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Commentary By e21 Staff

Some Numbers to Digest on Tax Day

Economics, Economics Tax & Budget, Finance

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This year, nearly half of all US households will be spared the sting of tax day. According to the Tax Policy Center (TPC), 47% of tax returns will have zero or negative income tax liability for the 2009 tax year. This is a 42% increase from 2007 when roughly one-third of households paid no income tax. While some of the increase is attributable to the recession, most of it comes from the expansion of the child tax credit and the creation of the “Making Work Pay” refundable tax credit. These policies were sold as “tax cuts,” but have proven in reality to be more government spending. On this tax day, lawmakers should take a pledge to the remaining American taxpayers that from now on they will be honest about the difference between the two.

Tax Filers Who Pay No Federal Income Tax

The table above compares the TPC estimate to the 2007 Internal Revenue Service (IRS) statistics of income data. The total bottom line compares the ratio of non-taxpayers to total tax filers. (The income subgroups are not directly comparable due to different definitions of income: the IRS statistics measure income after deductions and credits). The 2009 figures demonstrate that very few households with less than $30,000 of income pay any income tax. Generally, low-income households that pay no tax are also recipients of federal income support programs like Medicaid and food stamps so it is not surprising to learn that personal exemptions and the standard deduction take their taxable income to zero.

More interesting is that one-in-five households making between $50,000 and $75,000 and one-in-ten households with between $75,000 and $100,000 of income face no tax bill this year. These households have had their tax liability eliminated by tax expenditures – programs that use the tax code to achieve goals unrelated to raising revenue. The normal tax baseline allows for personal exemptions, a standard deduction, and deduction of expenses incurred in earning income. The tax revenue lost from any special deductions, credits, or tax preference items above this baseline is classified as tax expenditure. The households in the $50,000 to $75,000 range that pay no tax are almost certainly families whose tax liability has been eliminated by the $1,000 per child tax credit and the President’s new “Making Work Pay” tax credit, some of the most popular tax expenditures.

The table below provides the revenue impact for three tax expenditures (pages 57 to 88 of the pdf) from 2009-2015: the child tax credit, the “Making Work Pay” credit, and the earned income tax credit. In 2010, the federal government will collect $53 billion less than it otherwise would have thanks to these three policies. This $53 billion tax expenditure is largely responsible for removing the additional 14% of households from the tax rolls, but also includes tax benefits received by households with positive tax liability below the phase-out range for these provisions.

Tax Relief (in billions)

This $53 billion in lost revenue is not where the story ends, however. Each of these three policies also has a substantial outlay component. This is to say that the benefits of these tax expenditures do not end when the household’s tax liability is reduced to zero. Not only will the IRS collect $53 billion less this year, but as part of this tax filing season the IRS will actually send additional checks worth $114.3 billion to households with no income tax liability – thanks to these three programs.

Outlays (in billions)

Thus, it is not simply that 47% of households pay no income tax; for a substantial majority of these households the federal income tax system provides a large net cash benefit. There are now tens of millions of households that would be net losers if the tax code were repealed, not only because of the revenue lost to fund programs they depend on, but because of the cash provided by the tax system itself. The tax system once existed to collect revenue to finance government spending, but it has now become a large spending program in its own right. The amount spent through the tax code through the three credits in 2010 is more than 3.5-times the amount Congress will spend on the National Institutes for Health.

Critics point out that this math is only true when considering the amount of federal income taxes paid, and when other taxes are included (most notably the payroll tax) household tax burdens are different. While it is true that the payroll tax liability affects a much larger percentage of households than federal income taxes, as we pointed out here, payroll taxes are dedicated to specific programs and should be considered separately. Payroll taxes are collected to directly fund social insurance programs, such as Medicare and social security.

Progressivity is a worthy ideal, but it must be measured based on taxes actually paid. In 2007, the top 1% of taxpayers paid 40% of all income taxes despite reporting only 22% of all income, while the top 50% pay virtually all of the income tax collected. This situation looks rather progressive: the top 1.4 million households paid income taxes equal to 40-times their share of the population and roughly twice their share of income. Yet, the direction of tax policy since 2007 has been to increase taxes on top income earners (allowing current rates to expire) and increasing outlays for non-taxpayers.

When the top half of the income distribution pays all of the taxes, there can be no such thing as a “progressive” income tax reduction to those focused on changes in after-tax income. Cutting taxes requires collecting less from the people who actually pay federal income taxes. Rhetorical problems arise however, when this fact is not made clear. If the only households that pay income taxes are in the top half of the distribution, then any tax cut will, by definition, be “regressive” and provide only a benefit to those at “the top”. This definition is a formula for the never-ending expansion of the federal government.