Do the Rich and Businesses Pay their Fair Share?

Critics of Bush's three tax relief plans charge that only the wealthy benefited from the reductions in marginal tax rates. But is this true? And more broadly, do the wealthiest Americans pay their "fair share" of the tax burden?

The evidence shows that all Americans, rich and poor, benefited from President Bush's tax cuts. The rich saw taxes on their dividends and capital gains reduced (as well as their income taxes), and personal income tax rates were slashed across the board, which encompassed every middle-class taxpayer. Even the poor, who generally do not pay income taxes, were rewarded with a higher Earned Income Tax Credit (EITC) and child tax credits.

Progressivity and the Tax Burden

Our tax system, however, is highly progressive, meaning that as one's income rises, a higher proportion of that income is taxed. Thus, those in the highest tax brackets contribute more to the overall tax burden even though there are far more people in lower tax brackets.¹

• According to data from the IRS, the bottom 50 percent of income earners pay approximately 4 percent of income taxes.
• The top 25 percent of income earners pay nearly 83 percent of the income tax burden, and the top 10 percent pay 65 percent.
• The top 1 percent of income earners pay almost 35 percent of all income taxes.
• The top 400 richest Americans paid 1.58 of total income taxes in 2000.

Rising Federal Taxes for the Rich

The empirical evidence shows that the wealthiest citizens are also paying an ever-increasing proportion of all taxes collected by the federal government. Data from the Congressional Budget Office show not only that taxes on the wealthy have risen over time but that the 2001 Bush tax cut barely kept their share of the tax burden from rising further:²

• In 1984, after the Reagan tax cut had been fully phased in, the bottom quintile (20 percent) of income earners paid an average federal tax rate (individual, payroll, corporate and excise) of 10.2 percent.
• The top quintile of earners paid 24.5 percent and the top 1 percent paid 28.2 percent.
• In 2001, after the first Bush tax cut had taken effect, those in the bottom quintile paid average federal income taxes of 5.4 percent, about half of what they did 20 years ago.
• Those in the top five percent saw a slight decline in their federal tax rate (28.6 percent, down from 29.7 percent).
• The top 1 percent, however, saw their overall federal tax burden increase slightly, from 33 to 33.2 percent.

Despite the accusation that it was the very wealthiest who benefited the most from the 2001 tax cut, their federal tax burden stayed level at best and increased at worst. Progressivity in the tax system rose and the wealthy now pay about six times more than the poor.

We can also look at the overall share of federal taxes paid to detect a similar pattern. For example:³

• From 1984 to 2001, those in the bottom quintile saw their share of the total tax burden drop from 2.4 percent to 1.1 percent.
• Those in the top quintile saw their share rise from 55.6 percent to 65.3 percent.
• The top 10 percent increased their share from 39.3 percent to 50 percent; the top 5 percent's share rose from 28.2 to 38.5 percent; and those in the top 1 percent saw their share skyrocket from 14.7 percent to 22.7 percent.

Overall, the poor paid about half as much of the federal tax burden in 2001 as they did in 1984, while the rich paid about 50 percent more. Even those in the middle class, often said to be hit hardest by increasing taxes, saw their share decline by about a third.

Raising Taxes on the Rich is Counterproductive

Despite these figures, many critics of the Bush tax cuts still insist that the rich aren't paying their fair share of taxes, and that marginal tax rates should be increased for those in the highest tax brackets.

Interestingly, though, historical examples show us that when marginal tax rates on the rich are higher than 30 percent, the rich actually pay less of the total tax burden, because they tend to shelter, hide or underreport more of their income to avoid those high rates. Alternately, when taxes are lowered on the rich, their share of the total tax burden climbs. Consider the following evidence from three major tax rate reductions:⁴

• In the 1920s, the top tax rate fell from 73 percent to 25 percent, but the wealthy went from paying 44.2 percent of the tax burden in 1921 to more than 78 percent in 1928.
• In the 1960s, after JFK cut the top tax rate from 91 to 70 percent, those making more than $50,000 saw their share of the tax burden rise from 11.6 to 15.1 percent.
• In the 1980s, after Reagan's "supply-side" tax cuts, the top 1 percent saw their share of the income tax burden climb from 17.6 percent in 1981 to 27.5 percent in 1988.

The Myth of Spending Cuts for the Poor and Tax Cuts for the Rich⁵

During the 2005 budget reconciliation debate, critics claimed that Republi­cans were cutting spending for the poor to pay for tax cuts for the rich; however, the facts simply do not support these overheated claims and the accusation that poor families are shouldering more of the tax burden while receiving less of the spending is empirically false.

• From 1979 through 2003, the total federal tax bur­den on the highest-earning percentage of Americans -- who earn 52 percent of all income -- rose from 56 percent to 66 percent of all taxes.
• Their share of individual income taxes jumped from 65 percent to 85 percent.
• On the spending side, antipoverty spending has leaped from 9.1 percent of all federal spending in 1990 to a record 16.3 percent in 2004.

The data clearly show that the tax burden is shifting annually up the income scale while spending continues to move down the scale; the people with the highest incomes are paying more of the tax burden while the poor are receiving more of the spending.

Moreover, the persistent increase in federal antipoverty spending fosters an unhealthy depen­dence on government. For example:

• From 1990 to 2005, the Medicaid caseload doubled to 55 million participants, meaning that the government increas­ingly is taking over the health care system from pri­vate companies and from community and charitable organizations, thus eroding self-reliance, independence, and local community responsibili­ties.
• The measure of the effectiveness of government antipoverty programs is not how many people are trapped into financial dependence on the govern­ment, but how many people succeed in freeing themselves from dependence on the government.

Furthermore, the mathematically impossible principle that income tax relief should be concentrated among families who pay no income tax pre­vents any consideration of legitimate tax relief or tax reform. Additionally, the misperception that higher tax rates induce substantially higher tax revenues among upper-income taxpayers trans­lates into pressures for tax increases that harm eco­nomic growth without substantially increasing tax revenues.

Taxing the Untaxed Business Sector⁶

Some people believe it would be desirable to subject untaxed entities -- like nonprofit organizations -- that resemble businesses to the same income taxation as their for-profit competitors. The probable consequences of such a policy for federal revenue and the economy stem from the organizational structure of those untaxed entities.

Nonprofit organizations are exempt from income taxation if they are operated for charitable, religious, educational or other purposes specified in section 501(c) of the Internal Revenue Code; nevertheless, a number of nonprofit organizations are indistinguishable from businesses: they sell goods or services and use the receipts as the principle means of financing their activities:

• In the case of for-profit firms, shareholders demand that any surplus income in excess of expenses be distributed to them as dividends or retained as accumulated earnings.
• Those firms react to taxes by trying to shift them to customers in the form of higher prices or to employees in the form of lower compensation.

With untaxed entities, however, the absence of shareholders would give managers other options for avoiding income taxes: reducing their taxable surplus by lowering their prices and by increasing compensation or other costs; and because of their structure, untaxed entities would be likely to yield less tax revenue than their share of economic activity might suggest:

• To shrink their surplus and avoid taxation, state and local business enterprises could assume the costs of closely related nontaxable entities.
• Nonprofit organizations and cooperatives could increase borrowing and deduct the associated interest expenses.
• All of those entities could distribute more of their surplus as price reductions and cost increases.

For-profit firms that favor taxing untaxed entities as a way to level the competitive playing field might find that their competitors' prices were reduced even further; similarly, people who oppose taxation on the grounds that it would cause untaxed entities to raise the prices of socially beneficial services might find those prices falling instead.

Those reactions could impose a broader economic cost:

• Price reductions could encourage excess consumption.
• Cost increase would mean that more resources than necessary were used to produce a good or service.
• Both outcomes would reduce national income by diverting resources away from goods and services with a higher value than those being provided by the newly taxed entities.

However, over time, taxing the untaxed business sector might ultimately achieve its objectives, but the market presence and impact of the untaxed sector does not result solely from the sector's exemption from income taxes -- they also derive from the organizational structure of entities in the sector.

 The Rising Cost of Complying with the Federal Income Tax

In 2005, individuals, businesses and nonprofits were estimated to spend six billion hours complying with the federal income tax code, with an estimated compliance cost of over $265.1 billion.  This amounts to imposing a 22-cent tax compliance surcharge for every dollar the income tax system collects, and projections show that by 2015 the compliance cost will grow to $482.7 billion.

However, the burden of tax compliance does not fall evenly on taxpayers.  It varies by type of taxpayer, income level and state, but in 2005 businesses bore the majority of tax compliance costs. 
According to the Tax Foundation:⁷

• This totaled nearly $148 billion, or 56 percent, of total compliance costs.
• Compliance costs for individuals was only $111 billion, or 42 percent
• Non-profits, so far, have only paid nearly $7 billion, or 2.5 percent of the total.

But as tax compliance grows, more and more businesses will end up paying their fair share.

Conclusion: "A Rising Tide Lifts All Boats"

President Kennedy once said that a rising tide lifts all boats, and he was right. When the economy grows, rich and poor alike benefit from rising wages, incomes, and productivity. Conversely, stagnation hurts all income classes simultaneously. The evidence from the 1960s through today illustrates that lower tax rates correlate with rising incomes for all sections of the population. Even cuts on capital gains and dividends, often though to benefit only rich stockholders, allow for greater investment and more job creation, which ultimately helps lower-income Americans. Though the wealthy pay an enormous share of the overall tax burden, tax cuts on their income would not only bring in more revenue, but would help lower-income Americans become more upwardly mobile.

1. Daniel J. Mitchell, "The Truth About Tax Rates and The Politics of Class Warfare," Heritage Foundation, March 5, 2001. http://www.heritage.org/Research/Taxes/BG1415.cfm; Bruce Bartlett, "Kerry Tax Plan: ‘Them' versus ‘Us'," NCPA Brief Analysis, no. 487, October 8, 2004. http://www.ncpa.org/pub/ba487/
2. Congressional Budget Office, "Effective Federal Tax Rates: 1979-2001," Congressional Budget Office, April 2004. http://www.cbo.gov/showdoc.cfm?index=5324&sequence=0
3. Bruce Bartlett, "Distribution of the Tax Burden," National Center for Policy Analysis, April 7, 2004.
4. Daniel J. Mitchell, "The Truth About Tax Rates and The Politics of Class Welfare," Heritage Foundation, March 5, 2001. http://www.heritage.org/Research/Taxes/BG1415.cfm
5. Brian M. Riedl, "The Myth of Spending Cuts for the Poor, Tax Cuts for the Rich," Heritage Foundation, February 14, 2006. http://www.heritage.org/Research/Budget/bg1912es.cfm
6. Congressional Budget Office Report, "Taxing the Untaxed Business Sector," Congressional Budget Office, July 25, 2005. http://www.cbo.gov/ftpdocs/65xx/doc6567/07-21-UntaxedBus.pdf
7. Scott A. Hodge, J. Scott Moody and Wendy P. Warcholik, "The Rising Cost of Complying with the Federal Income Tax," Tax Foundation, January 10, 2006.  http://www.taxfoundation.org/research/show/1281.html