October 14, 2005

Shrinking Pool of Taxpayers a Puzzle for Tax Reform Panel

(This article originally appeared in the October 14, 2005 edition of the New York Sun.)

For the first time in 20 years, Washington seems poised to overhaul the federal tax code. Americans are ready to support fundamental tax reform judging from their responses to the 2005 Tax Foundation Annual Survey of U.S. Attitudes on Taxes and Wealth conducted by Harris Interactive. A majority of American adults believe federal taxes are too high, the tax code is too complex, and the income tax system is unfair. A majority even support simplification even if it means giving up the deductions and exemptions they now enjoy.

The biggest obstacle to reform may not be the army of Washington lobbyists who will fight to protect those deductions and exemptions. The most serious obstacle to reform is the fact that America has become divided between a growing class of people who pay no income taxes and a shrinking class of people who are bearing the lion’s share of the burden.

Despite the charges of critics, the tax cuts enacted in 2001, 2003, and 2004 dramatically reduced the tax burden of low- and middle-income taxpayers and shifted the tax burden onto higher-income taxpayers. In 2004, one out of every three Americans who filed a tax return (42.5 million) had no tax liability after they took advantage of their credits and deductions, while millions more paid next to nothing. As a result, the top 20% of taxpayers — those earning more than roughly $71,000 in 2004 — now pay over 80% of all the income taxes.

The widening gulf between the “payers” and the “non-payers” poses a dilemma for tax reformers. Generally speaking, the goal of tax reform is to broaden the tax base while lowering tax rates. But how do you craft a tax reform plan that (1) doesn’t raise taxes on the 42.5 million Americans who pay nothing — and in many cases receive a refundable credit — and (2) doesn’t “cut taxes for the rich” who now pay everything? There is no easy answer.

The first step toward a solution is to understand how our progressive income tax rate system is interacting with the demographic changes happening in America today. If we look at who comprises the top 20% of taxpayers, we find that they are the picture of most any suburban family:

  • They are largely dual-income married couples;
  • They live in high-cost metropolitan areas and have
    correspondingly high nominal incomes, but average living standards;
  • They are older workers, at or nearing their peak earning
  • They are college educated; and
  • They have business income.

In many areas of America, these taxpayers are “middle-class” by any standard. But these families are taxed at the highest income tax rates because our progressive tax rate system is not fully adjusted for such things as cost of living, age, education, or the number of incomes in a household. Unless we reform the tax code so that it is neutral to these demographic traits, America’s suburban middle-class may soon be the only “taxpayers” actually paying income taxes.

While no tax system can be fully adjusted for all of this nation’s vast differences, the most neutral system is a single-rate tax levied on consumption or on incomes above some politically accepted level, say $40,000 in annual income. Ideally, such a system should have as few deductions as possible and be applied to as broad of a base as possible.

Not only would a tax system free of these distortions be better for the economy, but it would restore a sense of fairness and equity to a tax code that too often resembles the new car market — everyone pays a different price depending upon their ability to navigate the system.

Former House Majority Leader Dick Armey once said, “If we are going to respect the tax code, we need a tax code that respects us.” The only system that will respect all of the vast differences in America is a single-rate tax levied at a low rate on consumption or income. If lawmakers can finally muster the courage to move to such a system, “April 15th,” as former Louisiana Congressman Billy Tauzin once said, “will be just another beautiful spring day.”

Scott A. Hodge is President of the Tax Foundation.