Friday, August 30, 2013

Those Who Pay Zero in U.S. Income Tax

Back in January 1969, the story goes, U.S. Treasury Secretary Joseph Barr testified before the Joint Economic Committee of Congress that 155 Americans with income of over $200,000 had paid no income tax in 1967. Adjusted for inflation, $200,000 in 1967 income would be equal to about $1.4 million in 2013. Back in 1969, members of Congress received more letters from constituents about 155 non-taxpayers than they did about the Vietnam War.

The public outrage notwithstanding, it's not obvious to me that 155 high-income people paying no income taxes is a problem that needs a solution. After all, a few high-income people will have made very large charitable donations in a year, knocking their tax liability down to zero. A few taxophobes will invest all their funds in tax-free municipal bonds. A few may have high income this year, but be able to offset it for tax purposes with large losses from previous years. It only takes a few dozen people in each of these and similar categories to make a total of 155 high-income non-taxpayers.

The ever-useful Tax Policy Center has now published some estimates of what share of taxpayers will pay no income taxes in 2013 and future years. Just to be clear, these estimates are based on their microsimulation model of the tax code and taxpayers--the actual IRS data for 2013 taxpayers won't be available for a couple of years. But the estimates are nonetheless thought-provoking. Here's a summary table:

At the high end, the top 0.1% of the income distribution would kick in at about $1.5 million in annual income for 2013--not too different, adjusted for inflation, from the $200,000 level that created such controversy back in 1969. Of the 119,000 "tax units" in the top 0.1% of incomes, 0.2% paid no income tax--so about 200-250 people. Given the growth of population in the last four decades, it's a very similar number to those 155 non-taxpayers that caused such a stir back in 1969.

The big change, of course, is that after 1969 an Alternative Minimum Tax was enacted in an attempt to ensure that all those with high incomes would pay something in taxes. But with about 162 million tax units in the United States, and an  income tax code that has now reached 4 million words, it's not a big shock to me that a few hundred high-income people would be able to find legitimate and audit-proof ways of knocking their tax liability down to zero.

Rather than getting distracted by the lack of tax payments by a few hundred outliers, I'd much rather focus on the tax payments of all 119,000 in the top 0.1%, or all 1,160,000 in the top 1%. As I've written before on this blog, I'm open to policies that would raise marginal tax rates on those with the highest incomes, especially if they are part of an overall deal to reduce the future path of U.S. budget deficits. But I would prefer a tax reform approach of seeking to reduce "tax expenditures," which is the generic name for all the legal deductions, exemptions and credits with which those with higher incomes can reduce their taxes (for earlier posts on this subject, see here, here, and here).

The other pattern that jumps out when looking at those who pay zero in income taxes is that the overwhelming majority of them have low incomes. The table shows that 87% of those in the lowest income quintile, 52% of those in the second income quintile, and 28% of those in the middle income quintile owed nothing in federal income taxes. This situation is nothing new, of course. The original federal income tax back in 1913 was explicitly aimed only at those with high incomes, and only about 7% of households paid income tax. Even after the income tax expanded during World War I, and then was tweaked through the 1920s and into the 1930s, only about 20-30% of households owed federal income tax in a given year.

The standard explanation for why the federal income tax covers only a portion of the population is that it is the nation's main tax for having those with higher incomes pay a greater share of income in taxes. With payroll taxes for Social Security and Medicare, as well as with state and local sales taxes, those with higher incomes don't pay a higher share of their income--in fact, they typically pay a lower share of income.

The standard argument for why a higher share of people should pay into the income tax is that democracy is healthier if more people have "skin in the game"--that is, if tax increases and tax cuts affect everyone, and aren't just a policy that an untaxed or lightly-taxed majority can impose on a small share of the population. I recognize the theoretical power of this argument, but in practical terms, it doesn't seem to have much force. If those with low incomes made minimal income tax payments so that they had "skin in the game," and then saw those minimal payment vary by even more minimal amounts as taxes rose and fell, it doesn't much alter their incentives to impose higher taxes on others. Also, it doesn't seem like the US has been subject to populist fits of expropriating the income of the rich, so I don't worry overmuch about it. Sure, it would be neat and tidy if we could reach a broad social agreement on how the income tax burden should be distributed across income groups, and then with that agreement in hand, we could raise or lower all taxes on everyone together. But I'm not holding my breath for such an agreement on desirable tax burdens to be reached.