Tax Day Cometh: Who Pays and How Much

 

For me, April's arrival always seems to bring with it a sense of foreboding. Maybe it's the start of another baseball season in which neither of my favorite teams, the Nationals nor the Orioles, have a prayer of finishing above .500, let alone making the playoffs. Or it could be the onset of April showers that do wonders for May flowers but can wreak havoc on Maryland's early trophy striped bass season. But most likely, it is the impending arrival of April 15, the day when we are all reminded that we really work first for the federal government, and only after we pay the federal piper do we get to pay ourselves. I suppose it wouldn't be so bad if our hard work was appreciated, but it seems that no matter how much we pay the tax man, Congress wants more! So at the risk of depressing my readers, I think it is important for everyone to understand just how much the government takes and from whom they collect it.

 

Government revenues are highly cyclical, fluctuating in tandem with the economy. During and after the last recession, government revenues fell sharply, bottoming out in 2003 and 2004 at around $1.8 trillion, or about 16.5% of GDP. However, as the economy recovered, so did government receipts, reaching an all-time high (in dollar terms) of $2.4 trillion in 2006, or about 18.4% of GDP. It is expected that government receipts will grow in line with GDP for the next few years at least.

 

The bulk of government revenue (more than 93% in 2006) comes from three sources: taxes on individual income, corporate income, and social insurance. By far, the largest of these is individual income taxes, which topped $1.0 trillion in 2006, or 43% of total revenues. Social insurance taxes are next with $838 billion in 2006, representing about 35% of all revenues. Finally, corporate taxes in 2006 were a record $354 billion, or almost 15% of total receipts, the highest share since 1978. So much for the often repeated myth that corporations don't pay taxes.

 

With so much confusion in the press and on Capitol Hill about who really pays taxes, it may be enlightening to take a closer look at the individual component to see how the tax collections break down among income classes. While the media often leave the impression that the rich don't pay taxes, data from the Congressional Budget Office (CBO) reveal a markedly different picture. According to CBO's report Historical Effective Federal Tax Rates: 1979 to 2004, the higher income groups have consistently paid a disproportionately large share of the tax bill. 

 

CBO's data for 2004 (the latest available) show that the top 1% of all households paid more than 25% of total federal tax liabilities-about the same percentage as they paid in 2000. The top 10% paid more than half of all federal taxes, and the top 20% paid more than two-thirds of total federal taxes in 2004. Both of these groups paid slightly more in 2004 than they paid in 2000. In contrast, the middle quintile paid less than 10% of total taxes in 2004, and the lowest quintile paid less than 1% in the same year. Both of these figures were slightly below the percentages paid in 2000. What is even more startling is that these figures include Social Security taxes, which fall more heavily on the middle and lower income classes because a higher percentage of their wages are covered by payroll taxes. If we were to look only at income taxes, the progressivity would be even greater.

 

Some critics contend that while the rich pay more in taxes, they have much higher incomes and thus still don't pay their "fair" share. The CBO data address this issue as well by computing effective tax rates, which measure the percentage of income paid in taxes by the various income groups. In 2004, the top 1% paid more than 31% of their income in taxes, and the top quintile paid an effective rate of more than 25%. The middle quintile paid an effective rate of less than 14%, and the lowest quintile paid an effective rate of less than 5%.

 

Moreover, while all the effective rates in 2004 were lower than in 2000, the biggest percentage drops occurred at the lower end of the income distribution. The effective rate for the top 20% dropped by less than 11%, while the percentage drop for the lowest quintile was almost 30%. Again, this data include all taxes, but the declines for just income taxes showed the same result-the percentage declines were greater for the poor.

 

Therefore, the data clearly indicate that, contrary to popular belief, high-income households not only pay the largest share of taxes, but they actually contribute a disproportionately large share compared with their share of income. Moreover, the relatively larger effective tax rate declines for the poor over the last few years mean that the tax code has become even more progressive since 2000.

 

While the facts are clear, the new Democratic-controlled Congress seems bent on skewing the tax code even further by putting an even greater burden on upper income individuals and corporations. Specifically, it proposes to scale back some of the Bush tax cuts for those taxpayers.

 

Congress is also suggesting a "fix" for the individual alternate minimum tax (AMT), which, under its PAYGO rules, would require offsetting tax increases likely to fall most heavily on the same upper income individuals and corporations. The AMT is a device that was enacted to pry income taxes out of those who would not otherwise be liable. It attempts to do this by limiting the benefits provided by deductions and other legitimate ways of reducing tax liability. While it added substantial complexity to the calculation of tax liability, its most notorious shortfall is that it failed to include an inflation adjustment. 

 

This is the ultimate irony because the AMT was instituted by a prior Democratic Congress to ensure that everyone pays at least a minimal amount of income tax. Congress devised the AMT so poorly that its attempt to "tax the rich" often failed to do that, and it further backfired because, in recent years, the AMT has been increasingly encroaching on the middle class, threatening more than 23 million individuals in 2007 and nearly 31 million in 2010. This time around, it would behoove members of Congress to be a little more thoughtful and get it right!