What's Fair?

For the record, I think it’s great that the Obamas earn as much as they do. And it’s great that Mr. Buffet earns as much as they do. The question really is not, and should not be how much someone ‘brings home’ every year. That amount is, in fact, determined by all of us. A-Rod makes $30 million every year because millions of people will pay to see him hit a home run (I suppose some pay to see him strike out, but either way it’s still entertainment). We will pay to listen to Adele sing. We also will pay for a good lawyer or a sound financial analyst. So far, simple and straightforward.

But the question that needs to be asked is this: what is a fair tax? To answer that question we really need to ask to other questions: what does it mean for a society to say that something is fair? And the second question is what is the purpose and meaning of a tax?

In this context ‘fair’ means (or seems to mean) unprejudiced and unbiased, hence no preconceived judgments and an absence of preference or partiality. And what is a tax? A tax is nothing more than a fee levied by government to raise money to run government operations. So, a fair tax would be a charge, levied by government, which was impartial and based on no preconceptions.

As it now stands the US government and most of the other governments in the world use some sort of version of what is known as “progressive” taxation. “Progressive” taxation simply means that as your overall income increases (however it is measure for tax purposes) your rate of taxation increases.

The justification for progressive taxation takes several forms. First is the simple observation that for a family that earns $50,000 per year (again, this is the adjusted income), housing costs, food costs and other ‘necessary for survival’ expenses consume most if not all of that income. Since little is left over, it isn’t ‘fair’ to tax them heavily. In the 2011 tax table (for ‘head of a family’) the federal income tax on $50,000 taxable income is $7,274 (a rate of 14.548%). For a family that earns $150,000 per year, the argument is that there is more remaining at the end of the year after all the various expenses, and the tax rate goes up, and the federal income tax is $33,185.50 (a rate of 22.12%).

If it were that simple, we could probably stop right here. But it isn’t that simple. First, we need to answer the question of what constitutes income. As it turns out, that really is what the tax code does. And the tax code is – literally - thousands of pages long. A hyperlink to the US Tax Code shows it to be 24 megabytes, 3.4 millions words long, but this is not everything – all the regulations, rulings, etc., just the law itself. For an exercise in frustration, go to the Government Printing Office website and browse through all that comes up when you search for Tax Code. (http://www.gpo.gov/ ) What all those pages do is explain and outline deductions and exemptions and exceptions. There are the obvious: children and other dependents, mortgage payments, etc. But, in a very real sense, all the thousands of pages of the tax code and the accompanying rules and regulations are efforts to identify and explain thousands and thousands and thousands of exceptions to the rules. And just to be crystal clear, deductions and exceptions are also called ‘loopholes.’

So, who uses those rules (exceptions, deductions, loopholes)? Well, everyone does. President Obama does; that’s why he only paid $162,074 in taxes on an adjusted income of $789,674. If you go to the tax table (http://www.irs.gov/pub/irs-pdf/i1040tt.pdf ) you will find that the tax on an income of $789,674 is $250,320.90 . That would be a tax rate of 31.7%. Where do these exemptions and exceptions and deductions come from? From Congress, which continually adjusts the law based on inputs from all sorts of people who petition Congress to adjust the law so that it is ‘more fair.’ Petitioning Congress is what lobbyists do. So, we are back to lobbyists. And since all but a few of the thousands and thousands of deductions are only used by perhaps a few million people, these deductions are for distinct minorities, such as owners of family farms, or small businessmen or any of seemingly countless other groups.

In short, every one of these groups is getting special treatment by the government. And who pays for that special treatment? Well, the rest of us do. We subsidize their special treatment. In short, it seems that everyone is getting some sort of ‘special’ deal, we all have our own ‘loophole’ that lets us avoid paying some taxes, and all of us are therefore both subsidizing someone else and in turn being subsidized. Confusing isn’t it?

We’re not done yet.

There is also the issue of who gets the most from government. One of the questions that comes up from time to time is the question of whether someone – say Warren Buffet – benefits more from government then the rest of us. It’s a good question. The basic argument is this: if Warren Buffet has (2010 income, per Forbes Magazine) adjusted gross income of $62,855,038, isn’t he receiving substantially more benefits from the government then the rest of us? In this case, the ‘benefits’ in question are not specific entitlements, but rather that the benefits that he receives from the society as a whole, and the various effects of government. This argument is based on the concept that without the order and legal and economic framework provided by government, he would not be able to generate the income that he is generating.

There is one major problem with this concept: it suggests that his wealth (or anyone else’s wealth) in some way derives from the government, and that the government has primacy. In fact, the central point of the Constitution is that the people – the citizenry – have primacy, and the government’s assigned role is to create and maintain a ‘foundation,’ an ‘infrastructure’ which all can access equally, but after that it is up to the individual. Certainly, we can’t argue that Warren Buffet receives more police protection then anyone else, or more fire department protection. The US Army doesn’t protect him more than it does me, the Department of Education does not provide for him more than me. In fact, in as much as he pays 40 times as much taxes as do I, yet receives the same services at the federal, state and local level, one might argue that he is getting the short end of the stick. When you consider too that his money, when put back into the economy, either simply by way of deposit in a bank, or in a more aggressive and complex manner such as the direct investment in a business, results in both more jobs (at least one for every $100,000), as well as additional tax revenue from the income created by these second order economic actions. In short, Warren Buffet’s millions create more millions, and more tax revenue. So, charging him more because someone says he ‘gets more from the economy’ is really sort of foolish, isn’t it? (For the record, Buffet’s taxable income for 2010 was $39,814,784 and his federal income tax was $6,923,494.)

Finally, add on that there are dozens of different kinds of taxes: income taxes, sales taxes, inheritance (also called estate) taxes, excise taxes, capital gains taxes, and many, many more. And, then there are the taxes that you can’t really see. For example, not only are there federal and state taxes on gasoline (for example), there are also the federal and state taxes on the income of the oil company. And taxes on the company that owns the pipeline, the company that owns the truck, etc., etc. All of those payments – obviously – come out of the total revenue from gasoline sales – paid by the consumer. Which means that everyone, even those folks that the federal government says don’t need to pay taxes because they aren’t making enough money – the federal government IS making them pay taxes. It’s just being sneaky about it.

So, where does all this leave us? My mom and dad would probably remind me at this point that life isn’t fair, and I agree – it’s not. But, they would both agree that taxes need to be massively simplified. But before we talk about how taxes might be simplified (in a follow-on article), we really need to answer two final and fundamental questions: Why are there so called progressive tax rates in the first place? And do the benefits to society of ‘progressive tax rates’ more than compensate for any of the costs of such tax rates?

The concept of a progressive income tax is fairly simple: the more money you make, the higher your rate of taxation. \

Is it truly progress to tax people more for earning more? One might argue that, if we wish people to have an incentive to work hard, we – as a government – would reward them for earning more, and the only means the government would have to do such a thing would be to reduce tax rates as you earn more. As it now stands, if you make a certain amount of money and you will pay at a given rate unless of course you qualify for this or that deduction/exception/exemption/loophole, in which case you will pay at a lower rate; but if you earn more that rate will increase. But, and this has been demonstrated time and again by the high and mighty (President Obama and Mr. Buffet for example) that people will go through quite sophisticated gyrations to actually reduce their income and therefore keep their taxes down. Repeat that: people avoid income. Does that really sound like a good policy for any government? “Let’s set up a system under which people will try to avoid increasing their income past a certain level.” That is the unintended consequence of “progressive” taxation.

But certainly there are benefits to society of a progressive tax rate? In fact, progressive tax rates, because the result in skewed economics and often pretzel like twists and turns of logic to avoid taxation, arguably result in less tax revenue then would a simpler tax that was both easier to compute and easier to forecast. Assuming that the point of the taxes – from the government’s perspective – is to raise the most revenue, there has been little to show that progressive tax rates raise the most revenue. What then is the value to society of a progressive tax rate? It would seem that if the value is not to maximize revenue, then the tax scheme must be tailored to provide a non-financial benefit to society. The obvious choice is that a progressive tax scheme conveys to the populace the concept that wealthiest are shouldering the greatest burden. But, if such were the case wouldn’t it be in government’s interest to send the signal that the current tax structure is fair?

Why then is the White House constantly harping about the wealthy not paying their ‘fair share?’ I would recommend you take a look at this article and the chart about half way through the article. ( http://www.financialsamurai.com/2011/04/12/how-much-money-do-the-top-income-earners-make-percent/ ) Two numbers will suffice (numbers for 2010):

The top 1% makes about 20% of the total income in the US; they pay 38% of the income taxes; the top 5% account for 34.7% of all income; they pay 58.72% of all income taxes. And so my question to the President is this: Is that fair?