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Analysis

Of all American taxes, the federal income tax generates by far the most debate. It's the biggest tax, and one of the most politically controversial. But in economic terms, is it effective, efficient, and fair?

These are huge questions. Critics like to point out that the tax code is more than 10,000 pages long and growing. In order to understand and comply with this code, businesses and individuals dedicate countless hours – hours that might be more productively spent actually doing useful work – just figuring out how to do their taxes. An estimated $265 billion is spent annually on record keeping and form filing. Another $345 billion is lost annually as a result of taxpayers not understanding the code or simply refusing to pay – illegally – in frustration with it all. 

Total Federal Income Tax Compliance costs, 1990-2015 (Projected)

Compliance Costs
Calendar YearCurrent Dollars ($Billions)Real 2005 Dollars ($Billions)Percentage of Federal Revenue
1990$79.70$107.6014.10%
1991$85.10$111.0015.50%
1992$94.70$120.7016.40%
1993$102.20127.4016.30%
1994$106.00$129.3015.60%
1995112.20134.2015.10%
1996$120.30$141.2014.40%
1997$128.50$148.4013.90%
1998$143.40$163.8014.30%
1999$162.60$183.1015.00%
2000$172.90$190.5014.50%
2001$181.10$194.9016.00%
2002$207.70$219.8021.70%
2003$232.50$241.6024.80%
2004$243.90$248.3024.40%
2005p$265.10$265.1022.2%
2006p$278.60$274..4021.90%
2007p$305.30$295.8022.80%
2008p$325.70$310.0023.00%
2009p$346.90$324.3022.90%
2010p$368.40$338.3022.80%
2011p$391.90$353.7021.50%
2012p$409.50$363.1020.70%
2013p432.70$376.9020.70%
2014p$457.20$391.1020.70%
2015p482.70$405.8020.70%

The root problem, many argue, is that policymakers have forgotten that the fundamental purpose of the tax system is to raise money. Instead, they have turned it into a tool for pursuing certain economic and social objectives. The tax code is so monumentally complicated because generations of lawmakers have been using it to try to encourage people to engage in certain supposedly beneficial behaviors – buying homes, saving for their retirements, even buying hybrid cars or installing solar panels – and to discourage other supposedly detrimental behaviors – short-term financial speculation, to take one prominent example. A dizzying array of tax credits and deductions are available to promote homeownership, factory modernization, industrial research, health insurance, college education, charitable contributions… the list goes on and on and on. And on.

Complicated as the resulting tax code may be, however, its defenders counter that these are all important objectives and the tax system is an appropriate place to pursue them. College tuition credits help parents meet the rising costs of education. Depreciation allowances allow businesses to invest in new technologies and better compete in the global economy. And countless charities from the United Way to the Boys and Girls Club benefit from the more than $300 billion dollars donated annually, at least in part, as a result of the tax deduction for charitable giving.Is the goal of tax simplification really worth making change might easily lead, for example, to a collapse in charitable giving and thus the destruction of countless useful non-profit organizations?

Whatever your take on the merits or drawbacks of using the tax code to pursue certain social aims, there are other equally controversial questions at play. Foremost among them: who should pay, and how much? The federal income tax is a progressive tax – that is, the more money you make, the higher your marginal tax rate.

Here's how that works in practice (using 2009 tax rates): For the first $8350 you earn, you pay back 10% to the government in income tax. For everything you make above $8350 but below $33,950, you pay 15% in income tax. For everything above $33,950 but below $82,250, you pay 25%. For everything above $82,250 up to $171,550, you pay 28%. From there up to $372,950, you pay 33%. And if you had a really, really good year, all your additional income above $372,950 is taxed at 35%.

Or at least it is, in theory. In practice, since there are all those deductions and tax credits available, just about everyone pays less – often quite a bit less – in actual taxes than their marginal tax rates would suggest. According to the Congressional Budget Office (pdf), for example, in 2005 households in the middle quintile (that is, households earning 40-60% of the median income – households that you'd expect to fall into the 15% or 25% tax brackets) paid an effective income tax rate of only 3.0%. And even households in the top 1% – earning well over a million dollars a year, putting them easily into the 35% bracket – actually paid an effective income tax rate of 19.7%. Households at the lowest end of the income scale actually pay a negative effective income tax rate – the value of the tax credits available to them is actually higher than the taxes they pay, so the government writes them a check rather than vice versa.

So… is this system fair? Is it just for people who work but don't make much money to pay less than nothing in federal income taxes? (Although don't forget that they do pay all kinds of other tax… a regressive federal payroll tax for Social Security and Medicare foremost among them.) Is it fair to tax wealthy people at a higher rate than the rest of us? Or should the wealthy be taxed at an even higher rate? (Back when the income tax first began, only extremely wealthy people paid income tax. And for most of the time from the 1930s through the 1960s, the top marginal tax rate – now set at 35% -- was 90% or greater… although remember that widespread deductions meant that just about nobody actually paid such a high rate (see chart below).)

The Top Martinal Personal Income Tax Rate 1913-2003

Should the entire system of tiered income tax brackets and thousands of deductions be scrapped in favor of a "flat tax" – a simple tax in which there are few or no deductions and everyone pays at the same rate?

The answers to those questions are political and moral as much as they're narrowly economic – different people will have different answers. That's why the federal income tax will probably continue to be a source of political and social controversy for as long as it exists – which is to say, in all likelihood, forever.

So those are the basics. It’s time to stop complaining and see if you could design a better tax system yourself in our Taxes Game. Don’t be afraid. It’s been centuries since tax officials were greeted with the Hillsborough Treat.

Why It Matters Today

Shortly after taking office in 2001, President George W. Bush convinced Congress to pass a series of significant tax cuts.  As part of those cuts, the highest marginal tax bracket dropped from 39%, where it had stood through most of the 1990s, to 35%.  Those tax cuts, however, were not permanent; the law that passed for Congress called for the top bracket to revert back to 39% in 2011 if Congress did not act explicitly to extend the cuts.

In 2009, Democrat Barack Obama, a more liberal president, took over the Oval Office.  In early 2010, Obama announced a budget plan that called for the Bush tax cuts to expire; in other words, Obama announced that he wanted to raise the top bracket back to 39%.  

As the economy struggles to emerge from a recession, is that a good idea?  Keynesian stimulus plans (which Obama embraced in 2009) call for tax cuts, not increases, during economic hard times.  And the people who pay taxes in that bracket (those who make more than about $250,000 per year) are understandably not too happy about the plan.  Will the new tax structure cause them to alter their economic behavior in ways that suppress macroeconomic growth?  It certainly could.  

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