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The Nation

Taxes Flatten but Deep Pockets Still Bulge

April 17, 2006|Joel Havemann | Times Staff Writer

WASHINGTON — A decade ago, when publishing magnate Steve Forbes ran for president, he vowed to deliver a new era of prosperity with a simple change in the federal income tax: Instead of people with more money paying higher rates, all would pay the same "flat" tax rate -- unleashing "the fantastic growth waiting to burst forth in our economy."

Forbes' flat-tax plan was dismissed as simplistic by many mainstream economists and viewed with horror by the legions of special interests that benefit from the deductions and loopholes that flat-tax advocates would eliminate.

But as millions of Americans face the deadline for filing their federal tax returns, they are operating in something very close to the world Forbes and other flat-tax visionaries proposed. Without any fanfare or philosophical debate, millionaires and middle-class Americans now pay taxes at almost the same rates.

So what about the "fantastic growth waiting to burst forth"? Has leveling out federal income tax rates produced a cornucopia of financial benefits?

The answer is probably yes -- if you're a millionaire. And probably no -- if you're almost anyone else. Flattened, and thus lower, tax rates have contributed to huge increases in the wealth of the wealthy, but so far most people haven't seen significant economic improvement.

"It's as if Santa Claus dropped bags of money down everybody's chimney," said Leonard E. Burman of the private Tax Policy Center. "Only he dropped extra-big bags in rich people's homes, and extra-small ones in smaller homes."

Though most pay at least somewhat less in taxes than they did a few years ago, the Federal Reserve Board, in its latest three-year examination of family finances, found that average family income fell by 2% between 2001 and 2004 after adjusting for inflation. In the previous three-year period, average family income grew by 17%.

Thanks to more credit card debt and borrowing against their homes, the 25% of Americans at the bottom of the wealth scale had negative net worth in 2004. On average, these families owed $1,400 more than their possessions were worth.

The idea that income tax rates should be graduated, with those who had more money paying a larger share of it in taxes, was a fundamental premise of the federal income tax system when it was created by constitutional amendment in 1913 on the eve of World War I.

The first federal tax code specified a maximum rate of 7%, but after the U.S. entered the war in 1917, Congress boosted the top rate to 77%. During World War II, the top rate hit an astonishing 94%. As recently as 1980, the maximum rate on investment income was 70%, although the top rate on wages was 50%.

The tax cuts engineered by President Reagan lowered the top rate for all income to 50%, and the 1986 tax overhaul brought the top rate to 28% in 1988, its lowest level since 1931. But that lasted only until 1990, before deficit-reduction packages gradually lifted it to 39.6%.

Taxes have had an intimate and often stormy relationship with America's economy and its politics since colonial days. In response to the British Sugar Act in 1764, which put duties on a range of foreign goods brought into the colonies, patriot leader Samuel Adams wrote: "If taxes are laid upon us in any shape without our having a legal representation where they are laid, are we not reduced from the character of free subjects to the miserable state of tributory slaves?"

If Adams had lived to see the rates imposed during the two world wars, he might have tried to start another revolution.

Under Forbes' largely forgotten flat-tax proposal, taxpayers would have paid 17% in taxes on all income beyond $36,000 a year, excluding pensions and profits from the sale of investments. The system was to be so simple, the candidate said, that most taxpayers would fill out a form the size of a postcard.

No such system was adopted or even seriously considered, but President Bush has achieved something close to the flat-rate structure by cutting tax rates on earned income and particularly on dividends and investment profits.

Although the top tax rate is 35%, nobody pays that percentage in total because it applies only to income beyond the first $326,450. At the other end of the income scale, the lowest rate -- 10% -- applies only to the first $7,300 in income.

And then there is the regressive effect of the payroll tax, which finances Social Security and Medicare. Social Security's share of the tax -- 6.2% -- applied last year only to the first $90,000 in wages. People who earned more than that paid a smaller percentage of their income in payroll taxes than did those who earned less.

As a result, people with income between $500,000 and $1 million owed the same share of their income in combined federal income and payroll taxes -- 22% -- as did taxpayers reporting at least $1 million in income, according to the Tax Policy Center.

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