Taxation, American Style

The U.S. tax code is more progressive and European than you think.

Americans often tout the contrast between the bloated, tax-funded welfare states of the Old World and our leaner, cheaper government. But the data reveal that the U.S. may be closer to Europe than we think.

Contrary to common belief, the American tax system is more progressive than those of most industrialized democracies. A 2008 report by the Organization for Economic Cooperation and Development (OECD), titled "Growing Unequal," gave two different estimates of the progressivity of tax systems in 24 industrialized countries. One ranking found that the U.S. has the most progressive tax structure; in the other Ireland beat America by a nose. France, which has a notoriously generous welfare state, ranked 10th out of 24 in both of the OECD progressivity indexes.

Other countries have higher tax rates than the U.S. but manage to be less progressive overall. How can this be? The answer is that the rate structure alone doesn't necessarily tell you much about the progressivity of a country's tax system. The top rates kick in at much lower income levels in Europe than in the United States, making E.U. tax codes more regressive than ours. 

In his new book The Benefit and the Burden (Simon & Schuster), economics columnist Bruce Bartlett presents a chart (reproduced here) that shows the top statutory personal income tax rate and an "all-in rate" that includes payroll taxes in selected countries as measured by the OECD. Bartlett calculated that the "average [European] worker making an annual income in the $40,000 to $50,000 range is in the top marginal tax bracket." A comparison of France and the U.S. is revealing: The top marginal income tax rate in the U.S. is 35 percent and kicks in at $379,000. In France the top rate is 41 percent and kicks in at $96,000.

The U.S. federal government also relies much more heavily on the income tax, rather than the regressive consumption taxes—such as the value-added tax (VAT), retail sales taxes, and gasoline and tobacco taxes—favored by most OECD nations. European countries generally have lighter taxes on capital as well, another regressive feature.

Finally, the U.S. tax code allows large deductions and personal exemptions for low-income households, distributing social benefits in the form of policies such as the child tax credit and the earned income tax credit. These adjustments increase progressivity.

Judging solely from government outlays, it appears to be true that the United States has a smaller, more efficient government than the big welfare states of Europe. Relative to the size of GDP, U.S. government spending is about 16 percent smaller than the average for the European Union. But the difference is largely illusory. European governments tend to channel much less spending through their tax codes than the U.S. does. A November 2011 OECD paper titled "Is the European Welfare State Really More Expensive?" calculates the share of tax breaks used in OECD countries, separating out those used primarily for social purposes. The data show not only that the U.S. offers more tax breaks for social purposes as a share of GDP than any other country (almost 2 percent as opposed to the 0.5 percent OECD average) but that roughly two-thirds are tax breaks toward current private benefits (such as encouraging people to have children). These breaks, which total some $84 billion a year, are better thought of as welfare spending via the tax code. 

Only by measuring tax breaks do you begin to see the true girth of the American welfare state. The chart at the top right shows social spending as a share of GDP in major countries, taking into account tax breaks for social purposes, direct taxation of benefit income, and indirect taxation of consumption by benefit recipients, all of which consume economic resources but do not show up in the budget or other measures of government spending as a share of GDP. According to these OECD data, net social welfare outlays in the U.S. consumed 27.5 percent of GDP in 2007—above the OECD average of 23.3 percent.

These social spending figures should not be confused with the amount a government spends to help poor people. Many tax breaks disproportionately benefit the middle class, not the least well off. The same is also true for spending; only 14 percent of the U.S. budget goes to lower-income Americans.

Which raises the issue of fairness. Basic principles of fairness tell us that people with roughly the same income should pay roughly the same amount of taxes. Unfortunately, the amount of taxes Americans pay today has little to do with how much money they make and more to do with how many kids they have, whether they rent or own a house, which state they live in, and whether they make their money in the form of wages or capital gains. This system is not only unfair; it is also highly inefficient, as the disparities encourage taxpayers to shift their income and investment around to reduce their tax burden.

Unlike their European counterparts, American lawmakers understand that low marginal rates are crucial to promoting economic growth. But when these lower rates are considered in conjunction with the fact that the U.S. government looks deceptively smaller on paper than those of many European countries, it is easy to overestimate our differences with Europe.

In fact, in many respects the U.S. government's tax framework may be worse than Europe's. It disproportionately relies on the top earners to raise revenue, it exempts a large class of taxpayers from paying any income taxes, and it conceals spending in the form of tax breaks.

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