Why You Should Care that Half of Your Fellow Citizens Pay No Income Tax

Posted by Jeffrey Brown on Apr 15, 2010

Filed Under (U.S. Fiscal Policy)

April 15 – tax filing day.  Undoubtedly, the newspapers will be full of the usual debate about whether the rich pay too much or too little in taxes. 

A Washington Post article (reprinted here) written by my fellow economists Rosanne Altshuler and Roberton Williams last week has received a fair amount of press coverage by pointing out that “about 45 percent of households will owe no federal income tax in 2010.”  This has led to the usual debates about whether this is “fair” or not.  But “fairness” is not a particularly well-defined notion, and your view of it probably depends a lot on whether you are one of those paying taxes, or one of those not. 

Rather than get into a debate about fairness, I want to make a point about economic efficiency, and a point about the interaction of politics and economic policy.  

The economic efficiency point is straight out of introductory public finance.  Most taxes have two impacts.  First, they redistribute resources in some way.  Second, they usually change relative prices and therefore distort economic decision-making.  These distortions in economic decision-making lead to real economic costs.  There are many names for it – the deadweight loss of taxation, including the excess burden of taxation, the efficiency cost of taxation, even the Harberger Triangle (named after the eminent economist who rigorously made this point). 

Whatever name you use, the point is simple: when you tax an activity, you not only raise revenue, but you also destroy some economic value along the way.  In other words, to raise a dollar of revenue, you may destroy another 25 or 30 cents of activity in the process of raising the dollar.  These excess burdens are not always easy to see with the naked eye because often it is in the form of something that did not happen – a transaction that never occurs, an hour of labor withheld from the market, an investment not made, and so forth.  Think of the “dog that did not bark in the night.”       

What is particularly important about this is that the size of this excess burden grows with the square of the tax rate.  That means, essentially, that if you double the tax rate, you significantly more than double the excess burden.  In short, each dollar of revenue gets a more expensive to collect.

As a result of this, most economists agree that the most efficient way to raise a given amount of revenue is to have a smaller tax rate applied to a larger tax base.  The Tax Reform Act of 1986 was a particularly good example of tax policy designed to do exactly that – including more sources of income in the tax base, removing special exclusions and exemptions, and then lowering the marginal tax rate.    

The fact that 45% of households face no income tax is one of many indications that we may have too narrow of a tax base, and therefore too high of a tax rate.  (There are many other examples, most of which are even more quantitatively important, including things like the exemption of home mortgage interest or health care insurance premia). When we leave one person untaxed, the tax burden on the remaining individuals must be higher.  And, importantly, the deadweight loss is higher. 

The second point I would make is that when nearly half of the population pays no income tax, what incentive does that half have to control government spending?  As we have learned over and over again in numerous contexts (including 3rd party insurance payments), people are a lot more likely to spend money when the money they are spending is somebody else’s.  After all, who wouldn’t like more public spending if somebody else is going to foot the bill?  

So whatever your views about the “fairness” of who pays taxes, let’s be clear that it has real economic and political consequences.  

2 Responses to “Why You Should Care that Half of Your Fellow Citizens Pay No Income Tax”

  • Dan Karney says:

    The danger of this headline comes from people confusing the idea of “No Income Tax” with “No Taxes”. It is my understanding that many individuals that pay no federal income tax contribute substantial portions of their yearly incomes in payroll taxes, sales taxes, and property taxes. Correct?

    -Dan

  • Jeffrey Brown says:

    Hi Dan,

    That is why the headline says “No Income Tax” instead of “No Tax.” :-)

    Yes, something like 2/3 of U.S. households pay more in payroll taxes than they do in income taxes. But payroll taxes are fundamentally different in a number of ways, not least of which is that there is at least some degree of a “tax-benefit linkage.” In other words, the more I pay in Social Security payroll taxes, the higher the present value of future benefits I receive (at least on average, if not always on the margin.)