What is a Fair Tax Rate?

As our representatives in Washington attempt to agree on a budget, one of the topics of discussion is how much tax we should pay. Specifically, should the wealthiest Americans continue to receive the tax cut put in place by President Bush?

Before anyone answers that question, I think it is important to go through the thought experiment of determining what a 'fair' tax would be. Let's say you were suddenly granted the power to decide the rate at which income tax is paid. We'll stick with income tax to focus the discussion, but there are a number of other sources of tax, including social security, medicare/medicaid, and payroll tax to name a few. First, let's look at the spectrum of income in the US. Income is typically divided into quintiles, which is dividing the spectrum into five pieces, each with equal population. The Census Bureau published the mean income for each quintile for the year 2009:

Bottom Quintile: $11,552
Second Quintile: $29,257
Third Quintile: $49,534
Fourth Quintile: $78,694
Top Quintile: $170,844

Within each quintile you will find folks who make more than the mean, and folks who make less than the mean, but the idea is that an equal number of households are making somewhere around this amount. Another thing to keep in mind is that for the year 2009, the threshold for poverty was annual income of less than $11,161 (I covered this in more detail in an earlier post).

So given that $11,161 is the minimum necessary to live, what level of taxation is fair?

One common school of thought is to impose flat tax amount, where each citizen pays the same. After all, we all are equal citizens, so we should all pay the same for that privilege. In 2009 the US government received $1.21 trillion in income tax. We'll ignore the fact that the US ran a $400 billion deficit this year, and assume that this amount of tax was sufficient for a balanced budget (along with those other tax receipts we are ignoring for the moment). The IRS received 236 million returns that year, so we'll use that as our population count. So if we divided the tax receipts ($1.21T) by our population (236M) we get $5,127.12 from every household.

Our top quintile would love that. After all, it is easily afforded, and likely much less than they pay now. Our bottom quintile is in real trouble though. They had less than $400 to spare, and are now several thousand dollars below the poverty line. As a percentage of income, the lowest quintile is paying 44.38%, while the top quintile pays just 3%.

That isn't the only school of thought though. There is also the concept of paying a flat percentage rate. So what percentage rate would we need to use across all of those households in order to get back to our $1.21T in revenues? First, we divide our population by five to get the number of households in each quintile (47.2M). Then, we multiple each quintiles mean income by the population for that quintile to determine the total income from the quintile:

Bottom Quintile: $0.545 trillion
Second Quintile: $1.380 trillion
Third Quintile: $2.338 trillion
Fourth Quintile: $3.714 trillion
Top Quintile: $8.063 trillion

Total Income: $16.042 trillion

Our revenue ($1.21T) is 7.54% of that $16T in income our households earned. If every household, regardless of income, paid that rate, the same amount of revenue would be generated. Now, of course, the math here isn't perfect because we have households earning more and less than our mean household income for each quintile, but it helps us understand how this works. Taking a look at our bottom quintile, this tax would cost them $871, which still puts them into poverty. Is that fair?

Again, not the only method for assigning tax rates. We could also apply a different tax rate to folks in each quintile. Let's say the bottom quintile pays no tax, the next quintile pays a small rate, and so on with the highest quintile paying the highest rate. This is close to how our federal income taxes are assessed now. The thinking is that those in the lowest tax bracket are least able to pay, and so they are taxed the least. Those in the upper tax bracket are most able to pay, and so are taxed the most. But how should those rates be assigned? It's a sticky matter, and this is the basis for the arguments going around about whether or not the wealthiest Americans should continue to receive a tax cut.

There is one issue that causes our current method to break down: extreme income disparity. Let's say that there are ten folks in a room, and they represent all of the income for the US. Let's also say the income breaks down something like this:

1: $5,000
2: $15,000
3: $25,000
4: $35,000
5: $40,000
6: $60,000
7: $70,000
8: $90,000
9: $150,000
10: $4,000,000

Whoa, I wanna be #10! I feel really bad for #9 though. If we assign our tax rate by quintile, #9 and #10 get taxed at the same rate. #9 and #10 represent 92% of the total income, and so it should be assumed that they should also be responsible for at least 92% of the taxes paid, if not more. Poor #9 is going to get saddled with a pretty hefty tax rate because he lives in the same quintile as #10, even though the income levels are extremely disparate. This is an extreme example. However, income disparity is real, and the trend has been for more disparity, not less. This means that in our room of ten people, we will have more folks at either extreme. What happens when 5 are earning poverty income, while 5 are earning six-figures?


Jade Mason