In the 2008 US election cycle, one of the largest policy distinctions was between the John McCain's proposal to keep the top marginal income tax rate either at current levels or to cut it further and Barrack Obama's plan to increase the top tax bracket. Obama's plan raised hackles in some quarters and met with the criticism that his tax proposal was essentially socialist, being an income redistribution engine designed to spread the wealth of those who worked hard to get where they are to those who haven't worked so hard. Many commentators have claimed that this state of affairs is claimed to be unjust. But a system of marginal tax brackets, the bedrock of income tax system in the US for almost as long as the US has had a federal income tax, was not pulled out of thin air or implemented to punish those who are successful. Rather, the marginal tax in the US stems from a basic principle of economics, the concept of diminishing marginal utility that is shared by every school of economics from Austrian to Neo-Classical save for the minority of schools that stick to a labor based theory of price setting such as the Marxist and Neo-Ricardian schools. As such, to claim that a marginal system of taxation is inherently unjust is to both undermine the basis of modern economic theory and, if that theory is correct, argue against the premise that the the income tax system should model the way the world actually works.
The background of the criticism of Obama's plan is that the US tax code is overly complicated, obtuse, perplexing and in need of reform. No one seriously disputes this. But time and again, the idea also surfaces that that in order for an income tax to be fair, it must be a flat tax, that the same tax rate (and not merely the same tax system) must be equally applied to everyone subject to it. If someone paying tax on x dollars pays a lower effective rate than someone paying taxes on x + n dollars, the argument goes, this is unfair. Worse yet, the opponents of a system of marginal tax brackets argue, the tax is not only unfair, but it stifles the economy of the country as a whole because the tax code ends up punishing success. If working harder to make more money results paying a higher tax rate, those who would work harder may be demotivated to do with the net effect that most workers work less hard and productivity suffers.
But the assessment of a marginal tax system as being inherently unfair ignores its basis in modern economic theory. The US tax system is built on system of marginal tax brackets because of the principle of marginal utility. This principle underlies supply/demand price theory upon which free markets are predicated. The principle is not a complicated one. The idea is that the first unit of a given good does not have the same value to the consumer as subsequent units of a good. While in most cases the value of additional units decrease, there are some situations where the additional value increases. (The decreases are usually in situations where the consumer approaches a tipping point. For example a person with one dollar who needs ten dollars to buy a particular good may not value an single additional dollar very highly until that person gets to nine dollars.)
The traditional textbook explanation, created by economist Eugen von Böhm-Bawerk, deals with bags of grain. Imagine a pioneer with five bags of grain. The first is used by him as sustenance. Without the calories present in one bag of grain, he would starve to death. The second bag is also consumed by him so that he might not just live but also have the strength to work. While it is important for the pioneer to work, it is secondary to survival. The third bag is used as feed for other livestock so that the pioneer might have variation in diet. While important, it is less important than either having the strength to work or to survival itself. With the fourth bag, the pioneer makes whiskey which has certain uses but is less important than the product of the bags that were already consumed. With the fifth bag, the pioneer feeds some pet parakeets. Now if the pioneer had to give up a bag of grain, he would not curtail all the purposes to which he put the grain. He won't eat less, stop feeding the chickens or stop making whiskey. Rather he would choose to give up the use which was least valuable to him, feeding the parakeets. This is the principle of decreasing marginal utility, that for most things, every additional unit is less valuable to the owner than the subsequent unit.
But what happens if the grain of the pioneer is being taxed per bag? It is clear that any tax on that first bag will be far more injurious to the pioneer than the tax on subsequent bags of grain because if the farmer had only one bag, the tax would affect his very ability to stay alive. A tax on the second bag, while still very injurious in that it affects the pioneer's very ability to work, is not as harmful as a tax on the first bag. A tax on the third bag is less injurious still and by the time we get to the fifth bag, any tax on the grain becomes a very small amount of injury to the one paying the taxes. Now, even if the tax on the fifth bag of grain were exorbitantly high, it would be less injurious to the pioneer than any amount of tax on the first bag of grain.
The US tax system is structured to reflect this truth of the value of income to the earner. Most US taxpayers pay close to no tax on their first ten thousand dollars of income. For the 2008 tax year, even a single person with no dependents and no deductions pays only 10% on the first eight thousand dollars of Adjusted Gross Income (AGI) which doesn't include the standard deduction or any non-taxable income such as pre-tax FICA, retirement and health care contributions. This is because this is the income that is needed for mere survival. A person making slightly more money will then pay 10% tax on that first eight thousand dollars of AGI and 15% tax on AGI between eight and thirty-two thousand dollars. So the money needed not to just survive but needed to buy necessary to work and the like is taxed at a slightly higher rate. AGI above thirty-two thousand dollars but below seventy-eight thousand dollars, the money needed not just to live or to work but to have a pleasant life, is taxed a bit higher at 25%. And so we go through all the tax brackets until we get to the highest at AGI earned above three hundred and fifty-seven thousand dollars, money which is certainly not required for the necessities of life but which goes to making life more pleasurable, which gets taxed at the highest rate of 35%. To claim that there is some inequality in this money being taxed at the same level as the lowest tax bracket is to claim that it harms the tax payer to lose 35% of every dollar earned well above three hundred and fifty some thousand dollars as it does to lose 10% of the first eight thousand dollars earned. Such is a ludicrous allegation, especially since someone making enough money to be in this tax bracket still only pays 10% on that first eight thousand dollars of AGI. After all, no matter what one's AGI is, one pays the same amount of tax on every dollar within a given tax bracket.
But some might still disagree over this assessment of fairness. But consider that the principle of marginal utility is what underlies the demand curve in the Austrian school of economics and what underlies the indifference curve which in turn underlies the demand curve in Neoclassical schools of economics. Given that the demand curve is half of what determines equilibrium prices in a free market, the allegation that the principle of marginal returns leads to injustice is akin to the claim that free market economics is either fundamentally unjust or somehow does not model reality. But clearly most proponents of a flat tax reject the ideas that the free market does not work or is inherently unjust. Rather they assume that the free market model is predicated on the way that human beings actually behave. If so, the principle of marginal utility is fundamental to human nature and the claim that a tax system based upon this principle is unfair is to claim that human nature ought to be different than what it is. It is perhaps illustrative that most of the countries in the present day that use a flat tax are former Soviet Bloc nations such as Albania, Bulgaria, Lithuania, Romania, Russia and the Ukraine. Most of these countries retain large vestiges of their socialist past and have not yet made full market reforms in many areas.
One thing that the above mentioned countries with flat taxes do have in common is a phenomenal economic growth rate which may seem to support the assertion by flat tax proponents that a flat tax leads to higher economic growth. The problem, however, is that these countries are not moving from a marginal tax system to a flat-tax system but, rather, are moving to market systems with a flat tax on income from a state owned system of production where the state confiscated virtually all wealth and ran virtually all industry. An increase in productivity, then, is hard to tie specifically to a flat-tax rather than market reforms in general and the new possibility of large numbers of people earning money. Further, if a flat-tax lead to an increase in economic productivity, one would expect that those times in recent US history where the tax code was the flattest would have seen the largest percentage increases in productivity in the US. But the history of the eighties and nineties belies this. In real GDP per capita, the Clinton and Reagan administrations saw similar increases and the increases in both were dwarfed by those under the Kennedy and Johnson administrations. Given that the tax code was the flattest, and taxes in general far lower, during the Reagan administration, one would expect the Reagan administration to have presided over the largest increase in productivity. But it did not, the Kennedy and Johnson administrations did. The historical numbers seem to indicate that the flatness of income tax has little to no effect on the over all economy. What it does greatly affect is the ability of the government to finance itself. Both the budget deficit and the national debt soared under the Reagan tax cuts.
The way that there is no apparent relationship between the flatness of income tax productivity in the US can be easily be explained by the principle of marginal utility. It may be true that paying higher taxes on incomes in higher brackets might lead workers to view each additional dollar of income as less valuable. But the principle of marginal utility suggests that rational economic agents will already view each additional dollar in income as less valuable than the previous dollar of income. It is not clear that the decrease in utility of additional dollars of income in a marginal income tax system is any more demotivating than reality itself. The fact of the matter is that most workers have always felt that additionally earned dollars, even though less valued than previously earned dollars, have been worth pursuing. A proper marginal tax system will never reach the 100% tax rate and, consequently, always allow a earner to be better off by earning one additional dollar, even if they move to the next tax bracket.
So in conclusion we see that a tax system built upon marginal tax brackets as presently used in the US is the most just in that it harms each individual taxpayer the least. It taxes the income needed the least the most and it taxes the income needed the most the least. To claim that this state of affairs is unfair is to allege that one of the fundamental suppositions behind setting prices in a free market is likewise unfair. Further, the claim that a marginal tax system hampers US productivity simply is not justified by the history of increases in real GDP in recent US history relative to the increases and decreases in the flatness of the US tax system. Why this is so is explained by the principle of marginal utility, workers are already expecting less value in each additional dollar earned. The two largest arguments for a flat tax, then, fail to be persuasive on either the basis of economic theory or the empirical data from the economic history of the US. Rather, the US should maintain its present tax system based on marginal brackets with tax reform being applied to those areas that really do need to be reformed: confusing, byzantine regulations; perverse incentives; tax brackets that disproportionately affect the upper-middle class. Ronald Reagan's goal of a tax return that can be filled out on a single post-card sized form is possible with a marginal tax system. The only thing that makes a marginal system different from a flat system in that regard is the use of a look up table rather (if I make x dollars, I pay y taxes) rather than multiplying x dollars by y percent.
