates. The one may

be a bachelor, the other a man with a large family dependent upon him;

the one may be well, the other ill . . . the one may earn his income, the

other may receive it as a gift . . . The attempt to ascertain a mathematical

scale of progression, so as to avoid a charge of arbitrariness, is fore-doomed to failure.12

This inability to prove the sameness of the marginal-utility curves of dif-

ferent people troubled Blum and Kalven to the point that they dismissed sac-

rifice theory as a theory on which to base a fair tax system:

The error lies in trying to translate money, which can be measured in

definite units, into corresponding units of satisfaction or well-being. In

the end satisfaction in the sense of happiness defies quantification. Utility

is a meaningful concept; units of utility are not. It is in the face of this

difficulty that, even waiving all other objections, the whole elaborate

analysis of progression in terms of sacrifice and utility doctrine finally

collapses.13

Kip Hagopian

12 . Seligman, 222-223. .

13 . Blum and Kalven, 63..


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If there is no accurate way to draw any individuals marginal-utility curve,

there is no way to compare the curves of different persons. The only things

that can be stated with confidence are that all persons have marginal-utility

curves that are ultimately downward sloping and that the slopes of individ-ual curves are determined by many factors in addition to income. And even

if, as a general proposition, the curves are similar (as intuition would sug-

gest), there are sufficient variations in them that sacrifice theory could not be

applied without resulting in the inequitable treatment of an unacceptably

large portion of the population.

Fourth, for a substantial (but indeterminate) number of workers

those who work because they need the money rather than because they

enjoy it the number of hours they choose towork is determined by the marginal utility of the

income they earn from that work. Thus, for these

workers, work effort has its own marginal-utility

curve that is essentially the same as the marginal-

utility curve for income. To illustrate: Harrys fami-

ly chooses to work 100 hours a week, while Toms

family chooses to work 20 hours a week. Harry

and his wife work these long hours because themarginal utility of the income produced from the

extra hours is greater than the marginal utility of

leisure (up to that point). Conversely, Toms family

has decided to work only 20 hours per week

because the additional utility of the income from

the 21st hour is sufficiently low to him that he

chooses to forgo it in favor of leisure. In this entirely plausible scenario,

the marginal utility of one extra dollar to Harry might be equal to themarginal utility of one extra dollar to Tom. It is also plausible that the

marginal utility of another dollar to Harry is even greater than it is toTom, in which case, under its own logic, sacrifice theory would call for

taxing Harry less than Tom. In either of these scenarios, taxing Harry at ahigher marginal rate than Tom (as required by a progressive income tax)

would be inconsonant with sacrifice theory, and by its own standard,

inequitable.

Fifth, the application of sacrifice theory would be plainly unfair to the

people in a society who work the hardest. Among people whose aptitudesare the same, the only way one person can earn more than a peer is byworking harder. But progression has the perverse effect of reducing average,

after-tax hourly wage or salary rates as work effort increases. Consider theClass brothers: While Toms average, after-tax hourly wage was $25 (hepaid no tax), Dicks was $22.82 , and Harrys was only $21.10 (this

assumes the tax on Harrys $75,000 in labor income was $11,725 or 50

percent of the familys total tax of$23,450). To put this into perspective,

imagine you are interviewing for a job. When you ask what the job pays,

April & May 2011 17


Among people

whose aptitudes

are the same,

the only way

one person can

earn morethan a peer is

by working

harder.


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18 Policy Review

your prospective employer says, Well that depends on how hard you

work. You say, Good, because I am a hard worker. To which the

employer responds, You dont understand. If you work 20 hours a week, I

will pay you $25 per hour. But if your family works 100 hours a week andhas income from savings, I will pay you about $21 per hour. The more

hours you work, the less average hourly wage I will pay you. John Stuart

Mill gave full voice to this apparent injustice when he denounced progressive

taxation as a penalty on those who worked harder and saved more than

their neighbors and a mild form of robbery.14

On the surface, sacrifice theory appears to be a respectable argument for

progression. But on close examination, it seems clearly without merit as a

rationale for a fair tax system. By far the most compelling condemnation ofsacrifice theory is not the argument over the slopes of the marginal-utility

curves, but the unfair penalty it would impose on the hardest working and

most productive people in society.

Ability to pay

The notion of ability to pay is most often identified with KarlMarx (from each according to his ability, to each according to his

needs), even though the basic concept was considered by scholars

long before Marx was born. While the phrase says nothing about progres-

sion, it has often been used to advocate it.

Ability-to-pay has been the subject of considerable debate on

definitional grounds alone. For example, a review of the literature on tax

theory does not turn up a generally accepted definition of the word

ability. What does according to his ability really mean? Does it mean(as some suggest) the financial wherewithalwith which to pay taxes which might come from either assets or income? Or does it mean the innate

or learned ability to earn income, which would equate to aptitude?

Both of these interpretations have been discussed in the literature. Either

way, ability could as easily dictate proportion as it could progression.

If the word means the financial wherewithal with which to pay taxes pro-gressively, the basic concept lacks an underlying principle of fairness to sup-port it. (Proponents of this meaning of ability-to-pay often draw on

sacrifice theory for intellectual support, but as shown above, the applica-

tion of sacrifice theory results in inequitable outcomes.) If the word

ability means the innate or learned capacity to earn income, it is synony-

mous with aptitude, in which case, the greater-value interpretation of

the benefits principle should be applied. This would lead to proportionate

taxation.

Kip Hagopian

14 . John Stuart Mill, Principles of Political Economy with some of their applications to social philoso-phy, Vol. II(D. Appleton and Company, 1894), 99, 401.


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Reducing income inequality

One of the most persistent arguments in favor of progressive taxa-

tion is that it reduces income inequality. For example, University of

Chicago economist Henry Simons writes:

The case for drastic progression in taxation must be rested on the case

against inequality on the ethical or aesthetic judgment that the pre-

vailing distribution of wealth and income reveals a degree (and/or kind)

of inequality which is distinctly evil or unlovely.15

To be sure, inequality exists in the United States as it does to a greater or

lesser extent in all other nations. But why should we care? If it is social jus-

tice we are concerned about, what is the evidence that the level of American

inequality is unjust?

There are at least five methodologies used for measuring income inequali-

ty. The most commonly used measure is the Gini coefficient, developed by

the Italian statistician Corrado Gini. The Gini coefficient is a method of

measuring the statistical dispersion of (among other things) income, con-sumption, and wealth. The figure of merit for the Gini coefficient ranges

from zero to 1.0, where zero equals total equality (all persons have identical

incomes) and 1.0 equals total inequality (one person has all of the income).

By this measure, the U.S. has higher income inequality than almost all other

industrialized nations. In 2009, the U.S. Gini was .468, while the average

Gini for the 27 European Union nations was .304, a ratio of1.54:1.

Interestingly, the per capita gdp in the U.S. in 2008 was $47,400, while

the average per-capita gdp in the eu nations in that year was $32,900, asimilar ratio of1.44:1. The point is that strong economic performance can

coexist with higher levels of income inequality (and vice versa).

It is important to note that the U.S. income figures cited above come from

the Census Bureau, which uses what it calls money income (income before

taxes, excluding the value of non-cash benefits). Money income is the

income definition most often used when citing income inequality mea-

sures,16 even though this definition of income does not include many vari-

ables that might affect inequality and standard of living, such as transfer

payments, taxes, employer-provided fringe benefits (primarily retirement

benefits and health insurance, which can amount to as much as 30 percent

of income17), capital gains, dividends, imputed rent from owner-occupied

April & May 2011 19


15 . Blum and Kalven, 72 . .

16 . Gini coefficients cited herein come from The CIA World Fact Book 2010, the Census Bureau reporton Income, Poverty, and Health Insurance Coverage in the United States: 2009 and other U.S. govern-ment publications, and Eurostat, the official statistical office of the European Union.

17 . Bureau of Labor Statistics, Employer Costs for Employee Compensation: December 2010.


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20 Policy Review

housing, size of household, increases in the value of home equity and other

investments, etc. Consequently, the value of using money income to measure

either standard of living or inequality is quite limited.

It has been widely reported that income inequality in the U.S. has beenrising for decades, and by implication, that the rise is ongoing. These

reports are arguably misleading. From 1967 to 2008 the Gini for moneyincome rose from .397 to .468 (17.9 percent), about four-fifths of whichoccurred from 1967 to 1993 . Roughly three-tenths of this increase

occurred between 1992 and 1993 due to a change in the way data were

collected. This change in methodology biased the Gini calculation upward.

Accordingly, figures from the period before 1993 are not directly compara-

ble with the period from 1993 to the present.During the 16 years between 1993 and 2009, the

Gini increased from .454 to .468 (3.1 percent),

and from 2001 to 2009 there was virtually no

change in income inequality as measured by the

Gini coefficient.

A more comprehensive measure of income yields

a very different picture. The Census Bureaus so-

called 15th measure of income adds to moneyincome, transfer payments, insurance supplements,

capital gains, Medicare, Medicaid, net imputed

return on equity in owned homes, and subtracts

taxes. This measure indicates that inequality

declined1.8 percent during the last 16 years (1993to 2009) from a Gini of .395 to a Gini of .388.

In any event, the consensus view among economists is that the best mea-

sure of living standards over the long term is consumption (determined notonly by income but by savings, home ownership, borrowing, barter, regionof domicile, and other factors), suggesting that consumption inequality is the

inequality that counts the most. A 2005 study conducted by the Bureau of

Labor Statistics found that in 2001 (the most recent year for which data are

available) the Gini coefficient for consumption was .280,18 indicating that

inequality with respect to this measure of U.S. living standards is relatively

modest. It also appears that consumption inequality has barely changed in

recent years. During the period 1986 to 2001, the consumption Gini went

down slightly, from .283 to .280.19 Since the Gini for money income was

virtually unchanged from 2001 to 2009, it is quite possible that the Gini

for consumption was also relatively flat during that period; in which case,

consumption inequality has not increased for 23 years or more. Support for

Kip Hagopian

The consensus

view among

economists

is that the

best measure

of livingstandards over

the long term is

consumption.

18 . David S. Johnson, Timothy Smeeding, and Barbara Boyle Toney, Economic Inequality Through thePrisms of Income and Consumption, Monthly Labor Review (Bureau of Labor Statistics, April 2006),available at http://www.bls.gov/opub/mlr/2005/04/art2full.pdf.

19 . Johnson, et al., Economic Inequality.


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this latter surmise comes from a 2010 study which concluded that in the

2000s overall consumption inequality shows little change.20

In addition to Americas substantial superiority in gdp per capita (which

is a measure of the performance of the economy without regard to howincome is distributed), the U.S. has a much higher standard of living than

virtually all of the most advanced European and Asian countries. According

to the Luxembourg Income Study (which uses a very comprehensive mea-

sure of income) median disposable personal income in the U.S. in 2002 was:

19.3 percent higher than Canada; 68 percent higher than Finland; 45 per-

cent higher than Germany; 59 percent higher than Italy; 31 percent higher

than Norway (despite its vast oil and gas wealth); 73 percent higher than

Sweden; and 31 percent higher than the UnitedKingdom. It should be noted that the figures forgdp per capita and median income understateAmericas advantage because the median age of

Americas population (about 36.8 years) is about

four years lower than the average of the median ages

in Western Europe and almost eight years younger

than Japan. Age (a proxy for experience) is one of

the most significant contributors to income and isalso, therefore, one of the most significant contribu-

tors to income inequality. In addition to higher

median incomes, Americans have higher median net

worths, which add further to the standard of living differential.

There is no question that until the recent recession, the U.S. economy

performed well in both absolute and relative terms over the 25-year period

from 1983 to 2008 . During this period, real compound annual gdp

growth in the U.S. was 3.3 percent, substantially greater than the growthof its g-7 counterparts, which on a weighted-average basis (using either

population or gdp), grew only 2.3 percent per year. Thus, the U.S. econo-

my grew 43 percent faster per year than the non-U.S. g-7 countries.

Moreover, in the recent recession, the U.S. economy contracted less than

the worlds other advanced economies. For example, U.S. gdp shrunk 2.6

percent in 2009, substantially less than the 4.1 percent contraction experi-

enced in the Euro area. In 2010, the U.S. grew 2.8 percent compared with

only 1.8 percent growth forecast for the Euro area by the International

Monetary Fund.

Another common claim is that incomes in the U.S. have been stagnant for

decades. But this claim is at odds with data from the Congressional

Budget Office, which uses a measure of household income that, like the

Luxembourg measure, is quite comprehensive, taking into account transfer

April & May 2011 21


The U.S economy

performed well

in absolute and

relative terms

over the 25-year

period from1983 to 2008.

20 . Bruce D. Meyer and James X. Sullivan, Consumption and income inequality in the U.S. since the

1960 s (2010) working paper, available at http://harrisschool.uchicago.edu/faculty/web-pages/Inequality60s.pdf


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22 Policy Review

payments, health and retirement benefits, profits from retirement accounts,

imputed interest on owner occupied homes, differences in household size,

and taxes paid. Using this more meaningful definition of income, from 1983

to 2005 real median household income in the U.S. rose by 35 percent,which can hardly be considered stagnant.

The presentation of these facts is not meant to suggest that income

inequality causes higher living standards or gdp growth. But it is clear thatit can co-exist with both high and low national living standards. Those who

advocate redistribution of income on grounds of social justice should consid-

er that Americas standard of living is higher and has grown faster than vir-

tually all of the nations exhibiting lower measured inequality. This suggests

that the most notable economic inequality in the world is that betweenAmericans and the citizens of all other countries.

The most compelling argument against the use of the progressive income

tax to redistribute income is simply that it is inequitable. Blum and Kalven

noted that when the tax system is used to redistribute income,

the welfare of one group in a society has been increased at the expense

of the welfare of a different group. Stated this way there is no general

welfare; there is only the welfare of the two groups and the wealthy

receive no counter-balancing benefits for their surrender of income orwealth.21

As contrasted with the benefits principle and sacrifice theory, each of

which relies on conceptions that purport to enhance equity, income redistri-

bution is simply a coercive transfer of wealth from one group to another

without an equity principle to support it. Note that $13,450 of Harrys

income was distributed to Tom and Dick. (This is the difference between

Harrys one-third share of the cost of the street improvements ($10,000)and the $23,450 he was forced to pay.)

Ironically, a progressive income tax can even have the extraordinary

effect of increasing rather than reducing income differences. Again, our

parable is instructive: Assume that Harrys boss is a construction foreman

who works 40 hours a week at $37.50 per hour, thus earning $75,000

per year (which is the entirety of the family income). The foremans hourly

rate is commensurate with his aptitude as a manager, while Harrys $25

per-hour rate is commensurate with his aptitude as a carpenter. They both

make $75,000 per year, but Harry does it working 60 hours per week

and his boss does it working 40 hours per week. Under the current pro-

gressive tax system, Harrys after-tax income will be $63,275 (after$11,725 in tax, which assumes that, since Harrys labor income is 50

percent of his total family income, the tax attributable to him is 50 per-

cent of the $23,450 tax paid by the family). His boss will take home$68,450 (after $6,550 in tax). Thus, a disproportionate amount of

Kip Hagopian

21 . Blum and Kalven, 75 . .


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Harrys income has been taken from him and redistributed, simply because

his family worked harder.

As noted by Blum and Kalven, and illustrated by our parable, redistribu-

tion requires that money be taken from some and given to (or not takenfrom) others. What is the equity principle that justifies this taking?

Redistribution has been justified by some as a means of rectifying social

injustice in the economic system. But proponents of this view have not pro-

vided a convincing argument that such injustice even exists.22

There is no persuasive evidence that reducing income inequality will

increase economic well-being for the majority of people; in fact, Americas

superior median standard of living relative to the other advanced economies

is evidence to the contrary.

The case against progression

The strongest arguments againstprogression are the rebut-tals to the arguments for progression. To wit: The pro-progressioninterpretation of the benefits principle is invalid because it depends

on the untenable assumption that the value of government benefits increasesmore rapidly than the rise in income; on the surface, sacrifice theory is a

respectable argument for progression, but on closer examination, it is clear

that its application produces an inequitable outcome (this is most obviously

so when applied to income derived from greater work effort); the ability-to-

pay argument lacks an equity principle (other than sacrifice theory) on

which to base a fair tax system; and redistributing income through a pro-

gressive tax system is inequitable.

These rebuttals to the arguments for progression, should be sufficient tosettle the case. But there are other important reasons to reject progressivetaxation.

Political irresponsibility. In 2008 , the top 1 percent of taxpayers inAmerica earned about 20 percent of all personal income and paid roughly

38 percent of federal income taxes; the bottom fifty percent of taxpayers

currently pay only 2.7 percent of income taxes,23 and it is estimated that

46.9 percent of workers paid no federal income tax for the 2009 calendar

year.24 Inasmuch as only a minority of taxpayers is affected by rises in tax

rates, there is a built-in incentive for the majority to act in its self-interest,

which opens the door to inequitable treatment of the minority.

April & May 2011 23


22 . To be sure, there are people in America who are needy or disadvantaged, in some instances grievouslyso. For such people the most effective remedy would be through direct spending programs. But the fund-ing for such programs should come from a tax system that is equitable.

23 . Mark Robyn and Gerald Prante, Summary of Latest Federal Income Tax Data, Fiscal Fact249(Tax Foundation, October 6, 2010), available at http://www.taxfoundation.org/news/show/250.html.

24 . Roberton Williams, Who pays no income tax?, Tax Notes (June 29, 2009), available athttp://www.taxpolicycenter.org/Uploaded pdf/1001289_who pay.pdf.


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Arbitrariness. Establishing a graduated rate scale and setting the top mar-ginal rate on that scale are inherently arbitrary tasks. Scottish economist J.R.

McCullough condemned this arbitrariness in the strongest of terms:

The moment you abandon . . . the cardinal principle of exacting from all

individuals the same proportion of their income or their property, you

are at sea without rudder or compass, and there is no amount of injus-

tice or folly you may not commit.25

The progressive tax system rests on a very slippery slope, making the term

fair share so subjective as to be an invitation to abuse. Did Harrys broth-

ers pay their fair share?Fomenting dissension. One of the inherent characteristics of the U.S. sys-tem of government (and that of all Western nations) is the tension that exists

between the political system (majoritarian) and the economic system (free

enterprise). Most Western nations are experiencing the effects of this tension,

which manifests itself in vigorous disputes over tax and welfare policies.

Many of those who favor income redistribution assert that inequality

foments dissension. Whether this is true or not, dissension is just as likely to

be caused by tax laws that are deemed unfair by those being taxed. By itsnature, a system that taxes people progressively without the support of an

accepted equity-based principle may breed resentment, particularly when so

many pay no tax at all. The deepest resentment will most likely be among

those whose tax rates differ solely because of their work effort.

A new doctrine of fairness?

There is no perfectly fair tax system. But based on an examina-

tion of the various tax principles and theories described in the liter-

ature, together with a critical analysis of the arguments supporting

and opposing progression, its possible to put forward a new doctrine of

fairness. It is based on five principles:

The most equitable tax system is one based on the value of benefitsreceived.

Income is the most equitable (or least inequitable) measure of the valueof benefits; thus taxes should be levied in proportion to income. Well-being is the ultimate benefit of government and income is a reasonable

proxy for well-being. Whether income is derived from aptitude (as

defined), a financial windfall, a random event or privilege, it is fair (or

less unfair) that it be taxed in proportion to value received. This princi-

Kip Hagopian

25 . J. R. McCullough, A Treatise on the Principles and Practical Influence of Taxation, or the FundingSystem (The Lawbook Exchange Ltd., 2007), 143-145.


27/100

ple serves as a rejection of a per-capita tax system and establishes the

affirmative case for proportion.

Only clear income defined as income above the level of subsis-

tence should be taxed. From the point of view of the state, an indi-viduals earned income up to the level of subsistence is effectively the

governments cost of production and should not be taxed. From the

point of view of the taxed, government benefits only have real value

after the taxpayer earns a surplus of income over what is needed for

subsistence.

The progressive taxation of income from work effort is inequitable.

Income is derived primarily from a combination of aptitude and workeffort. All things being equal, people with high-value aptitudes earn

more than those with low-value aptitudes. Each tier of aptitude

(whether there be 100 or 10,000 such tiers) comprises a mini-soci-

ety in which differentials in income between the members are derived

almost solely from work effort. Under a progressive tax system, work-

ers whose work effort is above the median in their aptitude tier will

pay higher average taxes per hour than those below the median. As a

result, at any one point in time, an unacceptably large percentage of the

total work force will earn less average, after-tax income per hour than

their peers, simply because they worked harder. This is inequitable on

its face.

The progressive taxation of income from aptitude is inequitable.Whereas the most equitable tax system is one based on the value of

benefits received from government; and whereas the value of govern-

ment benefits does not increase more rapidly than income, there is no

equitable basis for taxing income progressively. Thus, even if it wereassumed that income was derived solely from aptitude, progression

would be unfair.

Implicit in this fairness doctrine is that taxation in excess of a proportion-

ate share of the value of benefits (defined as clear income) is an inequitable

confiscation of property.

Critique of the doctrine

There are weaknesses in the logic of this doctrine that make

the fairness of a proportionate or degressive tax system less than

perfect. First, some have argued that the benefit derived from eco-

nomic well-being (as measured by income) should be considered separately

from the benefits derived from government protection of life, liberty, and

property. This alternative view has induced some scholars (John Stuart

April & May 2011 25



28/100

26 Policy Review

Mill, for one) to suggest that two types of tax should be imposed: a pro-

portionate tax to pay for economic well-being and a per-capita tax to pay

for the protection of life, liberty, and property. Putting aside the measure-

ment difficulties of such a scheme, if this alternative quid pro quo principlewere applied, and the two tax rates were blended to reflect the different

values of the benefits, the most equitable tax would be somewhere between

per-capita and proportion. Thus, a proportionate or degressive tax as pro-

posed, would favor lower-income persons at the expense of higher-income

persons.

Second, a proportionate tax would only be fair if all income were derived

from aptitude, when in fact a substantial portion of income is derived from

work effort. The inequity of this is demonstrated in the Class Wars parable,in which Harry paid more than a per-capita share of the cost of the street

improvements despite the fact that his benefits were exactly the same as his

brothers. (Note that in this all-too-common circumstance, where both apti-

tudes and benefits are equal, even a proportionate or degressive tax is redis-

tributive with respect to the hardest workers.) Thus, a proportionate tax

favors people who work less over people who work more.

Third, the merit of the clear income theory is somewhat undermined with

respect to hard workers. Again this can be seen in our parable: Using adegressive tax system and assuming the subsistence level of income was

$25,000, Tom would not have to pay any tax, even though he could easily

pay his share of a proportionate tax simply by working three more hours

per week. Thus, the degressive tax favors people who work less at the

expense of those who work more.

Since there is no perfectly equitable tax system, the goal must be to design

the least inequitable system. This doctrine of fairness uses sound principles

of equity to reject both the progressive and per-capita tax systems. At thesame time, it establishes the affirmative case for a degressive system as being

the least inequitable. Lastly, where the logic of the doctrine is flawed, in each

case it errs on the side of taxing lower-income people less, regardless of the

reason their income is lower.

Seeing income clearly

The flaw in virtually all of the intellectual arguments on the issue

of the progressive income tax (both pro and con), is a lack of

appreciation for how income is determined. Because of this, the

crucial implications of the distinction between income derived from aptitude

and income derived from work effort have been left out of the debate. When

the importance of work effort is considered, the inequity of progression

becomes clear.

While the title of Blum and Kalvens book appears to indicate that the

authors analysis led them to become uneasy proponents of progression, the

Kip Hagopian


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reality is more nuanced (and more uneasy). At the conclusion of the book,

they wrote:

The case for progression, after a long critical look, thus turns out to be

stubborn but uneasy. The most distinctive and technical argumentsadvanced in its behalf are the weakest. It is hard to gain much comfort

from the special arguments [in favor of progression], however intricate

their formulations, constructed on the notions of benefit, sacrifice, abili-

ty to pay, or economic stability. The case has stronger appeal when pro-

gressive taxation is viewed as a means of reducing economic inequalities.

But the case for more economic equality, when examined directly, is

itself perplexing.

The authors seem to be saying that the only argument for progression

that could not be dismissed was the value they ascribed to reducing income

inequality. And even that argument left them uneasy.

But it is clear from a careful reading of the book that Blum and Kalven

did not appreciate the implications of how income is determined, specifically

the special nature of income derived from work effort. If they had, they

almost certainly would have realized that taxing such income progressively

is inequitable. In the event, their uneasy case for progression would havebecome an easy case for its rejection.

April & May 2011 27



30/100

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The best law schools and public policy graduate schools

inculcate in their students an ability to make the strongestpossible case in favor of a position or policy with which

they disagree. The test of whether the lesson has been truly

learned is whether those who favor the position would

accept its rendition as a fair and effective representation of why they favor it.

With this in mind, I present below the argument for the U.S. stance favor-

ing a substantial rise in the undervalued Chinese yuan. The U.S. position has

been repeatedly stated, albeit in abbreviated and nuanced form, by President

Obama and Treasury Secretary Geithner. It is also reflected in the large

bipartisan majority in the House of Representatives that approved legisla-

tion to allow a retaliatory tariff on Chinas exports to the U.S. unless China

revalues its currency. It has been expressed more vociferously and combat-

ively by key leaders in the Senate, and by politically-charged commentators

including Paul Krugman.

A Smarter Approach

to the YuanBy Charles Wolf, Jr.

Charles Wolf, Jr. holds the corporate chair in international economics at theRAND Corporation, and is a professor in the Pardee RAND Graduate School.He is a senior research fellow at the Hoover Institution.

April & May 2011 29 Policy Review


32/100

30 Policy Review

Once the case for this pro position has been presented fairly and fully, I

will explain why I think it is fundamentally wrong. I will then go on to sug-

gest measures that would be more appropriate and effective in contributing

to a rebalancing of Chinas international accounts as well as those of theU.S. than would a revaluation of the Chinese yuan.

In early January, when President Hu Jintao met in Washington, D.C.,

with President Obama, the agenda for the meeting deftly acknowledged the

presidents disagreement on the currency issue without discussing, let alone

resolving, it.

The case for revaluing the yuan

The Chinese yuan (also known as the renminbi, or peoples

currency) trades in foreign exchange markets at a rate of approxi-

mately 6.7 yuan per dollar (equivalent to about fifteen U.S. cents

per yuan). Another measure that accords the yuan a considerably higher

value is based on the goods and services the yuan can buy within China

compared to what these same goods and services would cost in the U.S. This

rate is referred to as the yuans purchasing power parity (ppp). The ppp val-uation of the yuan is roughly two or three times higher (between 2.2 and

3.4 yuan per U.S. dollar, or between 30 and 40 U.S. cents per yuan) than

the market exchange rate.

Associated with the yuans value in foreign exchange markets is the fact

that the value of Chinas global exports of goods and services perennially

exceeds by large amounts the value of its imports. Indeed, this exc

Documents

Policy Review, April & May 2011, No. 166