“Congress, Congress! Don’t tax me, tax that fellow behind the tree.” This 1930s ditty reflects the sentiments of most Americans today as Congress once again tries to simplify and reform the 74,608-page Federal Tax Code and Federal taxes. Their task is particularly challenging since about 40% of citizens feel that they pay more than their fair share, according to Pew Research. The groups that don’t pay enough include corporations (80% agree), wealthy people (78% agree), and poor people (40% agree).
Overall, 56% of Americans feel that the existing system is either not too fair or not fair at all. But how exactly does the Federal tax system work? Is it truly unfair?
Here’s Everything You Need to Know About Taxes and Fairness
To answer the question “Is the U.S. tax system fair?” we must first explore:
- The Necessity of Taxes. The American colonists’ complaint of “no taxation without representation” was misleading. According to historian Richard T. Ely, “One of the things against which our forefathers in England and the American colonies contended was not against oppressive taxation, but against the payment of taxes at all.” For decades, the American government relied on excise taxes, tariffs, customs duties, and public land sales. Are income taxes necessary?
- Our Current Tax System. What taxes do Americans pay? According to one blog, Americans pay 97 different taxes each year. We pay taxes on the income we earn, the property we own, and the goods and services we buy. The government taxes gifts we make to others, assets we leave to our families, bad habits in which we indulge, and ill-gotten criminal gains. Who are the winners and losers of America’s existing tax system?
- The Difference Between Statutory and Effective Tax Rates. Misperceptions complicate understanding and agreement – especially those surrounding the Federal tax system. A 2017 poll found about a third of Americans claim to understand a “fair” or a “great deal” about U.S. tax policies but are unable to reach agreement on basic facts, such as whether the average Federal income tax rate is higher or lower than other Western democracies. This lack of understanding fosters disagreement about policy and complicates reform efforts.
- The Definition of Fairness. John Stuart Mill, in his “Principles of Political Economy,” wrote, “If anyone bears less than his fair share of the burden, some other person must suffer more than his share, and the alleviation to the one is not, on the average, so great a good to him as the increased pressure upon the other is an evil. Equality of taxation, therefore, as a maxim of politics, means equality of sacrifice.” Should taxes be proportional or progressive? Are they solely a revenue source or a method of social justice and income redistribution?
The complexity of the tax code, the machinations of those with special interests, and the sheer scope of administering, paying, and collecting taxes promotes misunderstandings, myths, and even malevolence about the role of taxes in society and the character of those charged with their administration.
Are Federal Taxes Necessary?
While many complain about taxes and hope for a future in which taxes are nonexistent, they overlook the consequences if essential government services – law enforcement, garbage collection, fire protection – were voluntary, and if public works, such as roads, electric grids, and water and sewer systems, relied on private donations. City streets, interstate highways, and railroads would not exist; there would be no schools, hospitals, nor airports. In short, a society without the means to finance community projects and reinforce social values would quickly degenerate into anarchy.
Taxes and civilization have been inextricably linked since the kings of city-states in Sumer around 4000 BCE collected taxes “in kind” – a cow, sheep, bushels of grain, or enforced labor – to build public works, provide defense, and fight wars. The Pharaohs of ancient Egypt used taxes to build the pyramids, the Caesars of Rome to fund foreign wars, and the English King Aethelred II, the Unready, to pay tribute to Danish raiders.
While America’s Founding Fathers were leery of government overreach, they recognized the need for taxes:
- Robert Morris, Jr., a signer of the Declaration of Independence, the Articles of Confederation, and the United States Constitution, wrote to his friend Alexander Martin in 1782: “In every Society also there must be some Taxes, because the necessity of supporting Government and defending the State always exist.”
- Alexander Hamilton, one of the authors of the Federalist Papers, acknowledged, “A nation cannot long exist without revenues. Destitute of this essential support, it must resign its independence, and sink into the degraded condition of a province. This is an extremity to which no government will of choice accede. Revenue, therefore, must be had at all events.”
- Benjamin Franklin recognized the critical relationship between taxes and government. In a letter to Jean-Baptiste Le Roy, he confirmed that the new Constitution was established and hoped for its permanency. He also coined the phrase “Nothing in the world can be said to be certain, except death and taxes.”
Over the last two hundred years, U.S. citizens have regularly protested, sometimes violently, the imposition of taxes. As recently as April 15, 2009, more than 700 Tax Day tea parties happened across the nation. Despite public opposition, the country’s leaders have consistently recognized that taxes are necessary to pay for community benefits, such as education, infrastructure, and law enforcement:
- In 1848, a Senate committee of the State of Ohio noted that “rightful taxation is the price of social order…that portion of the citizen’s property which he yields up to the government in order to provide for the protection of all the rest.”
- A House of Representatives committee of the State of Vermont found that “taxation is the price which we pay for civilization, for our social, civil and political institutions, for the security of life and property, and without which, we must resort to the law of force.”
- Supreme Court Justice Oliver Wendell Holmes, Jr. noted in a 1927 dissenting opinion that “taxes are what we pay for a civilized society…”
The answer to the question “Are taxes necessary?” is intuitive and pragmatic. Short of anarchists and ascetics, most citizens agree with former Mayor of New York City Michael Bloomberg’s remark that “taxes are not good things, but if you want services, somebody’s got to pay for them, so they’re a necessary evil.”
Which Taxes Are Collected by the Federal Government?
“The hardest thing in the world to understand is income taxes,” complained Albert Einstein in a meeting with his CPA and tax preparer Leo Mattersdorf in the mid-1950s. According to the Tax Foundation, the Internal Revenue Code has grown from 1.4 million words in 1955 to over 10 million in 2015. As a consequence, IRS Commissioner John Koskinen reported that professional tax preparers prepare 56% of individual returns each year while another 34% of taxpayers use special tax preparation software.
Federal tax laws and their application have repeatedly been extended, amended, and repealed over the past century. As a consequence, the current law is bloated, confusing, and excessively complex. President Ronald Reagan complained that taxes were “too high, too complicated, and utterly unfair.” Jimmy Carter, his predecessor, called the system “a disgrace to the human race.”
Progressive, Proportional, and Regressive Taxes
Most countries, including the United States, use a combination of tax types based on the income, assets, or activity of their citizens.
Taxes that rise as income increases are progressive, with a larger rate applying to higher-earning taxpayers than those earning less. As a consequence, a taxpayer’s average rate is always less than their marginal tax rate (the highest bracket of tax to which their income is subjected). Federal progressive taxes include corporate income taxes, personal income taxes, capital gains taxes, gift taxes, and estate taxes.
Corporate Income Taxes
Corporate income tax is a tax applied to corporate profits. The tax rate ranges from 15% of taxable income to 35% for incomes above $18,333,333. Corporate taxes account for 11% of Federal revenues, and more than seven million returns are filed annually.
Personal Income Taxes
Personal income taxes are the largest source of Federal revenues, with an estimated 245 million returns filed each year. Personal income taxes account for almost one-half (47%) of Federal funds. Taxable income (after exemptions and deductions) ranges from 15% for individuals earning $9,325, to 39.6% for income over $418,000. The same rates apply to those filing joint returns, as well as heads of households, and married separate filers.
Capital Gains Taxes
Capital gains were not distinguished from ordinary income for tax purposes until 1921. Among its many changes, the Revenue Act of 1921 established a lower tax rate for gains on assets held for a distinct period. Although holding periods and rates have changed over the years, Congress has generally given preference to gains on assets versus ordinary income.
The amount of tax owed for profits on assets held one year or longer depends on the filer’s marginal tax rate. For those with a marginal rate of 15% or lower, no tax is due. Filers in tax brackets 25% to 35% are taxed at a 15% rate, while those in the highest bracket (39.6%) pay a 20% rate.
Originally enacted in 1924 and repealed in 1926, gift taxes became permanent in 1932. Today, gifts to third parties are taxed up to 40% after a $14,000 annual exclusion per recipient and total gifts in excess of $5,490,000 during the giver’s lifetime.
Commonly called the “Death Tax,” estates with net assets greater than $5,490,000 are taxed at escalating rates of up to 40%. Federal estate taxes were eliminated in 2010 but reinstated in 2011 with a maximum rate of 35% on estates over $5 million. This rate was increased to 40% in 2013.
Taxes that maintain the same tax rate regardless of income are proportional. Accounting for about a third of Federal revenues, social insurance premiums, commonly called “payroll taxes,” are paid by employer and employee alike. The programs funded by these premiums – Old Age, Survivors, and Disability Insurance and Medicare – were established to be self-sustaining, but higher-than-anticipated medical costs, extended longevity, and an aging workforce have jeopardized the long-term viability of the programs.
Social Security Taxes
The Federal government began taxing employers and their workers in 1937. While there is much confusion about the social insurance program, over 62 million Americans will receive benefits totaling $955 billion in 2017. The current tax rate is 12.4% (split 50/50 by employer and employee) on incomes up to $127,500.
Created in 1966, the Medicare program provides hospital and skilled nursing insurance (Part A) for almost 60 million people aged 65 and older. Medicare is funded by a 2.9% payroll tax at all income levels (paid equally by employee and employer). Medical care and drug coverages are voluntary and paid through additional premiums. In 2013, Congress imposed an additional tax of 0.9% on incomes greater than $200,000 for individual tax filers and $250,000 for those filing joint returns.
Congress passed the Self Employment Contributions Act in 1954, extending Social Security, followed by Medicare, to sole proprietors and small business owners. The tax of 15.3% is levied on net business earnings (since the employer and employee are the same), though half of the tax (the theoretical “employer” portion) is a deductible business expense. The self-employed are also liable for the additional Medicare tax of 0.9% if their net business earnings are over $200,000.
A tax that affects those with lower incomes more adversely than those with higher incomes is considered regressive. This could be a sales or excise tax that requires a greater share of personal income as earnings fall.
The Federal Government relied primarily on excise taxes and duties – excises and duties collected by an intermediary, then paid to the government – until the passage of the Sixteenth Amendment in 1913. Also known as consumption taxes, excise taxes are imposed on a variety of different goods, such as alcohol, tobacco, firearms, air transportation, and gasoline. They are also considered voluntary, since the tax is paid by only those who use products or services that are taxed. Excise taxes generally fall into one of three categories:
- Sin Taxes: Taxes on alcohol and cigarettes are justified on the basis of the common good or to discourage harmful or socially undesirable activities.
- Luxury Taxes: The rationale for taxing products and activities considered a luxury seems to be similar to the motive of bank robber Willie Sutton. When asked why he robbed banks, he replied, “Because that is where the money is.”
- Use Taxes: Taxes collected from certain users of a product (gasoline) or service (air travel) are expected to benefit a specific activity, such as highway construction or airport facilities.
What Is the Difference Between Statutory and Effective Tax Rates?
Otto von Bismarck, the German chancellor in the late 19th century, compared the making of laws to the making of sausages – neither of which should be seen due to their crude, often unsavory processes. One hundred years later, an article in the New York Times complained that sausage-makers should be insulted.
Tax laws are especially complicated due to the influence of those with special interests, the necessity of compromise, and regulatory interpretations of the enacted legislation. The legislative process encourages constant reinterpretation of tax laws amid a changing framework of exemptions, deductions, and credits. Senator Rob Portman (R-Ohio) complained, “There have been literally hundreds of new tax preferences and loopholes added to the code since 1986.” In fact, a Presidential committee found more than 15,000 changes in the period 1986-2010. As a consequence, there is a substantial difference between an individual (or a corporation’s) real income and the income on which taxes are applied.
Individual Tax Payers
A family of four receives an exemption from income taxes equal to $16,200 ($4,050 for each person) as well as a standard deduction of $12,700. In other words, the family can reduce their taxable income by almost $29,000 before being subject to tax. Also, there are a variety of other deductions for retirement accounts, health care, and childcare available – and different tax credits that offset the actual tax owed.
According to the Motley Fool’s Matthew Frankel, an individual with $100,000 Adjusted Gross Income (AGI) could reduce their taxable income with deductions and exemptions to result in an average tax liability of $6,250. In other words, their effective tax rate is 6.2% less than a presumed 28% marginal statutory rate. In 2014, the overall effective income tax rate for all taxpayers was 13.9%, including 36 million filers who paid no income taxes. For those who paid taxes, the average rate was 14.9%.
Corporate Tax Payers
Corporations enjoy similar deductions – accelerated depreciation, employee health care and retirement plans, research and development – and tax credits. Multinational corporations can also defer paying taxes indefinitely on overseas profits. Citizens for Tax Justice reported that 15 major corporations have received extraordinary benefits, paying only $1.724 billion in taxes on profits of $107 billion between the years 2010-2014.
While the statutory corporate tax rates are among the highest in the world at 39.1%, the effective rate is 27.9%, according to the Organisation for Economic Co-operation and Development (OECD). There are proposals to reduce the top statutory rate to 25% or lower; however, passage is uncertain.
Understanding Statutory and Effective Tax Rates
Misunderstanding the difference between the statutory tax rate and the effective rate often leads people to comparing apples to oranges in partisan efforts to revise the tax code. Proponents of reducing tax rates use statutory rates in their arguments, focusing on the highest marginal bracket. For example, Martin Sullivan, chief economist for Tax Analysts’ publication, wrote in Forbes magazine, “It’s a rock-solid fact that the U.S. Corporate statutory tax rate is the highest among developed nations and considerably higher than the average.”
By contrast, those who want to raise or keep the existing tax rates often point to effective tax rates – the ratio of taxes collected after all deductions and credits to net income – in their arguments. A 2017 Congressional Budget Office study reported that the U.S. effective corporate tax rate is about one-half of the highest statutory rate of 35%. To Mr. Sullivan’s credit, he noted that “on average, the foreign effective tax rate [on multinational corporations] is not much lower than the U.S. domestic tax rates,” and that studies often exaggerate the differences.
What Is Fair?
When it comes to taxes, the definition of “fair” is both personal and relative. Most people would agree with the sentiment of cartoonist Bill Watterson, creator of the comic strip Calvin and Hobbes: “I know the world isn’t fair, but why isn’t it ever unfair in my favor?”
People have claimed that taxes are discriminatory as long as kings and governments have imposed them. Real and fictitious tax protestors throughout history – from Boadicea of the British Isles to Lady Godiva – are idolized, while those employed to collect taxes suffer hostility and social rejection. The Bible equates tax collectors with prostitutes, adulterers, and sinners, and the Internal Revenue Service is often likened to the Gestapo or the Mafia. Politicians frequently characterize taxation as “legalized robbery.”
In fact, taxes are what we pay for civilized society, and for security, modernity, and prosperity. They are essential to every government, but they should be as fair as possible. Though it is doubtful that everyone can agree on the definition of “fairness” when it comes to taxes, an Urban Institute panel in 2012 proposed several standards by which fairness might be measured:
- Horizontal Equity: People with equal ability bear similar tax burdens.
- Vertical Equity: Those who are better off pay more tax than those who are less well off.
- Generational Equity: Future generations should not be burdened by the cost of maintaining the standard of living for today’s generation.
How does the existing Federal tax system measure up to these proposed standards?
While payroll and excise taxes affect all citizens equally, income tax is progressive, designed so that those who earn more pay a higher percentage of their earnings in taxes as their income rises. Therefore, those with similar incomes should pay similar tax amounts; however, this is not the case.
Warren Buffett, one of the world’s richest men, wrote in a 2011 New York Times editorial that he paid a lower percentage in Federal taxes on his income than the other people in his office. The effective tax rate can be different for each taxpayer, depending on the source of their earnings and their ability to utilize loopholes and special treatments in the tax code.
While the vast majority of Americans who pay no income tax do so because of low income, a significant number of high earners also avoid payment. (According to the Tax Policy Center, 491,000 Americans making $100,000 or more paid no taxes in 2011.)
On the other hand, a macro-view of the taxpayer population suggests that taxpayer groups ranked by their share of total income pay a similar proportion of Federal taxes. Figures compiled by the Citizens for Tax Justice from the 2015 tax records show:
- The lowest 20% earn 3.3% of the nation’s total income and pay 2.1% of taxes.
- The lowest 60% earn 21.2% of the nation’s total income and pay 17.2% of taxes.
- The bottom 90% earn 54% of the nation’s total income and pay 49.9% of taxes.
- The top 10% earn 45.9% of the nation’s total income and pay 49.4% of taxes.
- The top 1% earn 21.6% of the nation’s total income and pay 23.6% of taxes.
While not perfectly aligned, it appears that the U.S. Federal tax system has a high degree of horizontal equity. Nevertheless, opportunities to reduce taxes with deductions and credits is not shared equally across the population; high earners and those whose primary income is from investments receive the greater benefits. Reformers often propose to reduce the number and size of deductions and credits in the tax code but are opposed by those with special interests who are reluctant to lose their advantages.
Achieving an acceptable balance between vertical equity (the notion that those who benefit more should pay more in tax) and individual equity (the idea that one should be able to keep the rewards of one’s effort) is incredibly difficult and invariably raises claims of “class warfare.” The challenge for government is to capture as much revenue as possible without discouraging continued effort and risk by those from whom wealth is taken. Jean-Baptiste Colbert, a French finance minister during the late 1600s, described the process best: “The art of taxation consists in so plucking the goose to obtain the largest amount of feathers with the smallest possible amount of hissing.”
Progressive taxation in America accompanied the legalization of income taxes in 1913. Since then, the top statutory income tax rate has ranged from 7% (1913) to 94% (1944). The current top bracket is 39.6% on taxable incomes of $418,400 and up.
Despite claims to the contrary, Americans do not pay the highest taxes in the world. According to OECD statistics, the top marginal tax rate (including social security contributions) in the United States was 48.6%, ranking midway on the list of 34 industrialized countries. The U.S. rate is slightly above Germany (47.5%) and the United Kingdom (47%) and below countries like Sweden (60.1%), France (55.1%), and Canada (53.5%).
American culture is based on the country’s history of emphasizing individual effort, free markets, and the viability of the American Dream. As a consequence, the populace has historically resisted punitive taxes on more wealthy citizens. However, two-thirds of Americans believe that the current economic system is rigged to favor the interests of the wealthy and powerful.
The top 1% have benefited disproportionately over the last 30 years. Since 1980, after-tax income for the top 1% of households has grown 192%. For the top 0.01%, this amount has increased 322%.According to an article by economists Thomas Piketty, Emmanuel Saez, and Gabriel Zucman, income for the bottom 90% increased just 0.03%, and the middle 60% increased only 41% during the same period.
The concentration of income and wealth is similar to the levels from 80 years ago (the Age of Robber Barons) when the bottom 90% of Americans held 16% of the country’s wealth and the top 0.1% owned about 25%. Today, the super-rich – the top 0.01% – control 11.2% of America’s wealth – a ratio not seen since 1916, the highest on record.
While tax rates for 99% of taxpayers are progressive, the tax rates for increased levels of income in the top 1% actually decline, according to figures compiled from IRS data by the Washington Post. The effective rate for the top 1% is 22.83%, while the rates for the top 0.1%, 0.01%, and 0.001% fall to 21.67%, 19.53%, and 17.60%, respectively. In other words, a household earning $250,000 (the 1% threshold) pays a higher rate than a household earning more than $30 million per year (0.01% threshold).
While some have argued that reducing the top marginal tax rates for individuals will spur economic growth, research suggests there is little correlation between changes in tax rates and economic growth. According to a 2016 study, employment and GDP growth were significantly higher in the six-year period following the income tax increase in 1993 than they were following the tax reduction in 2001.
Vertical equity of the Federal tax system has substantially eroded over the past two decades. The top 1% – especially the top 0.1% and above – has benefited disproportionately compared to other income groups, primarily due to discriminatory tax policies. This excessive distribution stifles the entrepreneurial spirit and exacerbates income disparity.
While the top 1% pay about half of the income tax collected, they have also received an increasing share of the nation’s revenue for the past 20 years. Significantly increasing the marginal tax rates for incomes above $1 million, while eliminating deductions and credits, would improve vertical equity within the tax system without retarding GDP growth.
For the last 14 years, Congress has been unable to balance the annual budget, spending more than its revenues and exploding national debt from $5.8 trillion in 2003 to $19.6 trillion in 2016. In other words, the taxes received by the Federal government are insufficient to pay the nation’s bills on a regular basis.
As a consequence, future generations of taxpayers will be required to discharge the debts created by this generation. If the American colonists rebelled about the injustice of taxation without representation, one can only imagine the social upheaval that will occur when our descendants are required to repay our borrowings.
Since 2000, revenues from income and social insurance have grown at 2.94% annually, while spending has increased 4.99% during the same period. The government regularly spends $500 million in excess of collections each year, and is unwilling to raise taxes or cut popular government programs. Thus, the burden on our children and grandchildren continues to grow.
By any measure, the existing Federal tax system is grossly unfair to future generations. A combination of tax and social insurance premium increases, in addition to limiting the growth of government programs, will be necessary to reduce the Federal debt to manageable levels. However, such reform is unlikely.
Antipathy toward taxes is widespread among America’s working population; hence, the popularity of a pledge to “oppose any and all efforts to increase the marginal income tax rates for individuals and/or businesses” promoted by Grover Norquist’s Americans for Tax Reform organization. The pledge has become de rigueur for GOP candidates running for political office.
Whether we like them or not, taxes are essential to the operation of government and community services. Since eliminating taxes is not possible, our challenge as citizens is to make them as fair as we can. Insurgency is the result of inequity in the application and collection of taxes – not taxation itself.
By most objective standards, the Federal tax system is unfair. Taxpayers with the same income pay at different rates, and those who receive the greatest benefits of the economy do not pay an equitable share of its cost. Further, the current level of taxation does not cover ongoing, ordinary expenses, which means future taxpayers will have to make up the deficits.
Can the existing system be reformed to be fairer? Possibly, if we accept the premise that “taxing the rich” actually helps democracy, suggests Professor Deborah Boucoyannis of the University of Virginia. She proposes that when a government is strong enough to impose a substantial obligation on its richest citizens, they (the wealthy) are inclined to lobby the government to ensure the funds are well spent.
Should taxes be raised on the top 1% of American taxpayers? The top 0.1% or 0.01%? Should government programs be eliminated or benefits from our social insurance programs reduced?