A Thought Experiment on Tax Philosophy 17-04-2011

I am by no means an Economist; I don't even profess to be intelligent on these matters in any way. However, I do think that approaching something as robust and complex as Economics with a common sense perspective can be useful. And lately, I've been thinking about marginal tax rates for different segments/brackets of the taxable population (partially due to these Quora questions on the matter and similar dialogues). Particularly, a thought experiment of sorts has been going through my head. And as the scenario has played out in my mind, it has highlighted to me that my own Economic principles are a bit scattered.

So this is partially an attempt to organize them by force. I should note that I am definitely a person concerned with normative matters and that am I very much concerned with what is just and fair. I'm not quite sure how exactly these factoids affect or inform the following, but I guess we'll see.

The Experiment

Imagine a nation which has been economically prosperous for decades and which has recently experienced a severe downturn due, in large part, to the ill-advised, irresponsible actions of those who have the vast majority of power in the financial sectors. And let us further assume that those who were most responsible for the economic crisis, which financially devastated a large swath of the general population of the country, were largely unaffected and in fact often times came out ahead in the aftermath. These people who gained at the expense of others were already quite wealthy, those who lost money were not, and many of these wealthy, powerful people that caused said disaster were awarded with humongous bonuses (by the corporations which they own, bonuses which were paid for in part by a tax payer provided bailout plan) after the fact for their startlingly poor failures. Let us call this nation Nation A.

Let us say that in Nation A, wealth is distributed as such: the top 1% of the wealthiest A-ites (that's the name of the citizens of Nation A, clearly) control 42% of the financial wealth of the nation while the bottom 80% control 7% of the financial wealth. The individuals of the top 0.01% of the population have nearly 1,000 times as much income on average as those from the bottom 90%. For a bit of historical perspective, let us assume that in this nation history has shown quite evidently that greater gaps between the rich and everyone else have correlated to a dangerous lack of stability in the economy; in fact, the last time such a large gap existed in Nation A, a massive, crippling economic depression developed which lead to untold amounts of poverty, with all metrics of personal wealth dropping sharply across the board, unemployment jumping to a staggeringly high 25% within the nation (and even higher amounts in other nations) and despair and misery for almost everyone.

Returning to the recent economic downturn mentioned in paragraph one of the experiment, let us also denote that the top 20% of the wealthy in Nation A control some 91% of stock ownership. Many of these companies which the elite own a vast majority of have been using the economic crisis as a reason for vast layoffs across a number of industries. Many workers have lost their jobs because the companies apparently could not afford to continue to support their employment. Those who lost their jobs were largely middle or lower class: they were certainly not in the wealthy 20%. Those 20% who owned the companies making the layoffs received immediate gain from the layoffs in the form of a predictable increase in stock value.

Now, let's say that Nation A taxes the income of its working citizens. The society of Nation A agrees upon allowing the Governing bodies to tax their hard-earned income because the taxes are used to support the infrastructure of said society, being distributed and utilized by the Governing bodies for programs which help to keep the society and the nation functioning and prosperous. Essentially, everyone in Nation A has agreed to give up a portion of their income (which they earn by spending an average of 1/3 of their daily life working) because it is for the good of all. Seems like a wonderful gesture by the community of Nation A. A gesture of selflessness and, really, of common sense. If the idea of a Governing body is to provide for the people what they cannot provide themselves, including such concepts as security, justice and stability, then it makes sense for the people to help pay for this extremely expensive cause. Any community must work to combat the forces of entropy, after all, if it wishes to survive.

But let us assume that in Nation A, the top marginal tax rate (the amount of taxes paid on the income of the wealthiest bracket of tax payers) has steadily decreased in recent decades. During the aforementioned crippling depression, the top marginal tax rate was at its lowest, just north of 20%. The next handful of decades, marked largely by economic success and prosperity, prominently featured much higher top marginal tax rates, frequently hovering around the 90% mark. And in the most recent years leading up and into the recent economic recession, the top marginal tax rate has dropped down to the mid-30s in percentage.

Let us also observe that the leader of Nation A is a President, with the Governing body being a constitutional republic. Note that around thirty years ago, the time when the top marginal tax rate started to plummet and the gap between the rich and everyone else began to skyrocket, a new President of Nation A (let us call him Hagan) was elected who heavily endorsed and implemented a system of economic policy based around the principle that increasing the ability to obtain/generate wealth (especially for those already wealthy) will lead to a trickling down of economic prosperity to the rest of the population. In short, tax breaks and other direct incentives for the wealthiest elite, so the theory goes, lead to indirect gain for everyone else, too. Let it be known that in the time since this President's election and the subsequent ushering in of this new economic philosophy, the average income of the bottom 90% of the wealthy slightly decreased (adjusting for inflation) while the average income of the top 0.01% of the wealthy multiplied by almost six (again adjusting for inflation).

Again returning to the recent economic crisis: let us assume that the Governing body and general population of Nation A have recently been debating how to cut the national debt and increase the national revenue. One large section of individuals has proposed slashing funding to major social programs which allow for, among other things, health care for those who otherwise could not afford it. Those who would lose the most from this proposal are the poor, those near the bottom of the wealth distribution. The ones who most rely on the success of the Governing body. Another section of individuals has suggest getting rid of recently imposed tax breaks which, evidence shows, have shifted the tax burden away from the high-income A-ites toward the low-income A-ites. These individuals correctly point out that simply eliminating the present tax breaks would be even better for the budget's bottom line than the opposition's proposal in terms of long term viability.

The idea of tax rate distribution has a been particularly controversial debate in Nation A, with many different sides and arguments. Some have argued that it is unfair to more heavily tax the wealthiest. The idea is that the wealthiest individuals are wealthy because of their own hard work, and additionally that the wealthiest individuals create more wealth, value and employment opportunities for the rest of the population (ignoring the fact that a large amount of the wealthy have become so rich without actually creating value or wealth, instead by simply manipulating currency and assets for personal gain). Not only is it simply unfair to have different tax rates for different citizens, so it postulates, but it is repulsive to the wealthy: with higher tax rates, there is less incentive for the wealthy to continue their work. It further states that because the rich are mobile and can move their assets elsewhere (namely, outside of Nation A), the nation should do its best to essentially appease these individuals so that they continue to grace Nation A with their presence and their fortune.

But some A-ites have argued that it speaks to the character of the wealthy that they would forego making a larger contribution, regardless of the legality, for the sake of self-interest. The top bracket of the financial hierarchy, so the argument goes, owe more to the society in which their wealth was accumulated because the structure of said society made such riches possible. They have more assets and wealth tied into the fabric and structure of the community (and more consumption from the nation's resources), so they have a greater responsibility for its wellbeing. And the fact that many instead use their resources not to better the community but to exploit vulnerabilities in the tax law and policy to pay even less taxes is damning, say these individuals. If so many of the wealthy A-ites are unwilling to shoulder more of the tax burden for their fellow citizens, who so desperately need it now more than ever, what does it say about these people? And all of this ignores the fact that many of these wealthy who work intimately close with the economy of Nation A were responsible for its recent failures, as mentioned in the beginning of the experiment.

So we come to the main questions to be answered with regards to Nation A's economy:

Is Nation A, with such seemingly vast gaps between the wealthy and the poor in terms of income and with such friendly financial policy for the rich, a plutocracy?
Does the correlation between relatively large gaps in wealth/low top marginal tax rates and poor economic stability and security mean anything?
Should the wealthy pay at a higher tax rate for the sake of Nation A and its less fortunate citizens?
Does the fact that the members of the top percentiles of wealth in the nation refuse to take on the tax burden because it is simply not fair to them smack of hypocrisy? Is it hypocritical for those who own the large corporations which are laying off the lower percentiles (to their own gain and to the detriment of the poorer) and who played a heavy role in the financial collapse of the nation's economy (again to their own gain, in many cases, and to the detriment of the poorer) to play the justice card when others ask for them to contribute more?
Should everyone only be motivated by self gain? If so, why not leave the social structure entirely and fend for yourself? Does it simply not matter that one could build their vast accumulation of wealth with great assistance from the economic structure and then refuse to chip in? Or is the structure there simply to be exploited by opportunists?

Fortunately, such economic hardship can be found only in the realm of the thought experiment. We're too enlightened.