What Does “Fair” mean when it comes to taxes?

MickelsonThere is a lot of talk in the media about tax policy.  Unfortunately, no one seems able to make any kind of dispassionate statement or argument about it.  One side keeps talking about “fairness” and the other side keeps talking about “class warfare”.  Of course we all want our tax system to be fair, and of course none of us want class warfare, or any kind of warfare for that matter.  It’s like abortion; who wants to be anti-choice or anti-life?  We also tend to make the mistake of not caring about what those who make more than we do are paying.  “It doesn’t affect me,” or “Everybody making more than me is rich so they SHOULD pay a whole bunch more in taxes.”  The recent dramatic increase on those with a taxable income over $1 Million in California (up from 9.3% to 13.3%) combined with the dramatic increase on the same folks in the federal tax code (up from 35% to 39.6%) and the new Obamacare tax (up from 0% to 0.9%) means an increase on the very well-to-do of 8.5% of their income.

Many people don’t think anyone should have a marginal tax rate of 49.8% (it’s not quite the 62-63% Phil Mickelson thinks it is because part of the self-employment tax is deductible and the state taxes are deductible not to mention the fact that he can only do math in relation to par.)  Half of everything you earn going to income and payroll taxes?  I don’t think that’s fair.  But what is?  Well, let’s think about it from a rational standpoint.

Everyone pays the same

One definition of fair might be that everyone pays the same amount.  Since we all benefit the same from a strong military, the rule of law, a nice road system etc, it seems reasonable that we all ought to pay the same for it.  There are 315 million people in the United States.  In 2011, the US had revenue from income taxes of $1.27 Trillion.  Divide that out and it comes out to $4032 a piece.  So if you have a family of 5, you pay $20K.  That’s your fair share.  Even if we decide we just want to divide up the tax by the number of households (115 Million) that’s about $11K per family.  Of course, that’s just using the revenue we collect.  If we actually had a balanced budget, we’d need more revenue, about $22,347 per family or $8158 per person.

Everyone pays at the same rate

Okay you admit, that’s fair in a sense.  But, you say, those who make more have greater capacity to pay more.  It’s only fair that the Exxon CEO pay more money than the guy who mows his lawn, even if they both benefit the same from the government.  Wouldn’t it be fair if the CEO had to pay at least the same percentage of his pay as the lawn mower?  It’s like tithing- 10% for everyone, right?  What would the rate be if there were a “flat tax”?  Again, 315 Million households in the US, $1.27 Trillion is the revenue, and the average household had an income of something around $65K (the more commonly seen number, $45K is the median).  $65K*115 Million = $7.48 Trillion.  So we’d all need to pay 17% of our income (or 34% if we balanced the budget.)  That seems awfully high.  No wonder the right thinks we have a spending problem.  Using those percentages the median family making $45K is now paying $7650 in taxes.  Someone with an income of $1,000,000 would pay $170K in taxes, or about 22 times what the average household pays.  Impossible to have a system like this?  Not really.  My state income tax is a flat tax, at least after your deductions.

How progressive should we be? However, the system we have now is far more progressive than a 17% flat tax.  As Mitt Romney famously made clear, 47% of taxpayers don’t pay federal income tax.  Thus the 53% must make up for all those households not paying their $11K share.  The left would argue that those households are paying other types of taxes such as sales tax, property tax, and payroll taxes.  It is true that the tax code is flatter (although still quite progressive) when you count in payroll taxes, especially Social Security since it is capped at an income of $113,700 ($7049 for employees and $14,099 for the self-employed).   The right would argue, however, that you shouldn’t count payroll taxes, since they are in effect a form of forced savings.  You get benefits in proportion to how much you put in.  In fact, the SS benefit system is actually quite progressive, since you don’t have to put much in to get significant benefits at the lower end, and then the benefits increase at a far lower rate than the premiums  as you move up in income.  Plus, those with significant income at the time of withdrawal are taxed on their Social Security benefits.  Medicare, of course, is just a flat tax, 1.45% (2.9% for self-employed) for the same benefits for Mitt Romney and Joe the Plumber alike.  Actually, with the new 0.9% Obamacaid Tax on income over $200K ($250K married), even the Medicare tax is progressive.

Tough argument to make

So those who would argue for even higher tax rates on high earners are left with a conundrum.  They call for fairness, but their definition of fairness appears to be nothing more than that those who make more than them should pay more, and those with their income, or an income lower than theirs should pay less.   Any objectively pre-meditated definition of fairness would call for a less progressive tax system than we had even before the recent changes increasing the progressiveness of the US system.  If the “fair” answer is a progressive tax system, how progressive is progressive enough?  It would seem to me that any fair system would require everyone to pay something.  We have an alternative minimum tax for those on the high end of the income scale.  I think it’s time we had an alternative minimum tax for those on the low end of the income scale.  Surely no one can object to paying $100 a year towards the protection afforded by the strongest military in the world and all the other benefits our government provides.

Taxing spending

I’m not the first one to make these arguments.  Proponents of the “fair tax” have argued that we should abolish our income tax system completely.  Instead of taxing income, they argue, we should tax spending.  Since those with a high income spend more, they’d pay more in taxes.  Alternatives include a national sales tax and a value added tax.  Experts estimate these taxes would have a rate of 15-25%, which is pretty similar to that 18% rate I calculated earlier.

What do you think?  What do you think a fair tax system would look like?  If you think it should be progressive, what percentage of income should someone pay in federal income tax if they make $25K, $50K, $100K, $300K, or $1M?  Comment below!


What Does “Fair” mean when it comes to taxes? — 37 Comments

  1. “It’s only fair that the Exxon CEO pay more money than the guy who mows his lawn, even if they both benefit the same from the government.”

    The power projection of the US military allow the Exxon CEO to feel safe sending his fleet of oil tankers to all corners of the earth, and then the (subsidized) US transportation system allows him to distribute his product all over the world. And then his company also gets a handout from Congress on top of that.

    But yeah, the I guess if the lawn guy is poor enough he can get on medicare so it all evens out.

    • Whoops, that should be Medicaid not Medicare.

      On a side note, I enjoy this blog a lot more when it deals directly with investing for physicians. There are many websites where I can go read political opinions, but few like this one.

      • I try to keep the political themes to a minimum, but occasionally can’t help myself. I think it’s an important question to address as a country- i.e. what does “fair” really mean? Plus, controversy tends to draw people to the blog. Look at the most popular posts on it- whole life insurance, tax issues, stupid things doctors do with their money etc. But we’ll get back to personal finance topics on Wednesday. Lots of good stuff coming up.

        • Jim,

          Controversy might draw people to the blog, but I expect a bit more than this post offers.

          To be clear, there’s nothing wrong with this post; it’s not like you’re angrily ranting, which is what I see commentators on TV do. But it paints an incomplete picture of taxation in America. It’s easy to get people to focus on income tax because we all have to file annually. And presumably your readers are paying a great deal of taxes. But there is a great deal more taxation than income tax.

          I’m not an expert on the issue, but the author of the book that I link to below (http://amzn.to/14aa8Ko) is. Just as some people have dedicated their professional lives to medicine, some have done so with tax policy. I feel that his book is a great introduction to the importance and complexity of the issues to the layman. Our country is having financial difficulties, so educating the public on the issue can only be a good thing.

          I would much rather see you write a thoughtful review of that book, and try to generate a conversation on that.

    • The CEO of Exxon really does not personally benefit as you indicate, now the corporation and its owners do. The transportation system is somewhat paid for by fuel taxes. While you have a point it is limited in my opinion.

  2. I think a combination of new taxes is essential to tax reform.

    I would like to see a lower VAT (say 5-8%) combined with a progressive tax system similar to what we have but at lower levels but that would also not start to phase in until a certain income (50K?). I think the only taxes under 50K should be for social security and medicare (and the VAT). I would prefer if the tax rates grew from that level (50K ish) at more linear rate up to a maximal tax rate of 36% at around $1,000,000. Tax both consumption and income. All income taxed equally.

    My two cents…

  3. You miss the point on taxes. Of course a 10 percent flat tax would be the most direct way, but only if everyone actually pays. This must include those 47 percent who pay nothing now.
    The problem is that that of course would anger the 47 percent who would no longer vote for those who promise to ‘tax the rich’. Those 47 percent might then support reducing government entitlement payments, since they also are being forced to support them. THey might also support supporting the overall nanny state, because it costs too much. That is is direct threat to the the bloated spending we see now. The 47 percent might also figure that if they do not support reducing government spending now, their kids will need to pay 20 or 25 percent.

    It is not about taxes, it is about votes. Anyone who wishes to talk about ‘new taxes’ of any kind is really trying to keep the gravy train rolling, at the expense of future generations. A simple way to defer cuts to the next generation or two.

    If all were serious there would be a simple bill that alters the tax code so we all pay 10 percent, no deductions or exceptions. Also the bill would cut the size of government, in REAL terms, 10 percent each of the next 3 years. The problem would take care of itself.

  4. The average American two earner family makes 44K. Which is probably a little high of a number given the outliers at the top. The average non-college graduate makes less than 30k. 10% of their income (after federal with holding) is the difference between making rent and not making rent. Flat Tax disproportionally hurts the lower and most of the middle class.

    Oh and please don’t say the 47% pay no taxes. They still pay 7.65% for SS/Medicare, sales tax, and possibly state income and property tax. They may pay a lot less but they still pay taxes. Incidentally that 47% figure is wrong anyways.

    • Beau, I question your numbers on the two earner family making $44k, source please. Even if that were true, ten percent is $4.4k. The discussion is about the Federal spending, the State issues (property taxes and state income taxes) are a entirely different issue. If the family you mention is really making only $44k from two incomes and cannot afford to pay their way for defense, Interstate roads and other Federal responsibilities, perhaps they should not have property taxes, a big screen, and other luxury items.
      The beauty of a flat tax is that it keeps everyone in the pot, and keeps everyone mindful of government overspending. That is simply good for the country and also bad for the politics of division we see today.

  5. “gravy train rolling, at the expense of future generations. A simple way to defer cuts to the next generation or two.”

    The ”gravy train” has just as much to do with the “gravy” the top earners and have poured themselves at the expense of not increasing pay to the lower 80% in the last 3 decades. That’

    • The average American is far better off than their parents of 30 years ago. The gravy train is kept going by telling others that those that have more must give it to the government. That is called socialism. Those top earners have created far more jobs, opportunities, and economic growth than government programs, all the while paying the vast majority of the income taxes.
      It is not a zero sum game. If you believe it is, then I have property in FL to sell you, or better yet a ‘revenue enhancement’ to have you hang around the neck of your children.

  6. We should all be so lucky as to have a high marginal tax rate be one of our foremost concerns. I do wish we had a less-complex tax code; even if everyone ended up paying the exact same dollar amount per year, it’d at least have the benefit of staving off nonsense about the poor not paying any taxes.

  7. Very gutsy taking on a controversial topic! I have thought about the “fair share” topic and like to think of it this way. Pretend you pay your taxes through the purchase of milk. Low earners are able to get their milk free, middle income might pay $5-$10 for a gallon of milk, and high earners have to pay $10,000 for a gallon of milk. When you go to the store, what do you think the shopping carts will like? My hunch is you will see some carts full of milk (low earners), others with a gallon or two (middle earners), and some with no milk at all (high earners). Why is this? Simple, if you don’t think the value of something is worth the price you won’t pay for it. Our government affords us great opportunities and protections, but is it really fair the top 10% pay 71% of the load? In my opinion probably not, I do think they have more to lose, so it makes sense they pay more but if we changed the tax system to buying milk I don’t think they would be buying much milk (ie they wouldn’t see it as being worth the price).

    I was providing some probono financial help and when reviewing a tax return for a bartender with an AGI of $12k I noticed they paid $122 in federal income tax during the year. Okay – that seems fair, but when I looked down they received a $6,000+ federal refund due to the earned income and child tax credits. No state income tax, don’t own a house, and I don’t consider SS/Medicare a tax (unless you are a high earner), so I would say yes they really are paying no tax. Also if you read the article it says 47% pay no federal income tax, so it is a completely accurate statement. State and local taxes really are something different than federal income taxes and you receive different services for those taxes.

    Beau – I think we would be crazy to just add new taxes. Let’s get our politicians to make responsible choices for our future and then make the tax code more transparent rather than more complicated. I think that is one of the problems with our medical system is that no one knows what they pay so there is no personal resposibility associated with it. What else do you buy without asking how much it is going to cost. I ask and still can’t get an immediate answer. They have to check with my insurance to figure out how much they are going to charge, then they have to figure out how much the insurance will pay, then the rest is up to me. Usually I figure it out two months later when I receive the bill. My point is there is something beautiful in simplicity and transparency.

  8. The saying life isnt fair comes to mind….actually the most recent time i saw it in a harry potter film where snape says it…There really is no way to come up with a fair system and there never will be. Personally im just happy if they dont continue to cut reimbursement. It makes me feel better if i make more and am taxed more than if i actually had more money through making less/tax less. Since i havent asked every person in america if they pay federal income tax, im not sure i know the exact number but i bet 47% is pretty close. Maybe thats okay.

  9. Dwolf: Excellent thoughts. My thinking on adding a VAT is that it does tax everyone to some degree but still allows for a better more stable tax income. I don’t think anyone below the poverty line should have to pay taxes. (really I don’t think anyone making less than twice the poverty line should pay taxes outside of FICA). Oh and you asked: “What else do you buy without asking how much it is going to cost?” For MILLIONS of Americans the answer is HEALTH CARE. Most non-elective care is provided prior to a discussion of cost and for those without insurance, it is provided at a much higher cost as well.

    I also don’t support tax credits at all…of any type except maybe the adoption credit but then only if they adopted from the US, not foreign countries.

    • I don’t have a problem with people legitimately disagreeing with my opinions. I just want people to think the question through. The discussions we need to have on the national level are # 1) How big will the government be and #2) How will we pay for it? With regards to paying for it, how progressive should the tax code be? There obviously isn’t a right answer to any of the questions, but that doesn’t mean it’s bad to talk about it.

  10. Hi Whitecoat,

    The best book I read on tax reform is “The Benefit and The Burden: Tax Reform-Why We Need It and What It Will Take” by Bruce Bartlett (http://amzn.to/XlCVV5). I highly recommend it. I consider it to be nonpartisan and excellent. The author is a true expert in taxation, policy, economics, etc.

    He mentions that the US might have such a need for revenue that we might need to move to a VAT system. One thing I have not seen mentioned is how that would affect the value of retirement accounts. I mean, if we suddenly reduce the marginal income rate from 30+% to 10%, and institute a 10% VAT then people who did a Roth 401k are going to rightfully be upset. They will have paid taxes twice instead of once.

    Also, please put commas in your numbers. E.g. $4,032 instead of $4032.

  11. I am a proponent of the flat tax (or it modified to the Fair tax). When the someone can legitimately explain to me how the last $100 I make is worth more than the first $100…then I will agree that our current tax system is “fair”

  12. I think the tax code should remain progressive and that top earners absolutely should pay more. I have no problem paying more taxes, and it would barely make a dent in my day to day living.

    I came from a poor family and have seen both sides. The people near the bottom of the income scale paying no income taxes? I have no problem with that. They have real problems unlike many of the comfortable six figure earners in my profession who get greedy, make foolish financial decisions, and complain about how unfair life is.

    • Having been at the bottom myself, and working myself mid-way up thus far, it is readily apparent and general common sense that everyone must have a vested self-interest. A large portion not paying any income taxes is one of the reasons we have such a government spending problem. If there is _no_ impact to half the folks when the next massive ‘stimulus’ program comes along, the answer will always be ‘why not?’ (maybe something will come our way – free phone anyone?). Having a shared self-interest will also bring us together – something that is sorely needed now.
      With a flat tax the top earners _are_ paying more, much more. It has always been a bad idea to penalize someone for success.
      Lets not end up like France or Greece. Lets keep America exceptional.

    • With a flat tax rate…the top earners DO pay more…Why should they get penalized with a higher rate as they earn more? The lower earners still should have some “skin in the game” as far as government spending. It is funny that it seems people agree we need to either cut spending or raise taxes, but only as long as it doesn’t have an effect on their benefits/taxes. I also have a problem with people that get tax credits, that result in them having a “negative” tax bill at the end of the year…that just doesn’t seem fair

  13. What is a fair taxation policy is a very difficult question to answer. Once, it is asked, the skewed metrics come out.

    Example –
    The bottom 47% pay no federal taxes – tis true, although they also only have 1 percent of the wealth.
    The top 10% pay 71% of the taxes – tis true, although they also have 74% of the wealth.
    Since 1989 till now, the wealth of the top 10% has increased – decreased for the bottom 90%.
    Nearly 500k of households making more than $100k pay no income tax – 7,000 with income over 1 million paid no tax.

    What is fair – is for everyone to pay a fair share – the wealthier one becomes, the easier it is for them to afford the services of others in order to avoid paying taxes. The system today is being gamed – and those who cannot afford the gaming are paying the freight – on all levels of income. Many wealthy people are able to frame their income as distributions in order to avoid W-2 wages. Why am I paying 20%, when a person with much more income than I pays 15% or less? The wealth of the wealthy can be setup to defer taxes for many years to come – even never being taxed at all. Think of a $100Million IRA, which can be transferred to heirs at death – deferring the taxes for decades to come – even skipping generations.

    What may seem most fair is similar to the Buffet rule, where each bracket pays a minimum amount – essentially capping the deductions that one can take advantage of.

    My question is this – why is the future of Social Security and Medicare tied into other programs like the Pentagon and SNAP? Social Security has a funding stream (as does Medicare) – if Social Security needs something done to make it more solvent for the future – either the FICA tax needs to increase or another change (like age increase, reduce benefits, etc) – but it needs to stand on its own. It should not be, we need to cut the Pentagon for the sake of SS. Chained CPI should not be implemented in order to keep the DOE.

    • One problem I have with statistics like those you quote is that they assume you are describing enduring classes of people. I made beneath the poverty level as i worked through college. I made 40-50K a year in residency (while i had 300k of student loans accruing interest). I make over 300K a year now. I pay over 100k in taxes and nearly 20K a year in INTEREST on my student loan debt. I pay about 100k a year towards principal on my loans. I have no wife no kids and my monthly spending is under 5k a month. So was I in poverty needing handouts when i was in college? No. But your stats put it in the readers mind that a member of that lower tax group is stuck in a lifetime of that. Do i need to pay more taxes now? NO. My high income currently is trying to beat back suffocating debt. I bust my butt for that money while I take care of some of the most entitled “I came to you because you are forced to care for me without pay. And gimmie a sandwich” people you ever knew existed.” Again, the income bracket i am in now doesn’t tell you anything about what the last decade of my life is like. And most of those people who wind up paying nearly nothing in taxes with a high income pay that low rate incredibly rarely. Its different people each year not the same people again and again. Its people who lost a boat load one year and carried forward the losses. Trying to look at statistics on tax returns from 10,000 feet and drawing conclusions that are meaningful is treacherous. We are individuals and the majority of us wind up in many of the possible income tax brackets at some point in our lives. Thats because of ambition and the promise that our hard work will be rewarded. If start taking 75% of a high earners income and giving more and most free services and hand outs to low income earners you may find that many people who would have climbed the economic ladder chose to stay put.

  14. First I deny that there are any “experts” on taxation, economics etc. There are only folks who have an “opinion” and are perhaps well known. Now as for vat it is a great thing for accountants, cheats, and others who want to wreck our economy. If our economy is based on consumption then such a tax will either reduce consumption or drive it under ground or both. What we really need is a taxation system that raises revenue and does not support other so called worth while things. Simple in concept but almost impossible in the real world.

  15. “Instead of taxing income, they argue, we should tax spending. Since those with a high income spend more, they’d pay more in taxes.”

    My understanding was that, at lower incomes, a greater percent of income is spent, and so the equivalent “income” tax rates under this sort of system would be fairly regressive.

    Other folks have suggested that the tax should instead target wealth, rather than income. I imagine his approach might appeal to physicians, many of whom have high incomes but little accumulated wealth, even at middle age.

  16. Great piece.

    What Keith said resonates with me a lot. Medical training feels like a prolonged lesson in social economics, poverty, and the dark side of human nature. So wait, I have to provide free care in addition to having my income taxed in order to provide these services AND not get so much as a “thank you” in return. That doesn’t seem fair at all.

    A flat tax is fair, but that’s never going to happen. So let people at every income level abuse the system and let’s just call it a day.

  17. I am totally with you on “fairness” Yes, I am another 6 figure income guy and of course I feel like i’m paying too much taxes. But I too didn’t start out this way. I had to take out student loans for college and there were years I was living off eating $1-3/day from 2006-2007 trying to start my business. I was also in the best shape of my life during this time.

    I’m also for welfare, disability, food stamps, etc, BUT only when the request are genuine. These services should help people from STARVing and not necessarily provide a complete balanced meal. If the government provides enough, what’s the incentive to get back out there and start working.

    Here’s an interesting article about the rise of disability claims.

    Also 14% of the country is on food stamps.

    The point is there is no incentive to to find a less then desirable job that pays like like $15,000(minimum wage) a year when you can not work and get $13,000 a year for free on disability. Honestly, I can live fairly comfortably off $13,000 a year. I did it from 2000 – 2007 more or less.

    My question is, is there a country/government that has a more “fair” taxation rules like the type described in the article?

  18. I would like to see the tax code be flatter and have an overall lower effective tax rate of no more than 33%. One of every three days at work for the government is the max where I don’t get a at least a little angry. Many physicians and working professionals are getting hit with high effective tax rates around 40% and with some approaching mid 40s. WCI, I’m not sure if you polled effective tax rates yet, but it would be a good one (if people would be accurate with their effective tax rates). We should not be disincentivizing work and productivity in this country! How will I solve this problem personally? I have to cut spending to a minimum! No nice cars, clothes, restaurants, etc. Sure, we splurge in a few areas. Rent $1600. It will effect our economy when people that have top 1% incomes are living like many college students do to win.

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