There's been a reasonably common theme recently that low income Americans pay so very little tax compared to wealthy Americans that it's unfair to wealthy Americans. Hell, Rick Perry even basically argued that the fact that 50% of Americans do not pay the federal individual income tax is a great sin. This discussion seems to have melded into a single line of "Half of Americans aren't paying any taxes". What some have suggested is slashing and burning the individual income tax deductions, exemptions and credits to make marginal rates more closely resemble effective rates, and this would be the revenue raising tax reform that might emerge from the deficit debate.
On the face of it, this argument has appeal, as does the flat tax argument. Everyone pays the same percentage on all of their income. It has a visceral effect on most people that hear it. Without thinking anything more, it will tickle their hearts and their guts with a warm sense of justice. No games or adjustments, just a single rate.
Well, first off, I think that one does have to look at the entirety of the tax system in the United States, from local taxes all the way up the spectrum. After all, higher levels of government provide significant support to lower levels of government. The federal government provides significant support to state governments in the form of Medicaid, child welfare, transportation, and environmental expenditures in particular. State governments in turn provide significant aid to their local governments in the form of school aid and aids to counties and municipalities. In 2008, state governments got close to $450 billion of their $1.6 trillion in intergovernmental revenue while local governments got $524 billion out of $1.5 trillion of their revenue from intergovernmental revenue. However, excluding the state transfers to the locals, one can look at the Feds as giving $481 billion to both state and local governments together, or just shy of 1/5th of all state and local revenues.
As such, one must look at the entirety of public finance. If you look at the whole thing, one must include not only federal income tax, but state income taxes, state sales taxes, local property taxes and even user fees. Use fees and charges brought in $373 billion at the state and local level in 2008 and thus pay for a substantial portion of government services. All of the state and local level taxes are, at best, a wash in terms of progressivity. User fees are quite regressive as are gasoline taxes and other excise taxes as they do not discount their costs at all on ability to pay. Taken together, the state and local side of public finance certainly does not spare the poor and the middle class from paying "their share".
Then let us move on to the federal level. Here, FICA taxes bring in nearly as much as individual income taxes these days and most of that burden is borne by people earning less than $75k a year. Indeed, with FICA the effective tax rates are higher on low income earners than they are on high income earners (those making more than $106,800) due to the wage cap on Social Security taxes.
I am not arguing that the tax system overall is not progressive, though the favorable rates of taxation on capital gains and dividends (both presently taxed at 15% regardless of income levels for long-term capital gains and qualified dividends) make the federal side slightly less progressive than it first appears. Except at the very high end, effective tax rates, all things being included, do tend to rise with income, but it isn't as simple as just looking at individual income taxes at the federal level.
Leaving all of that aside for the moment, let's just look at the individual income tax, which seems to be the focus at this time. The primary concern seems to be that low income earners, those earning less than $35,000 a year in particular, have it particularly easy as they pay anywhere between little and no tax, or even get a refund due to the child tax credit and the EITC. Coupled with deductions and exemptions, these credits mean that taxpayers up to a fairly high threshold will not pay taxes.
Working through the exercise, for a married couple the present standard deduction is $11,600. On top of that, there are exemptions of $3,700 per family member. Let's say that they have two kids, so a total of four times $3,700 for $14,800. Taking that together, $26,400 of this hypothetical family's income is not subject to federal income tax. If they have a total income of $40,000 (pretty typical), they will only have taxable income of $13,600. On this, a 10% tax rate is applied, or $1,360. However, the combination of the EITC, of which they would get a small amount, plus the child tax credit, will eliminate their federal income tax liability. Somehow, this is supposed to be a scandal. Some would look at the exemptions and standard deduction (and deductions more generally) and say "Well, there's the problem! Just get rid of those! We'd get a lot more tax revenue."
However, let's think for a moment why the exemptions and deductions are there. The idea is to shield a certain amount of income from taxation to cover certain basic expenditures. For instance, why is there a $3,700 increase in exemptions per person on a return? Well, it's an amount that correlates fairly closely with the increase in the poverty line per additional child, the idea being that a child will increase your baseline expenditures by about that much. It seems reasonable to exclude that from tax. As much as people pretend (hopefully they are pretending) not to understand the rational for the basic exemptions and deductions, there is a reason that they are there. It simply costs a certain amount to just barely get by and a great many households are at or below that point. As such, subjecting them to a flat tax of, say, 15%, on ALL of their income would dramatically increase their living costs ($6,000 in the example I used).
Using a 15% flat rate on all income as an example, a household with $40,000 a year in total income would pay $6,000 in federal income taxes while a household with income of $200,000 would pay $30,000. Needless to say, the household with the $170,000 after tax is much better able to bear the burden. As much as a flat percentage appears to be fair, it really isn't. The tax code should be based on ability to pay.
This gets to a point I always try to make. Yes, it is true that the richest ten percent have 33.5% of the income and pay 45.1% of taxes. Similarly, filers with more than $1 million in adjusted gross income have 10% of AGI, but pay 20% of taxes. However, if you look at the share of income beyond that needed to cover basic living expenditures, those numbers are a good deal different. Then, when you look at the totality of U.S. public finance, including user fees and state and local taxes, these numbers become more regressive.
The simple point is that taking the burden that the wealthy pay and shifting it downscale to even out the tax burden as a percent of income by "simplifying" the tax code does not improve tax equity. As much as it appeals to a primal sense of fairness for everyone to pay the same percentage of all of their income and not have deductions and exemptions, things would get materially worse for them. While an additional 10% on someone earning more than $300,000 hurts, it is not fatal. An additional 10% on someone earning $40,000 could be devastating.
While the theoretical examples that I used here are simply that, "theoretical", the argument that we need to broaden the base and lower the rates generally means subjecting more of the total amount of income to tax, which seems to mean hitting lower income earners. It could theoretically mean subjecting capital gains and dividend income to the same tax rate as earned income under a progressive system, but that doesn't seem to be the argument holding sway right now. People seem to be buying into a tax equity argument that has been turned on its head.