### Monday, December 13, 2010

## How the US Income Tax System Works

According to my research, the following has been attributed to David R. Kamerschen, Ph.D., Professor of Economics at the University of Georgia. However, in his online bio, Dr. Kamerschen disclaims authorship and says he does not know who wrote it, nor does he express an opinion on its merits.

It's been going around the Internet for a couple of years, at least, but I believe it's timely in light of the current debate about extending the “Bush tax cuts” and "tax cuts for the rich" to bring it to light again, in an effort to provoke thought and rational discussion. (To assist in interpretation of this parable and FWIW, I believe the ten men represent the ten deciles of income level in the US and their respective payment amounts represent the percentage share of total personal income taxes paid by each decile at the time it was written.)

Suppose that every day, ten men go out for coffee and the bill for all ten comes to $100. If they paid their bill the way we pay our taxes, they would divide the bill something like this:

The first four men (the poorest) would pay nothing. (0% of the total bill)

The fifth would pay $1. (1% of the total)

The sixth would pay $3. (3% of the total)

The seventh would pay $7. (7% of the total)

The eighth would pay $12. (12% of the total)

The ninth would pay $18. (18% of the total)

The tenth man (the richest) would pay $59. (59% of the total)

So, that’s what they decided to do. The ten men had coffee at the shop 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 coffee by $20. Coffee for the ten now cost just $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 drink for free. But what about the other six men – the paying customers? How could they divide the $20 windfall so that everyone would get his ‘fair share?’

They 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 each end up being paid to drink his coffee. So, the bar owner suggested that it would be fair to reduce each man’s bill by roughly the same percentage amount, and he proceeded to work out the amounts each should pay.

And so:

The fifth man, like the first four, now paid nothing (100% savings). (0% of the total bill)

The sixth now paid $2 instead of $3 (33%savings; saves $1). (2.5% of the total)

The seventh now pay $5 instead of $7 (28%savings; saves $2). (6.25% of the total)

The eighth now paid $9 instead of $12 (25% savings; saves $3). (11.25% of the total)

The ninth now paid $14 instead of $18 (22% savings; saves $4). (17.5% of the total)

The tenth now paid $50 instead of $59 (15% savings; saves $9). (62.5% of the total)

Each of the six was better off than before. And the first four continued to drink 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 man,’ but he got $9!’

‘Yeah, that’s right,’ exclaimed the fifth man. ‘I only saved a dollar, too. It’s unfair that he got nine times more than I!’

‘That’s true!!’ shouted the seventh man. ‘Why should he get $9 back when I got only two? 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 day the tenth man didn’t show up for coffee, so the nine sat down and had coffee without him. But when it came time to pay the bill, they discovered something important. They didn’t have enough money between all of them for even half of the bill!

And that, boys and girls, journalists and college professors, is how our 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 anymore. In fact, they might start having coffee overseas where the atmosphere is somewhat friendlier.

UPDATE 20101213:1856PST: Just for fun, I added the percentages of the total bill ($100 in the first case, $80 in the second) that each man paid. In the second case, not only did one more person get coffee for free, and each of the others pay a smaller absolute amount for their coffee, but every one of the men except the richest paid a smaller percentage of the total [smaller] bill in the second case! The richest man paid an increased share of the total--from 59% to 62.5%!

I suspect that this might have been written around the time the Bush tax cuts took effect, perhaps in 2003.

Labels: Tax policy, Taxes