Progressive and Regressive Taxation in the United States: Who’s Really Paying (and Not Paying) their Fair Share?

Progressive and Regressive Taxation in the United States:

Who’s Really Paying (and Not Paying) their Fair Share?

A long-standing political debate in the United States has focused attention on the fairness of taxes. While conservatives, Republicons, free market fundamentalists & Tea Party types claim their tax-cutting reforms make taxes fairer, critics counter that the majority of the tax cuts accrue to the

wealthy.

Conservatives like to portray proposals to raise marginal tax rates on the upper end of the income scale as an effort to "soak the rich".  They cite cherry-picked statistics:  most often, e.g., findings from the non-partisan Tax Policy Center -or-  Congress’ Joint Committee on Taxation that 47% ~ 51% of households did not owe any net personal income taxes in 2009.  Then they use such 'evidence' out of context to convince low-information voters to support regressive tax policies -- e.g., "Flat Tax" & "Fair Tax" proposals, extensions of the Bush tax cuts on the top 2%, proposed cuts to the Earned Income Tax Credit, or Herman Cain's 9-9-9 tax plan -- even when such policies are empirically at odds with such voters rational self-interest. 

Let's purge some of the miasma on the issue... Brian Roach, in this seminal analysis from Tufts University's Global Development & Environment Institute, perhaps sums the issue up best by saying:

While the fairness of the federal income tax is an important issue, little attention has been paid to a more important issue: the fairness of the entire U.S. tax system. The federal income tax is one of the most progressive elements of the U.S. tax system; other taxes are regressive including sales and social insurance taxes. Analysis of any particular tax reform proposal is incomplete without consideration of its impact on the overall distribution of taxes. 

[Brian Roach, Global Development and Environment Institute Working Paper No. 03-10, 2003;  see here.]

The paper goes on to conclude:

The current trend towards a less progressive federal income tax and more regressive state taxes suggests that in the foreseeable future the United States could have a tax system that is regressive overall.

...

This illustrates that distributional analysis of tax proposals needs to be assessed in light of the entire tax system if inequitable policies are to be avoided. In particular, claims that we are “soaking the rich,” supported with data on federal income taxes, are clearly misleading. One could make a comparable claim that we are “soaking the poor” with reference to state sales taxes or federal social insurance taxes. What constitutes a fair overall tax system can not be settled by objective analysis. However, the basis for an honest debate on tax issues must be an accurate and complete perspective on the entire U.S. tax system.

And things have not changed much since Roach's 2003 study.  For instance, see the Center on Budget & Policy Priorities' updated tax fairness analysis entitled "Misconceptions and Realities About Who Pays Taxes" (May 31, 2011; see full report .pdf here), which is summarized below:

A recent finding by Congress’ Joint Committee on Taxation that 51 percent of households owed no federal income tax in 2009 is being used to advance the argument that low- and moderate-income families do not pay sufficient taxes. Apart from the fact that most of those who make this argument also call for maintaining or increasing all of the tax cuts of recent years for people at the top of the income scale, the 51 percent figure, its significance, and its policy implications are widely misunderstood.

• The 51 percent figure is an anomaly that reflects the unique circumstances of 2009, when the recession greatly swelled the number of Americans with low incomes and when temporary tax cuts created by the 2009 Recovery Act — including the “Making Work Pay” tax credit and an exclusion from tax of the first $2,400 in unemployment benefits — were in effect. Together, these developments removed millions of Americans from the federal income tax rolls. Both of these temporary tax measures have since expired.
  
  In a more typical year, 35 percent to 40 percent of households owe no federal income tax. In 2007, the figure was 37.9 percent.

• The 51 percent figure covers only the federal income tax and ignores the substantial amounts of other federal taxes — especially the payroll tax — that many of these households pay . As a result, it greatly overstates the share of households that do not pay any federal taxes. Data from the Urban Institute-Brookings Tax Policy Center show only about 14 percent of households paid neither federal income tax nor payroll tax in 2009, despite the high unemployment and temporary tax cuts that marked that year.

• This percentage would be even lower if federal excise taxes on gasoline and other items were taken into account.

• Most of the people who pay neither federal income tax nor payroll taxes are low-income people who are elderly, unable to work due to a serious disability, or students, most of whom subsequently become taxpayers. (In a year like 2009, this group also includes a significant number of people who have been unemployed the entire year and cannot find work.)

• Moreover, low-income households as a whole do, in fact, pay federal taxes. Congressional Budget Office data show that the poorest fifth of households as a group paid an average of 4 percent of their incomes in federal taxes in 2007 (the latest year for which these data are available), not an insignificant amount given how modest these households’ incomes are — the poorest fifth of households had average income of $18,400 in 2007. The next-to-the bottom fifth — those with incomes between $20,500 and $34,300 in 2007 — paid an average of 10 percent of their incomes in federal taxes.

• Even these figures understate low-income households’ total tax burden, because these households also pay substantial state and local taxes. Data from the Institute on Taxation and Economic Policy show that the poorest fifth of households paid a stunning 12.3 percent of their incomes in state and local taxes in 2010.

• When all federal, state, and local taxes are taken into account,the bottom fifth of households paid 16.3 percent of their incomes in taxes, on average, in 2010. The second-poorest fifth paid 20.7 percent.

It also is important to consider who the people are who don’t owe federal income tax in a given year.

• Some 70 percent of people who owe no federal income tax in a given year are low-income working households. These people do pay payroll taxes, as well as federal excise taxes (and, as noted, state and local taxes). Most of these working households also pay federal income tax in other years, when their incomes are higher — which can be seen by looking at the low-income working households that receive the Earned Income Tax Credit (see next bullet).

• The majority of EITC recipients receive the credit for only one or two years at a time, such as when their incomes drop due to a temporary layoff; they pay federal income tax in other years. In fact, EITC recipients pay much more in federal income taxes over time than they receive in EITC benefits. A leading study of this issue found that taxpayers who claimed the EITC at least once during an 18-year period paid a net $473 billion in federal income tax over that period (in 2006 dollars). This finding shows that — while in any single year some taxpayers will receive refundable tax credits whose value may exceed their payroll tax liability — EITC recipients as a group pay significant federal income taxes over time in addition to the payroll and state and local taxes they pay each year.

• The fact that most people who do not pay federal income tax in a given year do pay substantial amounts of other taxes, and also are net federal income taxpayers over time, belies the claim that households that don’t owe income tax will form bad policy judgments because they ostensibly “don’t have any skin in the game.”

• The federal tax system is progressive overall, but state and local tax systems are regressive and undo a significant share of that progressivity. There is nothing wrong with having one part of the overall tax system shield low- and moderate-income households, who pay substantial amounts of other taxes and who generally pay federal income tax as well in other years.

To significantly increase the share of households that owe federal income tax, policymakers would have to take such steps as lowering the personal exemption or standard deduction — which would tax many low-income working families into, or deeper into, poverty; weakening the EITC or Child Tax Credit, which would significantly increase child poverty while reducing incentives for work over welfare; or paring back the tax exclusion for Social Security benefits, which would subject more seniors with small, fixed incomes to the income tax.

This analysis now explores these issues in more detail.

Oft-Cited 51 Percent Figure Is Temporary Spike Caused by Recession

In a typical year, roughly 35-40 percent of households have no net federal income liability; in 2007, the figure was 37.9 percent. In 2009, however, two factors combined to cause a large, temporary spike in the share of Americans with no net federal income tax liability — the recession, which reduced many people’s incomes, and several temporary tax cuts that have now expired. The 51 percent figure reflects these temporary factors.

• Recession-induced decline in incomes. In 2009, unemployment was at its highest level in decades and rising sharply, and incomes were falling. Income tax liabilities are designed to adjust to these cyclical factors, rising when the economy is strong and falling when it is weak; this automatic adjustment helps to stabilize the economy by cushioning the drop in people’s after-tax incomes — and thus their spending — during a downturn. One consequence of the economic downturn was a sharp decline in both federal and state tax receipts, as millions of workers lost their jobs or had their work hours reduced. For many Americans, the loss of income meant that while they owed federal income taxes in 2008, they did not in 2009.

• Temporary tax cuts. Policymakers responded to the deep economic contraction by enacting policies to stimulate consumer demand, including targeted public investments and temporary tax cuts that removed millions more Americans from the tax rolls. Roughly 95 percent of working families benefited from the Recovery Act’s Making Work Pay tax credit, which reduced their federal income tax liability by $400 for individuals and $800 for married couples. For some of these people, the tax credit eliminated their federal tax liability. Other temporary income tax cuts, including the exclusion of the first $2,400 in unemployment insurance benefits and a first-time homebuyer tax credit, eliminated federal income tax liability for additional taxpayers.

In other words, the federal income tax system did what it is supposed to do during the recession — take a smaller bite out of people’s incomes. As the temporary tax cuts expire and the economy and incomes strengthen, people’s tax liabilities will rebound (see Figure 1).

Lower-Income People Pay Considerable Payroll, State, and Local Taxes

The notion that “half of Americans don’t pay taxes” not only overstates the share of households that do not pay federal income taxes in a typical year. It also ignores the other taxes people pay, including federal payroll taxes and state and local taxes.
Policymakers, pundits, and others often overlook this point. At a hearing last month, Senator Charles Grassley said, “According to the Joint Committee on Taxation, 49 percent of households are paying 100 percent of taxes coming in to the federal government.” At the same hearing, Cato Institute Senior Fellow Alan Reynolds asserted, “Poor people don’t pay taxes in this country.” Last April, referring to a Tax Policy Center estimate of households with no federal income tax liability in 2009, Fox Business host Stuart Varney said on Fox and Friends, “Yes, 47 percent of households pay not a single dime in taxes.” None of these assertions are correct. As the Tax Policy Center’s Howard Gleckman noted regarding TPC’s estimate that 47 percent of Americans owed no federal income tax in 2009, “rarely has a bit of data been so misunderstood, or so misused.” Gleckman wrote:
Let me explain — repeat actually — what [the 47 percent figure] means: About half of taxpayers paid no federal income tax last year. It does not mean they paid no tax at all. Many shelled out Social Security and Medicare payroll taxes. In fact, only 14 percent of Americans didn’t pay either income or payroll taxes. Some paid property taxes and, it is fair to say, just about all of them paid sales taxes of one kind or another. So to say they pay no taxes is flat wrong.

The reality is that the income tax is one of a number of types of taxes that individuals pay, both over the course of their lifetimes and in a given year, and it makes little sense to treat it as though it were the only one that matters. Some 86 percent of working households pay more in payroll taxes than in federal income taxes. In fact, low- and moderate-income people pay a much larger share of their incomes in federal payroll taxes than high-income people do: taxpayers in the bottom 20 percent of the income scale paid an average of 8.8 percent of their incomes in payroll taxes in 2007, compared to just 1.6 percent for taxpayers in the top 1 percent of the income distribution (see Figure 2).

In addition, Congressional Budget Office data show that lower-income households pay a significantly larger share of their incomes in federal excise taxes (levied on goods such as gasoline) than middle- and upper-income households do.

When all federal taxes are considered, it is clear that the overwhelming majority of Americans pay such taxes. The poorest fifth of households paid an average of 4 percent of their incomes in federal taxes despite their low incomes in 2007, while the next fifth paid an average of 10 percent of income in federal taxes.
Low-income families also pay substantial state and local taxes. Most state and local taxes are regressive, meaning that low-income families pay a larger share of their incomes in these taxes than wealthier households do. The bottom fifth of taxpayers paid 12.3 percent of their incomes in state and local taxes in 2010, according to the Institute on Taxation and Economic Policy (ITEP) model. That was well above the 7.9 percent average rate that the top 1 percent of households paid (see Figure 3).

Considering all taxes — federal, state, and local — the bottom 20 percent of households paid an average of just over 16 percent of their incomes in taxes (12.3 percent in state and local taxes plus 3.9 percent in federal taxes) in 2009. The next 20 percent paid about 21 percent of income in taxes, on average. In fact, when all taxes are considered, the share of taxes that each fifth of households pays is similar to its share of the nation’s total income. The tax system as a whole is only mildly progressive.

Policy Options to Force People with Low Incomes to Pay Federal Income Tax Are Unsound
Some have implied or suggested that people who do not owe federal income tax are “freeloaders” who don’t have a “stake in the system” and that making them pay federal income taxes would improve the tax code. Yet the vast majority of the people who owe no federal income taxes fall into one of three categories (see Figure 4):

• Approximately 70 percent are working people who pay payroll taxes. As noted above, even the low-income households in this group pay substantial federal income taxes over time. The main options to force these people to pay federal income tax in years when their incomes are low include cutting the EITC or the Child Tax Credit, which would tend to reduce work incentives and increase child poverty and welfare use, and lowering the standard deduction or personal exemption, which could tax many low-income working families into, or deeper into, poverty.

• An additional 17 percent of people who did not pay federal income taxes in 2009 are people aged 65 or older. The main option to make these individuals pay federal income tax would be to subject their Social Security benefits to taxation.

• The remaining 13 percent consists largely of students, people with disabilities, the long-term unemployed, and others with very low taxable incomes. To make these people pay federal income taxes, policymakers would have to tax disability, veterans’, and similar benefits or make full-time students and the long-term jobless individuals borrow (or draw from any available savings) to pay taxes on their meager incomes.

In short, the kinds of policy changes that would impose federal income taxes on these groups of people would make the overall tax system less fair and less sensible, not more so. An examination of the EITC illustrates this point, as the next section explains.

Corporations and Small Business Owners Also Pay No Income Tax During Bad Years

As this report notes, in addition to paying other taxes each year (many of which involve significant tax burdens), most people who do not pay federal income tax in a given year do pay that tax over time. For example, more than half of the tax filers who received the EITC between 1989 and 2006 received the credit for no more than a year or two at a time and generally paid substantial amounts of federal income tax in other years.^* In fact, the taxpayers who claimed the EITC during this 18-year period paid $473 billion in net federal income tax over that period (in 2006 dollars) even after taking the EITC payments they received into account.

The tax-paying record of both large corporations and small businesses follows an analogous pattern — in some years no taxes are paid, while in other years substantial taxes are paid. During the years when they have net operating losses, companies that are subject to the corporate income tax generally have no tax liability.

A GAO study found that in every year from 1998 to 2005, approximately 55 percent of large corporations paid no corporate income tax. ^** But just 2.7 percent of large corporations reported no net tax liability in all eight of those eight years. This reflects a similar pattern as applies to families and individuals — those who do not pay income tax in a given year often do pay income tax over time.

This pattern also applies to small business owners and others who deduct business losses from their taxable incomes and thereby eliminate their income tax liability in some years.

* Tim Dowd and John B. Horowitz, “Income Mobility and the Earned Income Tax Credit: Short-Term Safety Net or Long-Term Income Support,” Public Finance Review (forthcoming).
** Large corporations are those with at least $250 million in assets or $50 million in gross receipts. Government Accountability Office, “Comparison of the Reported Tax Liabilities of Foreign- and U.S.-Controlled Corporations, 1998-2005,” July 2008, http://www.gao.gov/new.items/d08957.pdf.

Cutting the EITC Would Discourage Work and Increase Poverty

From its roots as an idea from conservative economist Milton Friedman several decades ago, the EITC has become an increasingly important tool to make work pay more than welfare and enough to lift people working full time at the minimum wage out of poverty. Research has demonstrated the EITC’s effectiveness. Nobel laureate (and noted conservative economist) Gary S. Becker has written, “Empirical studies confirm . . . that the EITC increases the labor force participation and employment of people with low wages because they need to work in order to receive this credit.” (Becker also has applauded the EITC for being “fully available to families with both parents present, even where only one works and the other cares for their children [i.e., for being available to low-income working families with stay-at-home mothers].”)

Studies of the EITC expansions of the 1980s and 1990s found those expansions induced more than half a million people to enter the labor force. One prominent study identified the EITC as “a particularly important contributor to both the recent decrease in welfare use and the recent increase in employment, labor supply, and earnings” among female-headed families. The creation of the refundable component of the Child Tax Credit, which like the EITC is available only to families that work, has complemented the EITC’s pro-work efforts. Moreover, the EITC and the refundable Child Tax Credit together lifted 7.2 million people out of poverty in 2009, including 4 million children. These refundable credits lift more children out of poverty than any other program or category of programs at any level of government.

Several factors reinforce the importance of these credits in promoting and rewarding low-wage work. In recent decades, incomes in the United States have grown increasingly unequal, with the lion’s share of the economic gains from globalization, advances in technology, and the like accruing to those on the upper rungs of the income ladder. CBO data show that the average income among people in the lowest income fifth was $17,700 in 2007; if all incomes had grown at the same rate since 1979, that figure would have been $6,000 higher. Our economy benefits from globalization and technological change, but there are winners and losers. The refundable tax credits help to offset a portion of the effects of the stagnation of wages at the bottom of the income spectrum.

In addition, the weak labor market is likely to continue exerting downward pressure on wages over the next several years. The unemployment rate remains stubbornly high, at 9 percent in April 2011. CBO projects that it will not drop to under 6 percent until 2015. Taking note of the current bleak employment picture facing out-of-work men, columnist David Brooks recently wrote that “wage subsidies” should be on the list of future policy responses. The EITC is a much-needed wage subsidy for low-income workers (although the EITC for poor workers without children remains very small and could be strengthened).
Finally, over the past several decades, policymakers have essentially relied more on the EITC to supplement low wages and less on the minimum wage, which they have allowed to decline by 19 percent in purchasing power since 1970 (i.e., the minimum wage has fallen by 19 percent in inflation-adjusted dollars).

For all of these reasons, scaling back the EITC in order to require more low-income working households to pay federal income taxes would be a significant step backward, discouraging work and increasing poverty.