Posts Tagged ‘taxes’

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One of the consequences of Bernie Sanders’s campaign for president is that economists and economic ideas that are often overlooked or marginalized are making the news.

Consider, for example, Gerald Friedman [ht: ja], a University of Massachusetts Amherst economics professor.* He’s front-page news on CNN, and that’s because he has provided “the first comprehensive look at the impact of all of Sanders’ spending and tax proposals”—including spending on infrastructure and youth employment, increasing Social Security benefits, making college free, expanding health care and family leave, raising the minimum wage, and shifting income from the rich to the working-class through tax hikes on the wealthy and corporations.

“Like the New Deal of the 1930s, Senator Sanders’ program is designed to do more than merely increase economic activity,” Friedman writes. It will “promote a more just prosperity, broadly-based with a narrowing of economy inequality.”

Emmanuel Saez, Professor of Economics at the University of California, Berkeley, is also in the news, because of his research on tax rates. In a 2011 paper he wrote with Peter Diamond, Saez argued that, in order to achieve a fair distribution of the tax burden in the midst of rising inequality, very high earners should be subject to high and rising marginal tax rates on earnings. While the top income marginal tax rate on earnings today is about 42.5 percent, they estimate the optimal top tax rate (which would maximize tax revenue from top-bracket taxpayers) to be 73 percent, even higher than Sanders is currently proposing.

“My feel is that the reasoning behind Sanders’s tax plan is not so much tax revenue generation from top earners but rather make top tax rates so high so as to discourage ‘greed,’ defined broadly as extracting income at the expense of the rest of the economy as opposed to real productive behavior,” Mr. Saez wrote in an email. “I think pretax top incomes would finally start to decline.”

Friedman and Saez are economists who are never cited in the mainstream media, and whose ideas are receiving a public airing precisely because of Sanders’s extraordinary success in the current campaign.


*Here’s the appropriate disclaimer: I did my doctoral work at the University of Massachusetts Amherst, although Friedman was not there at the time.


The share of income captured by the 1 percent more than doubled (from 10 to 20.1 percent) between 1980 and 2013.

How did they do it?

Well, we know the tiny group at the top received much higher CEO salaries as well as stock dividends, capital gains, interest payments, and rent on the land and buildings they own. Those sources account for about 60 percent of the increase.

What about the other 40 percent? According to a new study from the National Bureau of Economic Research, the rest stems from the rapid growth in so-called pass-through businesses.


The basic idea is that “pass-throughs”—businesses whose annual income is taxed at the owner-level (such as partnerships and S-corporations)—now account for more than half of all U.S. business income, thus passing traditional (so-called C) corporations. The figure above shows this dramatic transformation in the structure of business activity: 54.2 percent of U.S. business income in 2011 was earned in the pass-through sectors, compared to only 20.7 percent in 1980.

The key is that pass-through participation and income are especially concentrated among high-income individuals.

Relative to households in the bottom half of the income distribution, households in the top-1% of the income distribution are over fifty times as likely to receive positive partnership income. And the average top-1% household earns over six-hundred times the amount of partnership income as the average household in the bottom half. Overall, 69% of pass-through income earned by individuals accrues to the top-1%. S-corporate income is similarly concentrated, but other business income (typically considered very concentrated) is substantially less concentrated. For instance, only 45% of C-corporate income (as proxied by dividends) accrues to the top-1%, and top-1% households are only eight times as likely to receive C-corporate income as households in the bottom half. Furthermore, the majority of partnership income earned by the top-1% derives from partnerships in finance and professional services.

In addition, the pass-through income of partnerships is taxed at a much lower rate than traditional corporate income.

What the study shows, then, is that the change in the structure of U.S. business activity over the past three and a half decades means that members of the top 1 percent have managed to capture (via pass-through income) and keep (via lower taxes) a growing share of the surplus. That, as it turns out, is the major reason their share of total income has grown so dramatically. It’s also the reason why U.S. tax revenues from business income have decreased during that period.

The consequence is that rest of us, the 99 percent, have been forced to accept a smaller share of total income but to shoulder a higher tax burden.

That’s because the 1 percent have found new ways of both capturing and keeping the surplus.

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The Silicon Valley elite really should know something about inequality. By far the most unequal counties in California—especially San Mateo—are those that encompass the high-tech cities of Silicon Valley.* And San Francisco (“where a two-bedroom condo in the Mission was on the rental market a few weeks ago for $10,500 a month and alleys all over downtown are dotted with makeshift homeless encampments”) is the city with the largest growth of inequality in the country.**

So, what do members of the Silicon Valley elite say about inequality? Well, venture capitalist Paul Graham has just published a lengthy essay on the value of increasing income inequality—and Gregory Ferenstein [ht: ms], who for the past five years has been collecting data on what Silicon Valley CEOs believe, confirms they hold “a set of views that are somewhat more nuanced than Graham’s, but also in agreement with his fundamental view of the world.”

And what is that view of the world? Here are excerpts from Graham’s essay:

Since the 1970s, economic inequality in the US has increased dramatically. And in particular, the rich have gotten a lot richer. Some worry this is a sign the country is broken.

I’m interested in the topic because I am a manufacturer of economic inequality. I was one of the founders of a company called Y Combinator that helps people start startups. Almost by definition, if a startup succeeds its founders become rich. And while getting rich is not the only goal of most startup founders, few would do it if one couldn’t.

I’ve become an expert on how to increase economic inequality, and I’ve spent the past decade working hard to do it. Not just by helping the 2500 founders YC has funded. I’ve also written essays encouraging people to increase economic inequality and giving them detailed instructions showing how.

So when I hear people saying that economic inequality is bad and should be decreased, I feel rather like a wild animal overhearing a conversation between hunters. But the thing that strikes me most about the conversations I overhear is how confused they are. They don’t even seem clear whether they want to kill me or not. . .

As a manufacturer of economic inequality, the underlying causes are something I know about. Yes, there are a lot of people who get rich through rent-seeking of various forms, and a lot who get rich by playing games that though not crooked are zero-sum. But there are also a significant number who get rich by creating wealth.

And that group presents two problems for the hunter of economic inequality. One is that variation in productivity is accelerating. The rate at which individuals can create wealth depends on the technology available to them, and that grows exponentially. The other problem with creating wealth, as a source of inequality, is that it can expand to accommodate a lot of people.

I’m all for shutting down the crooked ways to get rich. But that won’t eliminate great variations in wealth, because as long as you leave open the option of getting rich by creating wealth, people who want to get rich will do that instead.

Most people who get rich tend to be fairly driven. Whatever their other flaws, laziness is usually not one of them. Suppose new policies make it hard to make a fortune in finance. Does it seem plausible that the people who currently go into finance to make their fortunes will continue to do so but be content to work for ordinary salaries? The reason they go into finance is not because they love finance but because they want to get rich. If the only way left to get rich is to start startups, they’ll start startups. They’ll do well at it too, because determination is the main factor in the success of a startup. And while it would probably be a good thing for the world if people who wanted to get rich switched from playing zero-sum games to creating wealth, that would not only not eliminate great variations in wealth, but might even exacerbate them. In a zero-sum game there is at least a limit to the upside. Plus a lot of the new startups would create new technology that further accelerated variation in productivity. . .

While the surface manifestations change, the underlying forces are very, very old. The acceleration of productivity we see in Silicon Valley has been happening for thousands of years. If you look at the history of stone tools, technology was already accelerating in the Mesolithic. The acceleration would have been too slow to perceive in one lifetime. Such is the nature of the leftmost part of an exponential curve. But it was the same curve.

You do not want to design your society in a way that’s incompatible with this curve. The evolution of technology is one of the most powerful forces in history.

And he continues. I won’t bore you with the rest (although you’re welcome to read the essay in its entirety by following the link above). Suffice it to say, Graham believes that he and other high-tech investors and CEOs are the ones who, through their own hard work and determination, create most of the wealth and deserve the largest share of it.

It should come as no surprise that fellow investor Mark Suster, who carefully avoids denouncing Graham or his core beliefs, still felt it necessary to respond to the “social stream based on blogs written, retweets rendered and attaboys handed out” to Graham. Here are excerpts from his own post:

I found the conversation a bit disconcerting. Yes, income inequality exists and yes it’s a natural consequence of capitalism and other forms of government are decidedly worse than capitalism because they inefficiently create and allocate resources. But the celebratory nature of today’s conversation felt tone deaf and seemed to ignore the rules that get bent in favor of those with resources or born into privilege.

So instead of celebrating income inequality perhaps we would be a bit more compassionate about it.

Here are a few things on the topic worth pointing out, in no particular order. :

1. Founders start companies. They get huge tax breaks for doing so. They get to have “long-term capital gains” taxes which are much lower than short-term capital gains taxes paid by people who have stock options or income taxes paid to workers. In the old days this may have made sense since founders took huge economic risks and often refinanced houses or built companies with almost no money. These days founders often raise money with minimal time spent creating a company and often have salaries from the early days. I’m sure the tax gains of founders is dwarfed by the economic gains made by merely creating a company – but it is worth at least pointing out that this tax break exists. It is seldom ever mentioned.

2. VCs also get large tax breaks. Everybody knows this. We invest large sums of our after-tax money into our funds and this gets a long-term capital gain tax rate when we make a profit. Most people think this is fair. I dunno. To me it favors people like me with capital over those that are purely labor. I’m certainly not a socialist – but pointing out that tax rates favor me over somebody else I guess is just a fact. VCs also get capital gains tax rates on “carried interest,” which is what irritates the masses. Carried interest is the upside that VCs get after returning the money they raised – it is the VC “profit” if you will. The arguments against a lower tax rate is that this money isn’t really “at risk” and I tend to agree with that. On the other hand, I’m not convinced many founders have the same “at risk” capital as they once did. It seems to me that these are both forms of tax breaks that favor a small number of elite people. Of course “carried interest” tax breaks are more at risk than founder tax breaks. Maybe that’s as it should be. But what I really wanted to point out is what happens to the 99% of people who work in the startup industry – they get neither of these benefits …

3. Both of these privileged, very small group of people in 1 & 2, have much better tax rates than say, the third employee at a startup who might have joined 3 months after the founders. That employee was given “stock options,” which pay the exact same rate of taxes as income. In California considering state, federal and local taxes that can be as high as 56%. Think about it – if the first two employees work 6 years and sell a company while employee 3 works 5 years and 9 months … should they really pay grossly different tax rates? Of course if an employee “exercises” his or her options AND holds the stock more than one year then they are eligible to earn long-term capital gains. But this often requires relatively large sums of money and it implies writing a check in a company whose future is uncertain. That might actually seem fair. But ask yourself why employee three (and four and four hundred) has to write the check while employees 1 & 2 do not?

I wish founders, startup employees and VCs all paid the same rate of taxes. I also wish we paid the same amount of taxes as nearly any employee earning above-average income. But we all don’t and we’re not likely to fix any of that.

4. Luckily many, not all, tech employees in Silicon Valley earn good wages as a result of educations from top schools that allowed them access to this talent market. So if one works for several years at startups one can acquire wealth afforded to accomplished individuals. As a free-market capitalist this is as it should be and of course this in its own right creates a degree of income inequality that is tolerable. So these people invest some of their income in stocks. If they choose companies who pay high dividend rates they can accumulate wealth with lower taxes because dividends pay lower taxes than income. If they keep their hard-earned money in the stock market they can one day sell their stock and pay much lower taxes because – again – long-term capital gains pay lower tax rates.

5. Finally, if one is lucky enough to leave ones money in the stock market over the long-term this tends to yield better results than many other investment types. But. The system can be juiced in favor of capital over labor. How? Well, when corporations make profits they have lots of decisions about what to do with those profits. They can expand operations and hire more people creating more wealth for a larger pool of people. They can increase worker wages and hire more employees, which benefits labor. They can pay dividends as outlined above, which is paid a lower tax rate to people who have investment dollars. And they can buy back stock. With fewer shares in a company the price per share goes up and those that own stock in the company own a larger, usually more valuable stake. It’s a form of compensation from company to shareholders. And you guessed it – it benefits both people with large amounts of capital and those pay smaller tax rates than secretaries or any average worker in the company.

For Suster, it’s not just hard work and determination. Those at the top also enjoy a series of tax breaks the rest of us don’t have access to. And he’s worried that glibly celebrating inequality might have adverse consequences for their own place at the top.

Here’s what I find interesting in this exchange: while Graham celebrates the increase in inequality and Suster reveals some of the tax advantages those at the top are able to avail themselves of, neither seems to be able to imagine that workers—whether in the Silicon Valley companies they own or manage or in the outsourced companies where the coding and the production of high-tech gadgets take place—actually create the extra value investors, CEOs, and others manage to rake in.

That’s what the members of the Silicon Valley elite—and, for that matter, the economic elite in the country as a whole—ignore or overlook in their discussion of inequality. They really do believe that they create jobs through innovation and deserve to be rich (Graham), and in addition benefit from enormous tax breaks others don’t (Suster)—but, either way, they want to hang onto what they see as a libertarian high-tech startup environment that serves to “unleash our societal potential.” And they steadfastly refuse to see the role played by all the others, the workers who are forced to have the freedom to work directly or indirectly for one of their startups and are left behind as the value captured at the top continues to grow. What they reveal, and what Ferenstein confirms, is that the Silicon Valley investors and CEOs really do believe they alone are responsible for the growth of wealth attached to their companies. And if the gap between the top and bottom is growing, it’s because those at the top are that much more productive.

They all get what they deserve.

So, yes, the members of the elite do in fact see the growing inequality, in their own counties and cities as well as in the country as a whole, but they can’t see that the current set of economic arrangements systematically rewards a few at the top based on the work performed by everyone else.

As Ferenstein explains,

fundamentally, Paul Graham is not much of an outlier among Silicon Valley’s elites when it comes to the relationship between ability and financial rewards. Most successful technology moguls know better than to be as blunt as Graham, but deep down a lot of them believe that a small minority — like them — create a hugely disproportionate share of the world’s wealth.


*In San Mateo the top 3.6 percent claimed over $18 billion in income, or 48 percent of the county’s total income pie. Meanwhile the bottom 48 percent made by with only $3.6 billion in income split among themselves. For the bottom 48 percent the mean income level was $22,000. The top 3.6 percent had a mean income of $1.5 million.

**San Francisco comes out on top when comparing the 2012 ratio between what the rich and poor earn (16.6) to the same ratio from 2007 (12.7). No other city saw the gap grow that much.


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Each of the top 400 U.S. taxpayers took home, on average, about $336 million in 2012—but they only paid 16.72 percent in federal income taxes. That’s down from tax rates in the 28-29 range in the early 1990s, according to the latest data from the Internal Revenue Service (pdf).

What happened? Basically, the tiny group at the top has used a portion of the surplus they’ve been able to capture—amounting to about $134 billion or 1.5 percent of U.S. (adjusted gross) income—to purchase favorable tax policy and hire an army of lawyers and accountants to shield much of their income from U.S. taxes.

In the meantime, their incomes have grown dramatically: on average (in 1990 dollars), from $47 million in 1992 to $76 million in 2012, and, as a total (also in 1990 dollars), from $17 billion to $76 billion.

As F. Scott Fitzgerald explained, these careless people, who smash up things and creatures, are able to retreat back into their money and let other people clean up the mess they have made. . .


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