Countdown to Tax Reform, Part II: Taxpayers and Non-Payers

October 13, 2005

Fiscal Fact No. 33

In addition to America becoming divided between single and married taxpayers (see Part I here), we are also becoming divided between those who pay income taxes and those who pay no income taxes.

Many of the tax cuts enacted over the past four years—specifically the doubling of the child credit to $1,000 and the introduction of the new 10 percent bracket—were “targeted” to help taxpayers in the statistical middle-class. It is unlikely that lawmakers understood how powerful these measures would be—not only lowering the tax burden for millions of lower- and middle-income taxpayers, but knocking millions of people off the tax rolls entirely—turning them into non-paying tax filers.

Tax Foundation economists estimate that in 2004, some 42.5 million Americans (one-third of all filers) filed a tax return but had no tax liability after taking advantage of their credits and deductions.

Figure 1 shows the percentage of non-payers between 1950 and 2004. During that period, non-payers averaged 22 percent of all taxfilers. Today, however, non-payers account for 32 percent of all taxfilers, a nearly 50 percent increase in the number of non-payers since 2000 and a 160 percent increase in the number of non-payers since 1985.

Figure 1. Percent of Tax Filers Who Owe Zero Income Tax Liability, 1950-2004

Source: Internal Revenue Service, Tax Foundation.

Individuals and families who earn enough to file a tax return can eliminate their tax liability by taking advantage of credits and deductions in the tax code. Many of these are familiar to all tax filers: the personal exemption was worth $3,100 in 2004, and the standard deduction was worth $4,850 for singles and $9,700 for married couples. For tax filers who have itemized deductions that exceed the standard deduction, there are the amounts paid for mortgage interest or given to charity as well as various education-related deductions. Business owners can take advantage of an even wider array of credits and deductions to reduce their tax liability.

In 1997, Congress enacted a new $500 per-child tax credit and expanded the Earned Income Tax Credit (EITC) for low-income workers. The 2001 and 2003 tax cuts increased the value of the child credit to $1,000 in 2004. These two tax credits—especially the child credit—have had a powerful effect on reducing, and many cases eliminating, the income tax liability for millions of Americans.

These two credits are unique in that a taxpayer can receive the full value of the credit even if they have no tax liability. To see how this works, consider, a family that earns $40,000 per year and has three children. Their three children make them eligible to receive $3,000 in tax credits (3 x $1,000) but, as the nearby example shows, they have a tax liability of $1,505. Under the rules of most tax credits, this family would only be allowed $1,505 in tax relief—an amount equal to their tax liability. But a “refundable” tax credit gives this family the full amount they are eligible for—$1,505 toward their tax liability, and the remaining $1,495 in the form of a refund check.

Of the 42.5 million tax returns that pay no income taxes, roughly 53 percent received some form of a refundable credit—either the EITC or the child tax credit. In 2004, Uncle Sam paid out about $33 billion in “refundable” checks to the families and single individuals who qualified for the Earned Income Credit and another $9 billion to families who were eligible for the child credit.

Figure 2 demonstrates the effect that refundable credits have in not only erasing the income tax burden for the lowest-income Americans, but transferring income from wealthier taxpayers and, thereby, shifting the burden further up the income scale.

Figure 2. Effect of Refundable Tax Credits on the Distribution of the Income Tax Burden

Source: Internal Revenue Service, Tax Foundation.

For example, before accounting for refundable tax credits, the bottom 20 percent taxpayers shouldered 0.2 percent of the income tax burden while the top 20 percent of taxpayers paid roughly 79 percent. After receiving more than $28 billion in refundable credits, the bottom 20 percent of taxpayers is found to receive more than they pay, while the burden on the top 20 percent increased to nearly 84 percent. The chart also shows that the refundable credits reduce the tax burden for the second quintile to almost zero while increasing the tax burden for the third and fourth quintiles—though less dramatically than for the top income group.

Broadly speaking, the 42.5 million non-payers are:

  • Low-income: 97 percent earn less than $40,000 annually;
  • Young: 36 percent are younger than age 25 and 56 percent are younger than age 35; 
  • Women and Unmarried: 54 percent are single women or female-headed households; 
  • Part-Time Workers: 42 percent work part-time while just 20 percent work full-time but less than 50 weeks a year; 
  • Benefit from Tax Credits: 34 percent claim the EITC while 50 percent claim the child credit.

In addition to these non-paying filers, roughly 15 million individuals and families earned some income in 2004 but not enough to be required to file a tax return. When these non-filers are added to the non-payers, they add up to 57.5 million income-earning households (sometimes referred to as tax units) who paid no income taxes last year.

Even 57.5 million is not the actual number of people because one tax return often represents several people. When all of the dependents of these income-producing households are counted, roughly 120 million Americans—40 percent of the U.S. population—are outside of the federal income tax system.

While some may applaud the fact that millions of low- and middle-income families pay no income taxes, there is a threat to the fabric of our democracy when so many Americans are not only disconnected from the costs of government but are net consumers of government benefits. The conditions are ripe for social conflict if these voters begin to demand more government benefits because they know others will bear the costs.

The Tax Foundation's 2005 Annual Survey of U.S. Attitudes on Tax and Wealth found that 59 percent of American adults said it is unfair that 42.5 million Americans pay no federal income taxes after deductions and credits, and that everyone should be required to pay some minimum amount to fund government.

Appendix: Example of How Refundable Tax Credits Reduce Tax Liabilities

Source: Tax Foundation.

(This "Fiscal Fact" is based on the forthcoming Tax Foundation book Putting a Face on America's Tax Returns.)

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