How progressive should our income taxes be?

An interesting report published recently by the Congressional Budget Office serves as sort of a template for a debate on just how progressive our income tax rates should be.

Before looking at data in the report, let's do a refresher on the concept of progressivity as applied to income tax rates.

An income tax system could, in theory take one of three forms. It could be:

' Progressive, (both the total amount and the marginal rate paid increase as taxable income increases);

' Proportional, (the total amount paid increases as income increases, but the marginal rate stays constant); or

' Regressive, (the marginal rate decreases as income increases.

Liberal complaints to the contrary, our federal income taxes are progressive, as the CBO report shows. Looking at 2011 returns, the CBO found that taxpayers in the lowest quintile paid an average tax rate of 2 percent, those in the middle quintile a rate of 11 percent, and in the highest quintile 23 percent. Furthermore, our rates are becoming more progressive. The Affordable Care Act increased rates for high income taxpayers effective in 2013. The CBO estimated that if 2011 income were taxed at 2013 rates, the overall rate would have been 1.7 percent higher. However, taxpayers in the highest 1 percent will have paid 4.3 percent more.

So our federal taxes are reassuringly progressive. Not so reassuring is the CBO report on income growth from 1979 to 2011. While the top 1 percent had income growth of 200 percent, the bottom quintile's growth was much more modest - 48 percent. The CBO does, however, show that our federal tax system helps to ameliorate income inequality.

What happens when income tax rates are cut, or increased? Economists tell is there are two conflicting forces at work:

The substitution effect: When taxes are cut, work becomes less expensive (after-tax wages are higher) and leisure becomes relatively more expensive. Thus, the substitution effect tends to stimulate work activity when taxes are cut.

The income effect: As after-tax income increases, an individual has more income to purchase everything, including more leisure. Therefore, the income effect tends to lead toward more leisure and less work.

Of course both effects are reversed as taxes are increased. As tax rates go up, work yields less after-tax income. Thus, workers tend to substitute leisure (which is now cheaper) for work. On the other hand, the decrease in after-tax income makes the individual want to work more to pay for everything, including leisure.

What would be a relevant range for tax rates that would be stimulative? Likely a modest tax cut would stimulate activity (the substitution effect would outweigh the income effect). However, at some level of activity, the desire for leisure would become inelastic (no additional amount of after-tax income would stimulate the individual to work more hours).

Similarly, if taxes were increased the initial effect might be to work less. However at some level of taxation, the desire to maintain a sufficient level of after-tax income would out-weight the desire for still more leisure.

So modest decreases in tax rates are likely mildly stimulative and modest increases mildly depressing to our economy. However, sharply lowering tax rates would at some level of taxation probably not gain any more stimulative effect while in the meantime starving government.

Our tax rates are progressive and becoming more so. The modest increases provided in the Affordable Care Act will probably have only a mildly depressing effect. If the Republicans propose a modest tax cut and Obama should sign it, the effect would likely be to stimulate the economy. However either sharp tax cuts or sharp tax increases would introduce an unneeded wild card into our economy. The mantra, 'don't do anything stupid” would seem to apply.

' Gary Maydew of Ames is a retired accounting professor at Iowa State University. Comments: glmaydew@hotmail.com