Wednesday, February 27, 2008

The Tax Myth

I am sure you have or will see this chain letter at some point in your life. Its a dumbed down version of how the US tax system supposedly works. Here is the way most people saw it:

Understanding the Tax System:
This is a VERY simple way to understand the tax laws.
Suppose that every day, ten men go out for dinner. The bill for all ten comes to $100. If they paid their bill the way we pay our taxes, it would go something like this.

The first four men -- the poorest -- would pay nothing;
The fifth would pay $1:
the sixth would pay $3;
the seventh $7;
the eighth $12;
The ninth $18. >
The tenth man -- the richest -- would pay $59.

That's what they decided to do. The ten men ate dinner in the restaurant every day and seemed quite happy with the arrangement -- until one day, the owner threw them a curve. "Since you are all such good customers," he said, "I'm going to reduce the cost of your daily meal by $20. "So dinner for the ten only cost $80.

The group still wanted to pay their bill the way we pay our taxes. So the first four men were unaffected. They would still eat for free. But what about the other six -- the paying customers? How could they divvy up the $20 windfall so that everyone would get his "fairshare?" The six men realized that $20 divided by six is $3.33. But if they subtracted that from everybody's share, then the fifth man and the sixth man would end up being *paid* to eat their meal. So the restaurant owner suggested that it would be fair to reduce each man's bill by roughly the same amount, and he proceeded to work out the amounts each should pay.

And so the fifth man paid nothing,
the sixth pitched in $2,
the seventh paid $5,
the eighth paid $9,
the ninth paid $12,
leaving the tenth Man with a of $52 instead of his earlier $59.

Each of the six was better off than before. And the first four continued to eat for free. But once outside the restaurant, the men began to compare their savings. "I only got a dollar out of the $20," declared the sixth man. He pointed to the tenth. "But he got $7!" "Yeah, that's right," exclaimed the fifth man. "I only saved a dollar, too. It's unfair that he got seven times more than me!" "That's true!" shouted the seventh man. "Why should he get $7 back when I got only $2? The wealthy get all the breaks!" "Wait a minute," yelled the first four men in unison. "We didn't get anything at all. The system exploits the poor!"

The nine men surrounded the tenth and beat him up. The next night he didn't show up for dinner, so the nine sat down and ate without him. But when it came time to pay the bill, they discovered something important. They're $52 short! And that, boys and girls, journalists and college instructors, is how the tax system works. The people who pay the highest taxes get the most benefit from a tax reduction. Tax them too much, attack them for being wealthy, and they just may not show up at the table anymore.

Here are the problems with this low brow nonsense:

1.The top tax rate is now only 35%, not 59%

2. The guy who paid 59 % of the meal was eating lobster and drinking Chimay, the 4 guys who ate for free had PBR's and a burrito, I'm not saying that isn’t still a good deal but we all know that looking at what everyone paid, the free guys weren’t eating the same stuff as the guy paying $59.

3. The poor guys in this story still pay taxes; They pay sales taxes, gas taxes, cigarette taxes, liquor, real estate(if they own it), phone tax, utility taxes, etc.

4. During WW11 and through the Korean War and into the 60s, the top tax rate was over 90% and the economy didn't collapse (just the opposite), rich people didn't quit the work force and retire or move to Mexico. To say we can't tax rich people because they will stop working or leave the country is ridiculous. Of course, one of the reasons why personal income taxes are so high is because corporations, the ones the 10th guy works for, incorporates their businesses in the UAE and the Cayman Islands. These situations came about when we started taxing corporations less, not more and of course when Reagan made it easier to companies to exploit tax loop holes.

5. The guy who paid 59% also probably paid the owner off under the table, or "invested" in the restaurant (perhaps similar to donating to an election campaign) and therefore expected something in return when he ate at the restaurant which was one of the reasons he got the 20% discount in the first place. Sure other people benefited as well, but who benefited the most?

6. The restaurant who gave that discount probably had a good year and or had a decrease in price of expenses and therefore made a wise decision to reward faithful customers when they could afford to. Due to war and military contractors, no costs have gone down for the US. In fact we have one of the largest deficits in history. Last time we were spending money on a war that lasted for over 3 years that’s when the top 1% paid a 91% tax rate. We actually won those wars.

7. The aforementioned Deficit weakens the value of the US dollar thus making imports from Mexico and other countries more expensive. That expensive produce, the electronics, auto parts etc. don’t affect the bottom line of rich people who buy them (besides maybe French and Italian wines and Bently's) but add up to a family that is scraping by.

8. Tax cuts, or at least Republican tax cuts, don't work like they do in this story. There isn't a number out there which is then divided between us all. First of all, the story should have started with the owner saying I am going to give you a percentage discount, not a dollar amount discount. In that case, if he was using Bush's tax model the middle guys would get a 4% decline (as opposed to a 100% decline) in their price while the richest guy would get a 19% decline in his price instead of the 12% described in the story. That's how taxes really work, it's not an equal decline in everyone's taxes like the story would suggest. The ones who make and paid the most not only save the most money because its a larger number but they also get a bigger percentage discount than the person trying to figure out how to pay for their kids college. That is what isn't fair about the Bush tax cuts, not only is it not an equal dollar amount (which is fine) but it's not even an equal percentage decrease.

9. That being said, the Bush tax cuts don't really work like that either. The story would be more accurate by saying the guy who pays more gets more in tax cut savings but not only that, the owner would have also given the top payer (or anyone who drives a luxury car for instance) free valet parking and desert while the other 9 guys still had to pay for parking and then walk to the rest of the way to the restaurant and only received a mint at the end. Oh, and in order to give the rich guy free valet service, the owner had to take the forks and eating utensils from away from the 4 poorest guys and served their dinners on dirty plates and wouldn't give them a doggy bag for leftovers for their children.

10. Besides, if the 10th guy left, the bill wouldn't be the same for 9 guys eating burritos as it would for 10 guys. In fact, without his lobster, Valet parking, expectations, etc., the bill would be much lower.


Patrick M said...

I've seen this letter, although in mine it was beer instead of food.

The premise of the story does work in general. Most of your points are what make the tax system even more unwieldy and sick. And while we are taxing income, and putting extra taxes on certain items, there will always be someone benefiting more than someone else.

I suggest something that honest liberals and conservatives should be able to agree on: The FairTAX.

Consider that it will make the rich pay most of the taxes, and the poorest will pay nothing.

And you will know how much you really pay in taxes rather than the current confusion where people with lots of accuntants can erase their tax burden while the middle class pays the most.

So read it and decide if you're honest enough to get on board.

Toad734 said...

Anything called The "Fair" Tax makes me think its probably not really fair.

Is this the Huckabee plan where he sends checks out to poor people? That's a terrible idea.

Sure, I'm all for tax reform and would obviously like to pay less and realize that really rich people can pay more I just haven't seen a plan that speaks to me. First of all, if we can't tax dead rich people who can we tax? I know the Fair Tax would eliminate the Estate Tax and thats just ridiculous. Thats the tax that should be raised and the limit should be lowered back to 1 million, not raised to 3 million like what Bush wants to do.

I also think the fair tax has some good ideas but I think it will ultimately discourage spending and the economy would suffer. And just think, what incentive would someone have to put their money in an IRA? I think there are a lot of things that hasn't been thought about regarding the fair tax. But I agree, the tax code is a bit complicated and there are too many people avoiding their share.

Patrick M said...

First of all, the FairTax came along before Huck-a-duck. He just adopted it and got a lot of support out of it.

Second, there's really not enough space to explain everything to you, so I'll quickly address a few points, then let you go learn.

The prebate check is sent to all households to offset the cost of living. It nullifies any tax burden on the poor.

The FairTax eliminates ALL payroll and income taxes, period, eliminates the 16th amendment, and makes federal taxes 100% transparent. You see what you pay when you buy something.

It doesn't apply to savings, only spending. It doesn't apply to used items, and it only taxes people once.

Finally, and most importantly, it take power away from the federal government so George Bush, Nancy Pelosi, or any politician can bend the tax code to fit their ideology.

Also, how would the economy suffer if everybody gets their money up front rather than waiting a year for the government to have their way with it? I know from experience (and overdraft charges)that I could use the money sooner, not in a lump sometime a year after I had it ripped from my check.

Toad734 said...

Actually, I think it would suffer because you don't notice an extra $350 a month (I don't anyway) but I do notice $4200 in February when I get my tax refund.

The smart thing to do is claim 0 dependants on your taxes and you can therefore put that extra money in an interest bearing account instead of giving the government a free loan. I get that but no one does it. I file 1 dependant so I don't have to rely on myself to save it. Having an extra few thousand dollars a month or so after Christmas and still being ski season helps a ton. Paying 30% more for that ski vacation will make me think twice about taking that vacation. I know it’s the same money but it doesn't feel that way.

And what I was really talking about is that you currently get to avoid taxes by putting your money into an IRA. That money goes to fund managers who generate wealth with it both for themselves and for me. The government has already given me an incentive to A. Help the economy and myself when I retire making myself more independent and less reliant on Social Security or any other government support when I retire. With your proposal, people would be less likely to do that and may just leave their money in the bank which doesn't generate as much wealth for anyone. That’s just one of the problem I see right off the bat.

2. How and who is going to divide that sales tax up? Currently sales taxes go to the states. Are the states going to be responsible for creating a branch that gives the Feds their cut? Who decides how much goes towards Social Security, Schools, Defense, Etc. That part will still be decided by a politician’s political agenda. Clearly Bush would use that money to start more wars and buy more bombs and Pelosi would use it to help sick people or schools which Libertarians certainly wouldn't support.

3. How much foreign vacation coin would we lose? I suppose we could institute some sort of tax refund like most other countries do for people vacationing there but it’s a pain in the ass and most people will just vacation closer to home to avoid paying 30% taxes on their hotel rooms.

4. I think the only way I would support something like this is if different things were taxed differently. Instead of handing out checks to poor people every month why not just institute a lower tax on bread, milk, eggs, diapers, etc and putting a higher tax on Imported Luxury cars, fur coats, Homes over 500k, cars over 40k, Sail boats, etc. That way you don't need another government agency dealing out checks to poor people and you still have a progressive tax scheme.

5. Poor people still spend all their income but rich people don't. That’s why a fair tax isn't going to be fair. If rich people did spend all their money and put it into the economy we wouldn’t be having discussions about the Estate Tax. Of course one up side to the fair tax is that at least Paris Hilton will have to pay taxes on her unearned inheritance which if republicans had their way, she would have never paid any taxes on.

Toad734 said...

On 5 i mean that when she spent that money on mercedes and $2000 purses we could get her fair share of taxes.

Start with a premis like that and I might be sold.

Toad734 said...

Oh, and put a higher tax on junk food too. That would help out with our health care bill. Anything with High Fructose Corn Syrup, Partionally Hydrogenated anything,excessive amounts of sugar or fat, Cigarettes etc.
But that of course could be abused by Neo Cons who would tax the hell out of porn and liquor and liberals would want to tax guns but as long as I was the one who got to decide what gets taxed then I'm fine with it.

But I also thought of another huge downside of a flat tax which is a big consideration today. What happens to the housing market when we:
A. Have to now finance 30% more and pay the interest on that 30%?
B. That extra 30% and the rest of the mortgage interest would now no longer be tax deductible. I would have kept renting if that was the case.
C. Not only would that (not owning) affect my credit standing which would lead to me having less credit which woul lead to me not buying as much but ehe result is less wealth for myself which means I will be spending less and the government would not be able to collect that revenue.

handmaiden said...

Interesting post & your version makes a lot more sense then the simplistic one.

Not that I'm any good with economics. God knows mine are in a mess, but I realize that things are never as simple as they seem. Esp. when someone is trying to pull the wool over your eyes.

Toad734 said...

Agreed, Im not Economic geneus either but I know the top tax rate isn't 59% and that when you cut taxes on rich people who can easily afford them and you are in a multibillion dollar war, someone's getting their services cut. Usually that ends up being poor children.

Patrick M said...

Ok, last words on why the FairTax will really be fair.

1. Embedded taxes. Any time you tax a corporation, they put the tax into the cost of goods. The FairTax eliminates that problem by making all taxes visible when you buy the new product.

2. Gross vs net income. Ask most people, they can tell you how much they bring home, but not how much they make. I can't, without checking my pay stub. That problem is eliminated.

3. The price of goods under the fairtax will drop, and will more than likely be less expensive with the fairtax added back on, even if the companies increase their profits in the process, as the cost of labor goes down, the administrative costs of taxes and payroll go down, and there is no penalty for investing money.

4. I made less money than you did in 2007. Trust me on this one. I had 9 dependents listed on my w4 form, which nets to no deductions for income tax. I got my refund yesterday, and it was about $4800.
I would probably stand to lose money under the FairTax. using the 2006 Figures, I come out even. The point is I'd rather have responsibility for my money than the government. Reliance on the government eats your soul.

5. The prebate is a check you get in advance of your month's expenditures which eliminates any taxes the poor will pay. This you could spend, or invest in something that isn't designed to shelter the cash from taxes, but is designed to grow money. Again, there is no penalty to investing. And playing with the tax rates on different items goes back to taxing behavior, which no one likes when their political opponents are the ones deciding what to tax. One number for all items is as fair as you can get. And remember, the poor don't pay for the necessities of life. A rich man, buying a $1 million boat, will pay $300,000 in taxes on that one purchase. Fair enough for you?

6. Anyone who is not a legal citizen does not get the prebate check. This means we collect money from anyone who comes to the US and spends money, whether it be vacationers or illegal aliens. Once the prices have leveled out after the tax change, it's just part of the price of coming here.

7. The fairtax goes to the federal government as taxes do now, replacing the current system. Government spending is a separate issue, and not a concern of the Fairtax. In addition, the states can make money collecting the tax, which is easy if they already have a sales tax of their own.

Finally, here's my original post on the Fairtax. I'm sure I'll have more, at which time I'll entertain an assload of questions. And if you have any more, shoot me an email, where I can address them more completely.

Toad734 said...

As for 2, its just the opposite for me. My check isn't the same every month so maybe thats why.

3. If the government is collecting the same amount of taxes, how would the cost of the goods go down unless the tax burden is shifted away even more from corporations than it is individuals. At least the way Huckabee explained it, they would pay taxes on all raw materials, business expenses etc. There are no write offs. As they don't have to pay taxes on inventory or what not but they will pay new taxes which would have at one point been a write off. I now see that anyone who is self employed would benefit as they don't have to pay those extra taxes but I don't see how bigger corporations would really benefit.

4. 9 Dependents? Irish Catholic much? I agree, the government always wastes money on military contractors, useless wars and 2000 for a toilet seat.

5. I still don't like the rebate check. That just means we change the IRS' job from tax collecting to check writers. If I were to vote for fair tax it wouldn't include rebates but rather lower tax rates on essential foods, diapers, medicine, TP, etc.

6. Or they just buy and sell on the black market. Which brings up a good point, I see the mob and organized crime rebounding under the "fair" tax in that there will now be a huge demand for stolen black market items which can be sold without the tax.


Toad734 said...

Bottom line is that its not a terrible idea in theory but I think they really need to work out the kinks. Not that we don't need to work out the kinks on our current system. Besides the fact that it seems to have worked for the last 70 years or so.

Patrick M said...

Okay, maybe this will be the last post.

3. The tax burden is always on individuals. The tax is only on new, finished consumer products. Also, don't take Huckabee's word for it, go and read the actual facts!

4. 2 children, followed the worksheet on the back of the W4 form, came up with 9 and eliminated any income tax deduction from my check.

5. then you reduce the tax burden proportionally on the rich, who spend more on essentials as well.

6. There will always be somebody trying to evade taxes, and there will be a black market. But the number of people the successor to the IRS will have to monitor will be much smaller. And money is sucked back into the system when illegally obtained money is then used to buy things legally.

7. silence is golden.

Bottom line: They did work out the kinks. That's how they came up with their numbers. They did an assload of research, crunched a lot of numbers, and this is the result.

Toad734 said...

Oh well then I think that system sucks if only consumers have to pay taxes and I am almost positive that wasn't Huckabees plan. From what I know, if you were a printer and bought a truckload of paper rolls you would be taxed 30% on that just as I would be taxes 30% on a 4 pack of Guinness. Whats to stop me from Incorporating myself and buying everything tax free?

Rich people don't buy any more toilet paper, baby food, groceries and diapers than poor people. And realistically, poor people typically have more kids and so therefore it would just lower the tax burden on the poor. You could take the same percentage you lowered the essentials and add that to shit like fur coats, cars which cost over 40k etc.

Patrick M said...

Corporations DON"T PAY TAXES NOW!!!

You keep forgetting a fundamental part of how businesses work. They pass the cost of business, including TAXES, on to the customer.

And yes, the rich buy more than the poor. When I go to the store, I buy the bottom end meat, the bottom end oil, the generic everything. If I had more money, I would buy the better quality shit.

Just one question. Have you actually gone to the FairTax website and read this for yourself?

Patrick M said...

Point of correction:

Businesses do pay the FairTax. If they buy final consumer goods, those items are taxed like any other. It's any other taxes that may affect the cost of production (energy, payroll, etc.) that are eliminated. Also eliminated are tax breaks for some industries as those are part of an income tax system.