Why ‘tax the rich’ policies may make sense in a K-shaped economy

New York Gov. Andrew Cuomo

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“Tax the rich” policies being weighed in some statehouses to cover Covid-era budget shortfalls may make more sense in the current economy.

Inequality has been a hallmark of the pandemic recovery, marked by job loss for those at the bottom and soaring wealth for those at the top.

This so-called “K shaped” recovery means the richest Americans are in a better position to absorb higher taxes relative to low and middle earners, according to some economists.

But it’s not just wage income. Officials may also consider raising taxes on capital gains and luxury home sales or purchases, given that stock-market and housing booms were disproportionately reaped by the wealthy, economists said. They may also boost taxes on inheritances from large estates.

Democratic Gov. Andrew Cuomo last week proposed an increase to New York’s top income-tax rate to help close a projected $15 billion budget hole, the largest in state history.

If approved, residents earning $5 million or more would see a hike, which would be largest for those making over $100 million. In New York City, the richest residents would pay a 14.7% combined rate, the highest in the nation.

“Targeted tax policies that focus at the top respond to the diverging economic trend we’re seeing,” said Wesley Tharpe, deputy director of state policy research at the Center on Budget and Policy Priorities, a left-leaning think tank.

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State proposals come as the Biden administration calls for higher taxes on those earning more than $400,000 a year.

“There is broad agreement that higher taxes on wealthy families can raise substantial amounts of revenue and make the tax code more progressive,” Janet Yellen, Biden’s nominee to head the Treasury Department, said Thursday in written testimony to the Senate Finance Committee.

Treasury Secretary nominee Janet Yellen

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However, raising income taxes may have the unintended effect of leading some rich residents — especially those already facing a higher relative tax burden — to consider relocating, according to Jared Walczak, vice president of state projects at the Tax Foundation. That may be especially relevant in an era of greater mobility and work-from-home capabilities, he said.

States may be better-suited by broadening sales taxes — to digital goods like streaming services, for example — instead of raising income taxes, Walczak added. They could also consider new markets, by legalizing marijuana and sports betting, for more tax revenue.

Lawmakers in Arkansas, Mississippi, Montana and West Virginia have even called to cut income taxes this year.

Washington State Gov. Jay Inslee

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California, New Jersey and Washington

Several states, like California and Washington, are also weighing millionaire-type taxes.

Washington Gov. Jay Inslee, a Democrat, wants to impose a 9% capital-gains tax on “a tiny fraction of the state’s wealthiest taxpayers,” according to his 2021-23 budget proposal.

The tax would hit capital-gains earnings above $25,000 for individuals and $50,000 for joint filers who sell stocks, bonds and other assets. It would raise an estimated $1.1 billion in 2023 and affect roughly 58,000 people, according to the Department of Revenue.

California lawmakers proposed hiking income taxes for millionaires, a move expected to raise more than $6 billion a year. Residents making over $5 million would pay a top tax rate of 16.8%.

In September, New Jersey enacted a measure to increase income taxes for residents with yearly income between $1 million and $5 million.

K-shaped recovery

These policy tweaks respond to diverging experiences for the rich and poor during the pandemic.

The unemployment crisis has hit low earners hardest since March.

Employment is still down 25% versus pre-pandemic levels for those in the bottom third of the earnings curve (who make less than $27,000 a year), according to Opportunity Insights, an initiative run by economists at Harvard University and Brown University.

These workers tend to have service jobs and are overrepresented by racial minorities and those without college degrees.

Employment is up about 1% for those in the top third (who make over $60,000). Such individuals are more likely to be White, college-educated and work from home.

Meanwhile, the wealthy prospered from gains in financial assets like stocks and homes, which they overwhelmingly own.

The S&P 500 is up more than 16% over the past year, despite cratering in the early days of the pandemic. The stock index hit a new high last Thursday.

Homes prices were up 13% in December compared with the same month in 2019, according to the National Association of Realtors. Sales volume last year was at its highest since 2006.

“It makes sense for this emergency to use progressive taxes as a way to fill in [budget] gaps,” Ernie Tedeschi, a policy economist at Evercore ISI, said of taxing the wealthy during the pandemic.  

This approach would make most sense for states with a large population of rich residents, said Tedeschi, a former senior advisor at the Treasury Department.

States should only consider higher taxes as a fallback measure if they don’t receive more aid from the federal government, he said. Biden recently asked Congress for more state-and-local funding in a $1.9 trillion Covid package.

Indeed, Cuomo’s tax plan would only kick in if New York received $6 billion in federal funding (instead of the full $15 billion).

Doomsday scenarios

California Gov. Gavin Newsom

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Of course, many states aren’t faced with doomsday financial scenarios they’d forecast at the beginning of the pandemic.

That’s largely a result of state taxes on unemployment benefits; historic levels of federal stimulus, which propped up spending (and sales taxes); and higher employment for the wealthy (who then paid tax on their wages).

Officials may not see a need to raise taxes as a result.

Only a handful have seen significant losses — states like New York with major metro areas that emptied out, and energy-dependent states like Alaska, North Dakota and Wyoming, Walczak said.

California even has a $15 billion budget surplus, precisely because rich taxpayers have done so well recently, Newsom said.

Californians made $185 billion in capital-gains income last year, a record, on the back of a surging stock market. That generated $18.5 billion in tax revenue.

As a result, tax hikes on the wealthy “are not part of the conversation” right now, Newsom said Friday.