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Beemer

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Taxes [Apr. 14th, 2010|01:57 am]
Beemer
I asserted on a friend's Facebook status today that flat taxes are a bad idea for anyone except the very rich, because income has a power-law distribution, so if you want to maintain the same level of revenue (and you do*), if you switch from our current progressive tax-bracket system to a comparatively regressive flat tax system, tax rates go up for everyone except those out in the high-income tail.

(*Revenue can't drop because only about 5% of the federal budget is what you'd call discretionary; the vast bulk of it goes to things like medicare and national defense, which have not, historically, been especially popular areas to make drastic cuts in spending. See http://washingtonindependent.com/81684/the-futility-of-budget-cuts for some lovely graphs.)

So, of course, having said that, I then had to go and prove to myself that I was right. And I am (yay dinking about with spreadsheets!), but the nifty thing is that I found a very interesting paper on Temporal evolution of the “thermal” and “superthermal” income classes in the USA during 1983–2001.

What it shows is that only the top 3% of individual incomes follow a Pareto (power-law) distribution; the other 97% follow a Boltzmann-Gibbs (exponential) distribution. The exponential bulk is in thermal equilibrium (if you correct for inflation), while the power-law tail is "superthermal" and fluctuates with the stock market. There's a cutoff point (about 4 times the normalized "income temperature") where the distribution switches over; in 2001 it was around $150k.

Which is all quite fascinating, but what does it mean? There must be some reason why the rules are different for part of the populace than they are for the other part; it's not as if you were making $149k and got a $2k raise that your bank account would suddenly magically work differently. So I was pondering this, and I think I came up with an answer.

It has to do with where your money comes from.

Most people's income derives from wages, or something equivalent: there's some thing that you do, and other people give you money for doing it. But! If you have a lot of money, enough that you have a decent pile of it sitting around after you've paid all your bills, you can invest it, and get more of it just for having it. And investment is a positive feedback loop: the more you've got, the faster it grows. Take a bunch of investments, apply exponential growth and some noise, and quite naturally you will get a power-law distribution.

Basically everyone who can invest money does so, and there's only so much you can increase your cost of living as your income increases. So as people get more wage-type income, pretty universally they'll start to get investment income as well, and eventually that can grow to matter more than wages. Which means that 4*T = $150k crossover point isn't anything special, it's just the statistical average of the point where any individual's investments start to dominate the kinetics of his income stream.

So I thought that was interesting. It has significant implications for how a society should structure its tax code to achieve various goals. And I'm psyched that I was able to figure it out.
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Comments:
[User Picture]From: zalena
2010-04-14 01:09 pm (UTC)
Wow! This has lesson-plan potential.
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[User Picture]From: dr_tectonic
2010-04-14 07:48 pm (UTC)
I am intrigued. Tell me more!
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[User Picture]From: casecob
2010-04-14 02:15 pm (UTC)
Interesting!
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[User Picture]From: dr_tectonic
2010-04-14 07:48 pm (UTC)
I thought so! :D
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[User Picture]From: drdeleto
2010-04-14 03:05 pm (UTC)
It's interesting that "capitalism" today seems to mean simply "free markets" and protected private property. I think this is essentially how capitalism sells itself, and it's more than a bit dissembling. But I had an epiphany awhile back when it finally clicked that capitalism really is defined by the split you just posted about: the split between wage earners and investors (or owners/wage-payers).

Granted, many of us today are a combination of both, but rarely in remotely even proportion. And since, as you point out, the income dynamic of each is fundamentally different, treating them the same is going to be awkward and inequitable.

I believe there was a sincere effort on the part of the Bush Administration, actually, to slightly rebalance the equation with the concept of the "ownership society." It went nowhere, and that's probably a good thing, given that, by its proposals, it would have just meant more ignorant people blindly investing in abstract instruments. But apart from the specific proposals, I think the very basic concept of a society of broad ownership instead of wage-earning is intriguing (if impossibly radical).
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[User Picture]From: pink_halen
2010-04-14 03:40 pm (UTC)
I'm sure that "Capitalism" and "Free Markets" aren't what the majority of voters think they are. If we really had a "Free Market" it might be a big problem for most people to make it work. Where would most products be without marketing hype and some degree of regulation.
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[User Picture]From: pink_halen
2010-04-14 03:37 pm (UTC)
Please, Don't confuse us with facts. We have our beliefs and we have faith that they are correct.
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[User Picture]From: nehrlich
2010-04-14 03:46 pm (UTC)
That's a keen observation. And the paper result is interesting that a portion of the population has different rules than everybody else.

One point is that the flat-taxers claim that high-income people actually pay a lower tax rate right now, due to the number of exceptions and loopholes in the tax code (e.g. Warren Buffett famously claiming he pays a lower tax rate than his secretary). This is related to your observation in that the tax code has many incentives to promote investment, so people who make it into that bucket pay less taxes as a result (e.g. I get to deduct my entire 401k contribution and all of the costs associated with renting my condo, including the mortgage, repairs, and HOA fees). So the theory of the flat tax is that tax rates would actually go down for most people because the rich people would be pulling their weight if we got rid of the investment loopholes.

There are reasons to promote investment, though, too, which is what makes this complicated. I'm not so convinced of the benefits of home ownership (community, stability, blah blah blah), but rich people investing their money in companies and other opportunities creates jobs and provides an upward lift on the economy. The shutdown in startup financing that happened in 2008-2009 is an example of what happens when everybody pulls out. Startups are the job engine of the economy (there was a recent study that claimed that startups generated all the new net jobs over the past 25 years). So giving people who have money to invest the incentive to invest it is a way to keep the economy growing.

So as usual, whenever I start thinking about political issues, it's really complicated and I can see both sides. And I don't have a strong opinion except to say that it's complicated :)
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[User Picture]From: ng_nighthawk
2010-04-14 04:07 pm (UTC)
Also note that after $150k many income packages from work include some amount of stock in the company you work for.

Looking at my own situation, I can foresee natural career growth that moves a bit beyond $100k base salary, at least hypothetically--whether or not I personally realize that is founded on a few questions of opportunity and my own choices, but the potential is there. But to get up above $150k I believe I would have to move out of a contributor role, even as a manager, and into a higher level of management. Director at least, probably vice-president. And that's a different job entirely, even if I prove myself by doing some similar tasks at a manager level.

Now, that's the technology industry. Offhand, I can think of one industry where you might make more than $150k/year at the level of individual contributor or middle-management, and that's investment banking.

But lo and behold, then you're dealing in stocks and such. So effectively the phenomenon you're describing is just being applied more generally to the people who work in an industry.

Anyway, there are a few ways to get into investment income without working your way up to the level of vice-president or the equivalent, but I'd guess the most common way is working in high-level management. Which reinforces Chris' point below.

The other interesting thing about all this relates to this conversation which we had five years ago.

.... five years ago! 0.o

But the idea at that time was that progressive taxation was justified because taxation itself was justified based on participation in the economic system (as well as other peripheral but supportive systems) the government maintained. But now that you point this out, we can make an even more dramatic statement: people aren't just participating in the system, they own pieces of the system.

In my mind that's the problem with trickle-down economics, even if it worked: it's giving money to the people in control of the economy. So rather than pushing money from the bottom up, and letting market forces shape the flow of wealth, it becomes from the top down and the people who already make decisions about the winners and losers in society based on their preferences and biases are getting even more power to shape society through economics.

So progressive taxation is more than just about a fee for a high level of engagement with economic systems, it's actually part of the cost of ownership of that system, which in turn gives you the ability to become to a much greater degree in control of your own economic fate.

Not everyone will invest money wisely, obviously, but you have the opportunity to make the choice of where you will invest and how you will make money, which is a much greater degree of agency than the situation where you're deciding where to work. Not that the choice of where or for whom to work doesn't have dramatic implications--especially when decisions are multiplied across the entire labor pool, like how long of a commute is tolerable or what kind of hours you're expected to keep--but deciding where or how to give someone money is a greater position of power than exchanging labor for money.

So you pay the recurring cost of that power in the form of taxes, and we like that because it's more fair (by my definition of fair, at least) to make the people with more power to affect the systems support those systems that they're controlling.

Intuitively, as a final capstone of a too-long comment, it's appropriate that investment bankers who made decisions about risk which collapsed the economy contribute to a greater extent to fixing the TARP part of the national debt.

Deep stuff. Thanks.
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[User Picture]From: detailbear
2010-04-14 05:26 pm (UTC)

Agreeing with you, with extensions

I can think of a couple of other jobs at the contributor level which can lead to incomes over $150,000, and they fall into 2 groups:

First, the high end of real estate agents and some other high-end sales people can reach that level. In general, they could be considered as investment agents in a similar position to the bankers above - dealing with the assets of the investor class.

The other would be entertainers, in music, film and sport. The up-and-coming ones would soon pass through into becoming proprietors of their own businesses (like doctors), and then effectively becoming CEO's of their own little empires. But the B-List (or maybe C-List) celebs could stay in the $150K-200K range for many years.

Does that sound about right?
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[User Picture]From: ng_nighthawk
2010-04-14 05:35 pm (UTC)

Re: Agreeing with you, with extensions

Am I stretching too much to argue that these people make that kind of money because they're making cultural decisions on behalf of lots and lots of other people? It's still reaching the top of the pyramid, just a different pyramid.

Interesting, though, that many (though not all) of the entertainers are unable to figure out how to wisely invest their earnings. That happens to upper management types, too, of course.

There's probably a relationship here between lifestyle expectations. I'm not sure how common this is in real life, but there's the story of the guy who works at a factory or as a janitor and lives terribly simply, invests as much as possible, and winds up wealthy.

Ownership is available to anyone given enough time and focus, but it's easier for some folks than others. Income is only one of the factors there...
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[User Picture]From: nehrlich
2010-04-14 07:05 pm (UTC)

Re: Agreeing with you, with extensions

I think the point about consumption is an important one. It doesn't matter how much you make if you spend it all. I was astonished to read that 30% of people making 100k+ live paycheck-to-paycheck. Accumulating wealth is about making life choices like spending less than one makes and then saving money away. Admittedly, this assumes that basic life needs can be met while spending less than one makes, which isn't true for everybody.
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[User Picture]From: backrubbear
2010-05-09 03:44 pm (UTC)

Re: Agreeing with you, with extensions

And this, reading through my backlog, is much of the point I would have chosen to make. There's the old saying, "You need to have money to make money". Looked at through a slightly different set of glasses, this can be read as "once you have covered your regular expenses, the stuff that's left is what you can use to effect major changes to your actual income bracket.

It's possible to seriously change your life by realizing this and realizing what you can live with and without. You can do this at a much lower income bracket if you've been trained into it as a child, but most of us grew up wanting with desires that translated into living in perpetual debt.

Ever since I got myself out of credit card debt, I've been doing much better. It took many years to get there, but even now my only major debt is the house. It's still a bit of a struggle across the whole household since I tend to be very conservative in how I choose to spend money while Chris isn't nearly anywhere that conservative. But that's just a thing you have to deal with in relationships. :-)
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