How the U.S. Tax System Works
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I recently came across this on the interweb. Good stuff.
Bar Stool Economics
Suppose that every day, ten men go out for beer and 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 would pay $7.
* The eighth would pay $12.
* The ninth would pay $18.
* The tenth man (the richest) would pay $59.
So, that’s what they decided to do. The ten men drank in the bar 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 beer by $20”. Drinks 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 beer. So, the bar 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, like the first four, now paid nothing (100% savings).
* The sixth now paid $2 instead of $3 (33%savings).
* The seventh now pay $5 instead of $7 (28%savings).
* The eighth now paid $9 instead of $12 (25% savings).
* The ninth now paid $14 instead of $18 (22% savings).
* The tenth now paid $49 instead of $59 (16% savings).
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 $10!”
“Yeah, that’s right,” exclaimed the fifth man. “I only saved a dollar, too. It’s unfair that he got ten times more than I!”
“That’s true!!” shouted the seventh man. “Why should he get $10 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 night the tenth man didn’t show up for drinks, so the nine sat down and had beers 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 drinking overseas where the atmosphere is somewhat friendlier.
David R. Kamerschen, Ph.D.
Professor of Economics, University of Georgia
5 Comments on this post
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Apollo said:
Great post and right on target. That is exactly what happens to all of those who favor the ‘Robin Hood’ approach to the tax system. Once the tenth man was gone…all collapsed and it is very easy for the tenth man to just go elsewhere.
Notice that the tenth man never complained about paying more than half of the bill…
March 28th, 2008 at 11:04 am -
Carol said:
Great way to explain our current tax system! Enjoyed reading it and can’t wait to share it with others.
April 4th, 2008 at 8:38 am -
Llama Money said:
I’ve never seen the tax system explained so eloquently. They should have this post as a lesson in colleges… so people can know what they’re talking about before they get angry about taxes.
April 7th, 2008 at 9:16 pm -
Living Off Dividends & Passive Income said:
I posted that same example over a year ago. I emailed the prof asking if it was really his example but he denied it.
April 11th, 2008 at 11:49 am -
Greenback Cafe said:
Ahem. This example is flawed because it describes consumption, not income.
Consumption taxes, like Value Added Tax (“VAT”) and sales tax, tend to be the same for all consumers. E.g., if sales tax is 10% and I buy a beer for a dollar, I pay $.10. The guy down the street buying the same beer pays the same $.10, even though he may be making only half of what I make. And if Warren Buffett or Bill Gates bought that same beer, they too would pay $.10 in tax.
Now, let’s say all four of us consume about the same dollar amount of goods (Warren and Bill don’t really feel like buying yachts this year — they don’t know where to put another one …). And, just to keep things simple, say we each consume $10,000 worth of goods. With a straight 10% sales tax, Bob (the guy down the street) pays $1000, I pay $1000, and Warren and Bill each pay $1000. If Bob makes $20,000/year, he is paying 5% of his income in sales tax.
Ouch.
I could be making twice as much as Bob, so I would be paying only 2.5% of my income in sales tax.
And Warren and Bill each pay such a small portion of their incomes in sales tax, that they just don’t care.
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In the United States, passive income from dividends, etc. has a straight tax of 15%. Personally, I see this as double taxation because the corporation paying out the dividend has already paid income taxes on the profits that produced the dividends.
The dividend tax should be abolished.
Yet, the dividend tax does serve as a counterbalance to corporations that receive tax incentives, government subsidies, patents based on government funded research, depreciations, etc. Unless we reform the corporate tax structure to eliminate such corporate welfare, I guess we’re stuck with the dividend tax. Such a reform, I might add, should be enacted along with a reduction in the base corporate tax rate — it is currently inflated in order to partially offset welfare.
In the meantime, the American worker does pay the bulk of taxes — taxes on earned income (wages) include a 15% payroll tax for FICA (on paper, employers pay half of this, but that’s just rolled up into their cost of keeping a person employed). To add insult to injury, this 15% payroll tax is only paid on the first $100k (or so) of an individual’s earned income. If you earn $150k, you do not pay 15% on the “extra” $50k. That’s $3750 for you and $3750 for your employer, straight into your pockets.
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If the plutocrats running the system really wanted it to be “fair”, they would chuck the current structure out the window, assess the dollar amount needed to run the country with all programs fully funded and intact, figure out what percentage of the GDP that amount was, add a percentage point or two to give a break to people who really can’t afford to pay income taxes (and to save for a rainy day) and charge everyone else, individuals and corporations alike, that percentage figure in tax.
That’s the idea behind the straight tax.
April 23rd, 2008 at 12:18 pm
