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Who Benefits From A Tax Cut

5 min readBy: Scott Hodge

Like you, I get a lot of junk e-mail. But I also read many messages from concerned taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. payers who give their insights into the tax code, and often their frustrations with it. Over the past six months, however, dozens of Tax Foundation supporters have e-mailed me the same parable that puts our tax system, and President Bush’s tax cuts, in terms everyone can understand.

Despite my attempts to identify the author, he or she remains anonymous. (It is not, as some e-mails have claimed, an economics professor in South Dakota.) So while another urban legend lives on, I want to share this story with you and relate it to some of the research we have done recently on who does not pay taxes in America.

Suppose that every day, ten men go out for dinner. The bill for all ten comes to $100. They decided to pay their bill the way we pay our taxes, so they divided the bill like this:

The first four men — the poorest — would pay nothing. The fifth would pay $1, the sixth $3, the seventh $7, the eighth $12, the ninth $18, and the tenth man — the richest — would pay $59.

One day, the owner threw them a curve (in tax language, a tax cut).

“Since you are all such good customers,” he said, “I’m going to reduce the cost of your daily meal by $20.” So now dinner for the ten only cost $80.00.

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 “fair share”?

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 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 bill 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, then, pointing 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, a little late what was very important. They were FIFTY-TWO DOLLARS short of paying the bill! Imagine that!

And that, in a nutshell, is how the income tax system works. Like all e-mail stories, the numbers aren’t exact — but see pages 10 and 11 for statistics that show how true-to-life this story is.

The people who pay the highest taxes get the most benefit from a tax cut. We don’t have to feel sorry for them because they earn a lot too, but a fair tax cut goes to highly taxed people. If overtaxed, high earners will react predictably — they’ll earn and invest less.

One of the most exciting projects we started last year at the Tax Foundation is called “Putting a Face on America’s Tax Returns.” The goal is to study the demographics of American taxpayers to find out who really bears the burden of taxes.

For example, although the “top 10 percent” of tax filers are routinely disdained in the press as being too rich to merit a tax cut, the Bureau of Labor Statistics tells us that an assistant high school principal married to an assistant fire chief is in the top 10 percent — statistically “rich”, but decidedly middle-class by any reasonable standard.

When estimating the value of tax cuts, the January 12 edition of Time contained a typical presentation:

“Although Bush touted the fact that the average tax bill would shrink $1,083, almost half of all filers would get reductions of less than $100, according to the left-leaning Center on Budget and Policy Priorities.”

The reason this statement is misleading is that the people who make up “almost half of all filers” owe almost no income taxes to begin with. Indeed, this year, 35.8 million tax filers (representing 69.6 million people) will have a zero tax liability. That is 26.7 percent of the roughly 133 million expected tax returns this year. The Bush plan will take 3.8 million more tax filers off the tax rolls (see story on page 11).

The bottom line is that it is impossible to give income tax relief to people who do not pay income taxes. Unfortunately, when Congress’s Joint Tax Committee or Congressional Budget Office calculates the distributional impact of the President’s plan on “taxpayers,” they include all 133 million tax filers, including the millions who owe nothing.

If distributional analysis is to be the standard by which Washington judges any tax plan, then we should calculate the plan’s benefits to taxpayers — those filers who have a positive income tax liability.

And that number shrinks with every new tax bill.