The Facts Regarding Income Tax

Since we are going to be hearing a lot about taxes over the next few months, I wanted to post this article to help ground us when evaluating the proposals.  Thanks to my buddy Kevin for sending this article my way...

The tax debate we need to have
By Geoff Colvin, senior editor at large

(Fortune Magazine) -- Here's a cold reality that none of the presidential candidates want to tell you: a shrinking number of Americans are bearing an ever bigger share of the nation's income tax burden.

Is that fair? Is it sticking the rich with what they deserve? Or is it a sign of a growing social problem? As you file your tax return, and as the candidates cite assorted half-truths about U.S. taxes, those questions are worth our attention - as long as we spurn political spin and face the surprising facts.

The first surprise for most people is the large proportion of Americans who don't pay any income tax at all. The number of people who actually get money back - not a refund, but a net payment - through the income tax system, is huge. In 2005 (the most recent year for which data is available), the bottom 40% of Americans by income had, in the aggregate, an effective tax rate that's negative: their households received more money through the income tax system, largely from the earned income tax credit, than they paid.

That means that the number of people who actually pay America's income taxes - totaling almost $1 trillion in 2005 - is surprisingly small. Of those who filed returns (themselves a subset of the population), just half accounted for 97% of the Treasury's total income tax revenue. The top half's share of total payments has been growing steadily for the past 20 years. The top 10% of taxpayers kicked in 70% of total income tax. And the famous top 1% paid almost 40% of all income tax, a proportion that has jumped dramatically since 1986.

But wait a minute. Senators Hillary Clinton and Barack Obama rail against President Bush's "tax cuts for the rich." How does that square with the growing share of total tax paid by the wealthy? Are the richest Americans paying so much because they're actually getting clobbered with higher tax rates? No. Their effective tax rate - the total tax they pay as a percentage of their income - has declined substantially. The top 1% paid an effective tax rate of 23% in 2005, down from 27.5% in 2001.
The rich are getting richer, faster

So if the rich are paying more income tax, yet are being taxed at a lower rate, there can be only one explanation: their incomes must be growing fast, much faster than the rest of the population's. That is what's happening. Back in 1986, an income of $119,000 got you into the top 1%. By 2005 it took $365,000 to get into the club. Those numbers are unadjusted for inflation; if you correct them, it turns out the price of admission still rose by a huge 72%. By contrast, the inflation-adjusted definition of a median taxpayer - that is, someone in the 50th percentile - didn't budge.

Now consider some of the heated tax controversies of recent years. Did Bush cut taxes for the rich? Yes. But he cut taxes for the poor even more. If we look at the measure that really matters - the change in effective tax rates - the bottom 50% got a much bigger tax cut than the top 1%. Did the dollar value of Bush's tax cuts go mostly to the wealthy? Absolutely. It could hardly be otherwise. Since the well-off pay the overwhelming majority of taxes, any tax cut with a prayer of influencing the economy would have to go mostly to them. You could completely eliminate income taxes for the bottom half of the population, and the Treasury would hardly notice.

The real issues here are clear. One is having a shrinking minority of citizens pay most of Washington's bills. Social cohesion falls apart. The majority who pay nothing resent those with higher incomes; the minority who pay heavily resent those who don't pay.

More fundamental is why some people's incomes are growing so much faster than other people's incomes. That, and not taxes, is what the supposed tax debate is really about. Watch to see if the candidates make substantive proposals for dealing with the issue, including how low-income citizens can get some of the earning power now going heavily to the better educated, plus how U.S. workers in general can be worth their high cost in a global labor market. It's a lot harder than changing income tax rates.