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Understanding Tax Fairness (and Why the Buffett Rule Is a Distraction)

Tuesday, April 17, 2012

While the number of tax returns filed jumped from 107 million in 1987 to 140 million in 2009, the number of taxable returns actually fell from 87 million to 82 million.

President Obama took to Twitter last week to advertise the fact that 1,470 millionaires paid no federal income tax in 2009. The White House has proposed a “Buffett Rule” mandating that taxpayers earning more than $1 million pay at least 30 percent of their income in federal income taxes. However, the unfairness the Obama administration has identified is only one limited, albeit particularly eye-catching, manifestation of more systemic problems in the tax code.

The president’s focus on a few thousand millionaires who avoided income taxes overlooks the fact that 5.1 million households with incomes ranging from $40,000 to $100,000 also paid no income taxes in 2009. For the 35.8 million other people in the same income range who paid, on average, thousands of dollars in federal income taxes, this is also a significant matter of fairness.

In 2009, 42 percent of all tax filers paid no federal income taxes, the highest percentage of tax returns with no tax liability in more than 24 years. In fact, while the number of tax returns filed jumped from 107 million in 1987 to 140.5 million in 2009, the number of taxable returns actually fell from 87 million to 82 million. While the great majority of those who paid no federal income taxes had incomes below the median level, millions of those who escaped the income tax had much higher adjusted gross incomes (AGIs), including but not limited to the 1,470 millionaires. For example:

•    Of the 10.8 million taxpayers with AGIs between $40,000 and $50,000, 22 percent paid no federal income tax in 2009, while those who did have tax liability paid an average of $3,000.

•    Of the 18.7 million taxpayers with AGIs between $50,000 and $75,000, 12 percent paid no federal income tax. Among the remaining 16.4 million returns in this income bracket, the average tax bill was about $4,700.

It is simply unfair that similarly situated taxpayers have radically different tax liabilities, but many middle- and high-income taxpayers are able to avoid the federal income tax because of the myriad of tax breaks in the tax code. Many of these tax expenditures are perfectly nice-sounding, such as the child tax credit, education tax credits, an extra standard deduction for the elderly, and the mortgage interest deduction. But, taken together, they completely wipe out tax liability for tens of millions of taxpayers.

Homeowners pay less tax than renters. Parents pay less than pet owners. Charitable givers pay less than misers. Buyers of electric cars pay less than those who take the bus or ride a bike.

This situation is a natural consequence of Congress’s long-standing use of the tax code for social engineering. Homeowners pay less tax than renters. Parents pay less than pet owners. Charitable givers pay less than misers. Buyers of electric cars pay less than those who take the bus or ride a bike.

This gives rise to genuine concerns about fairness. When some millionaires don’t pay income taxes, it irks both the less well-off who pay hundreds or thousands of dollars in taxes annually and the millionaires who pay hundreds of thousands of dollars in income tax. Similarly, a typical taxpayer with an income between $75,000 and $100,000 should be miffed that nearly half a million others with the same income avoid income taxes completely. It is more shocking to hear of millionaires who pay no income taxes, but both situations raise legitimate questions of fairness.

These tax breaks for particular activities or goods not only lead to wild disparities in tax burdens among similarly situated taxpayers, but also distort consumer choices and impede economic efficiency by misallocating resources. And the resulting convoluted tax code is nearly impossible to navigate without specialized expertise.

In 2009, 42 percent of all tax filers paid no federal income tax, the highest percentage of tax returns with no tax liability in more than 24 years.

While broad-based, fundamental tax reform would best ensure a fairer and less distorted tax code, progress could also be made with more modest steps to broaden the tax base. For example, Congress could eliminate itemized deductions completely, allowing all taxpayers to claim a standard deduction based on whether they are single or married. Such a change would dramatically simplify the tax system and significantly cut down on the number of middle-income taxpayers who escape the income tax system. Yet it would have little impact on lower-income taxpayers because they rarely itemize their deductions. Part or all of the additional revenue collected by the simplification could be used to reduce marginal tax rates.

There is no single solution to the faults of the tax code, but the Buffett Rule is among the least logical Band-Aids imaginable. It adds another layer of tax complexity and creates another set of economic distortions. The issue of tax fairness is a legitimate one for lawmakers to consider, but deserves a broader focus and more structural solution than the Obama administration’s attack on a small group of millionaires. The Senate was right to reject the idea. Now, hopefully, it will turn its attention to more fundamental tax reforms.

Alex Brill is a research fellow at the American Enterprise Institute.

FURTHER READING: Alex Brill has also written “Housing Finance: For Once, Please Leave It Alone,” “The Payroll Tax Holiday Is a Bad Bipartisan Idea,” and “Banks and Government Near Settlement on Mortgages: What Does It Mean?” Veronique de Rugy contributes “Slay This Tax ‘Monster’.” Alan D. Viard says “‘Buffett Rule’ Not a Serious Response to Budgetary Problems,” and explains “Why Congress Won’t Simplify the Tax Code.”

Image by Rob Green/Bergman Group

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