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Tax Systems

Okay, now you know what all those taxes eating up your paycheck are. Onward to a more philosophical question: who should pay for government?  What kind of tax system is fair?

(And no, "somebody else should pay" probably isn't a very philosophical answer.)

Economists break taxes into two basic categories—those based on the “benefits received principle” and those rooted in the “ability to pay principle.”

These are pretty self-explanatory. According to the “benefits received principle,” taxes should be paid only by those using a particular government program and in proportion to amount that they use it. Gas taxes embody this principle, for example. If you drive a lot, and use a lot of gas, then you have to pay a lot of gas tax. Want to pay less gas tax? Buy less gas.

In contrast, under the “ability to pay principle,” those with greater wealth (and thus presumably a greater ability to pay) should finance a larger share of the government’s efforts regardless of whether or not they use more of the government's services.  According to this theory, wealthier people should pay higher taxes to support schools, build highways construction, and provide national defense even if they are childless, don’t drive, and maintain their own squad of commandos.

So which approach is fairer?  Your answer will probably depend on some combination of your circumstances (how much money do you have and how much tax are you being asked to pay?) and your philosophical outlook (is it just for those who have more to pay more, or does that unfairly punish the successful?).  

There's no one right answer here, which is why the overall tax structure tends to represent a hodgepodge of both systems.

Meanwhile, other economists employ a different set of organizing concepts in sorting out taxes; they break taxes into three categories: progressive, proportional, and regressive

Progressive taxes impose higher rates of tax on people with higher incomes—the more you make, the higher rate of tax you pay. Based on the “ability to pay principle,” progressive taxes include the federal income tax and most state income taxes. 

Proportional taxes impose the same rate of tax, regardless of income. A person making $10,000 and a person making $10 million pay the same rate of tax. The wealthier person writes a bigger check since x% of 100,000 is more than x% of 10,000. But both taxpayers pay the same percentage of their income.  Some tax reformers have proposed adopting this system as a "flat tax" to replace the progressive federal income tax.

Finally, regressive taxes impose higher rates on people with lower incomes. The poorer you are, the higher percentage of your income you pay in taxes.  The federal payroll tax is a regressive tax, since it is capped at $97,500.  If you make that much money this year, you pay the exact same amount as a guy who makes $20 million... which means that you pay at a much higher rate.

Why It Matters Today

Who should pay?  That's the key question that lies at the heart of most of our heated political debates over tax policy.  

Take a look at this data.  Does it shock you?  In 2008, the wealthiest 1% of the population paid more than 40% of all federal income taxes in the United States.  Meanwhile, the bottom half of the population paid just 3%.  

Those are attention-grabbing numbers, to be sure.  Do you think that's fair?

Would it change your opinion to know that the richest 1% of the population also owns more than 40% of the country's financial wealth, and the bottom 40% owns less than 1%?

Does the progressive federal income tax treat wealthy people unfairly, punishing them for their economic success?  Or is it perfectly fair to tax those people who have achieved the most economic success at a higher rate, just because they can presumably afford to pay more?  

Of course, if they can afford to pay more, they can also afford good accountants to help them avoid paying more.  Very high tax rates set up incentives for people to change their behavior to avoid having the government take away so much of their money.  At some point, "soak the rich" tax schemes become counterproductive.  So maybe a less progressive income tax structure would work better?

But then, on the other other hand, what happens when you consider additional taxes, apart from the federal income tax.  Most Americans, for example, actually pay more in federal payroll taxes than they do in federal income tax.  And the payroll tax hits everyone at the same rate (15.3% of pay) from the first dollar earned up to $97,500; if you earn more than that, though, you don't have to pay another cent.  

Is that unfair to poor and middle-class working people?  After all, if you make $10,000 a year, you're going to pay a much higher proportion of your earnings in payroll tax than, say, baseball star Alex Rodriguez, who makes $20 million a year.  Does that seem fair?

Would it change your opinion to know that the payroll tax funds Social Security and Medicare?  Social Security is supposed to pay out benefits to individuals broadly in proportion to how much they've paid into the system; the reason the cap on the tax exists is that there is a corresponding cap on the benefits.   The thinking is that it wouldn't be fair to make Alex Rodriguez pay in $1.5 million a year when he'd never ever be able to take that much out once he reaches retirement age.  

So... what's fair?  Does that question seem more complicated now than it did five minutes ago?

Sometimes, a Song Says it Better: Success Story, by The Who

“Away for the weekend
I've gotta play some one-night stands
Six for the tax man, and one for the band”

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