The Truth About Taxes and the Rich

Separating economic myth from economic fact

Editor's Note: Reason columnist and Mercatus Center economist Veronique de Rugy appears weekly on Bloomberg TV to separate economic fact from economic myth.

Myth 1: Wealthy people pack up and move when their taxes increase.

Fact 1: High taxes generally do not cause the wealthy to move.

As governors and state legislatures consider tax increases to fix state fiscal issues, concern over the potential flight of wealthy residents has surfaced again. For a given state, wealthy residents provide both a greater proportion of that state's income tax revenue and a disproportionate share of the charitable donations made within that state. According to the Survey of Consumer Finances, sponsored by the Board of Governors of the Federal Reserve, on a national basis households with a net worth of at least $1 million, headed by a person age 60 or older, comprised 4 percent of all households but donated approximately 25 percent of all household charitable contributions made in 2007 (the most recent year for which data is available). It is obviously in each state's interest to keep these wealthy residents around.

A number of studies in the economic literature explore the impact of taxes on the migration behavior of households in the United States. What these papers have generally shown is that taxes have little impact on cross-state migration. Instead, the migration impacts of unemployment are much greater. Overall, the results suggest that taxes do not cause out-migration, but they do influence the choice of destination for some migrating households, such as retirees.

The above chart uses data from a study by the Boston College Center on Wealth and Philanthropy to illustrate the effect of a tax increase on New Jersey residents making greater than $500,000 per year. Following the tax increase, the authors conservatively estimate that net out?migration in this income bracket rose by about 350 out of 44,000 people, or by about 0.8 percent of New Jersey's taxpayers making more than half a million dollars a year. This is a small, but noticeable effect. However, the study also claims that the rate of out-migration by higher income earners was in line with the out-migration rate of people who weren't subject to the tax. In other words, the behavior of the rich is consistent with the behavior of the rest of the population.

According to a regional household survey conducted by the Metropolitan Philadelphia Indicators Project at Temple University in 2004, just 27 percent of respondents in Philadelphia cited tax concerns as a reason they moved to their current location. Compare this to the 59 percent of survey respondents who said their residential choice was motivated by housing costs, the 47 percent who were motivated by good schools, and the 44 percent who wanted to be closer to family and friends. On the list of reasons for moving, tax concerns ranked ninth.

When respondents were asked whether they had ever considered moving in order to pay lower taxes, 73 percent of Philadelphia residents said no. Within the subsection of respondents living in affluent suburbs, the number climbed to 83 percent. (Interestingly, those who had considered moving because of tax concerns were more likely to move within the next two years than others in the group surveyed.) Similarly, a 2003 study in the Journal of Gerontology found that while tax burdens are the most important fiscal characteristic affecting the location choice of retirement-age individuals, factors such as climate, general economic conditions, and housing costs are still much more important.

Why? Because while location matters, taxes are one of the factors that define how desirable a location is. Among the factors that keep people in high-tax places are jobs, family, friends, and city amenities (few New Yorkers would agree to pack up and move to North Dakota no matter how low the taxes there might be).

In addition, there is the fact that moving is usually a costly hassle, and most people's social lives are grounded in their community and their workplace. Relocating often results in a longer commute for those still employed, causes disruption to the children who are still in school, and often means giving up on your social network and friends.
Presumably there is a level of taxation that will prompt more high-income individuals to move or change their behavior radically. However, it is also likely that the wealthy already have fairly well-developed tax sheltering strategies in place.

The general conclusion is that moderate tax increases on the rich, even if no neighboring jurisdictions follow suit, is unlikely to lead to much in the way of emigration.

That being said there are other reasons not increase taxes on the very rich. Higher taxes do slow down the rate of business development and job growth. In turn, high taxes reduce the number of wealthy people a given state may attract.

Myth 2: Blue states are big government states and red states are small government states.

Fact 2: Blue states are net payers, meaning residents pay more in income tax than they get back from the federal government, while red states are net recipients. Only one red state pays more into the system than it gets.

Only 10 blue states are net recipients of federal subsidies, as opposed to 22 red states. Only one red state is a net payer of federal taxes, as opposed to 16 blue states. Another blue state pays in as much as it gets.

This chart uses data from the Tax Foundation documenting the amount of federal spending in each state per dollar of federal taxes paid with states classified as red or blue according to their respective voting results in the 2008 presidential election. As you can see, red states receive more in benefits from the federal government than they put in; the opposite tends to be true for blue states. Only one red state receives less from the federal government than it pays in; compare this to the 17 blue states that receive less in benefits than they pay in federal taxes. Conversely, 21 red states are net recipients of federal funding, while only 11 blue states are.   

The top 10 recipients of federal money are New Mexico, Mississippi, Alaska, Louisiana, West Virginia, North Dakota, Alabama, South Dakota, Kentucky, and Virginia. The top 10 payers are New Jersey, Nevada, Connecticut, New Hampshire, Minnesota, Illinois, Delaware, California, New York, and Colorado. Rhode Island breaks even.

With a few notable exceptions, the Northeast, the Upper Midwest, and the West Coast bankroll the South and Great Plains. That pattern also looks like a red and blue state map from any recent presidential election. While the differences between the red and blue states are often exaggerated, it remains an interesting proxy to some heartfelt differences between rural and urban states.

There is a very strong correlation, then, between a state voting for Republicans and receiving more in federal spending than its residents pay to the federal government in taxes (the rust belt and Texas being notable exceptions). In essence, blue state residents are subsidizing those in red states. Both red and blue states appear to be acting politically in opposition to their economic interests. Blue states are voting for candidates who are likely to continue the policies of red state subsidization while red states are voting for candidates who profess a desire to reduce federal spending (and presumably red state subsidization).

Myth 3: The federal income tax may be progressive but the rest of the tax system is not, particularly the payroll tax.

Fact 3: The entire tax system is progressive.

We hear this argument all the time: While the federal income tax may be progressive, the rest of the tax system isn't, particularly the payroll tax, since Social Security taxes are capped. However, the thing to keep in mind is that Social Security taxes, at least for now, are funding Social Security benefits. As Andrew Biggs of the American Enterprise Institute explains:

Analysts of this system consider them together in order to determine whether the program is or isn't progressive. One way they do it is by calculating what's called the "net tax rate"—that is, the statutory 12.4 percent Social Security tax paid by workers minus the benefits they receive from the program. If you receive benefits equal to your taxes, then your net tax rate is zero. If you pay more in taxes than you receive in benefits, your net tax rate is positive; likewise, if you receive more benefits than taxes your net tax rate is negative.

Based on Biggs' data I made the following chart:

As Biggs explains:

This is for the 1940 birth cohort; I take the PV of lifetime taxes, benefits and earnings for the earnings quintiles as a whole and then calculate the net tax rate (taxes-benefits)/earnings. If you do it a the individual level you get a lot of people with zeros in either the numerator or the denominator and so it screws things up. These are pretty similar to the earlier numbers but lack the odd path. These were calculated with the Policy Simulation Group models and they should match up well with what SSA or CBO puts out. These are Social Security only; Medicare would be more progressive than this, since it's basically a flat benefit for everyone.

As we can see, while Social Security taxes are much less progressive than the income tax, they too are progressive.
However, here is something to consider: Based on income distribution data, we know that the fourth quintile is made up of households whose income is above $55,000 per year. What that means is that households making more than $55,000 are likely to pay more into Social Security than they get back. Now, $55,000 is more than the median income (which is roughly $49,000), yet I suspect most people making that amount wouldn't think of themselves as wealthy. They also probably do not realize they are paying into a system only to get the illusion they are getting something in return for their old age.

Contributing Editor Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University.