Sunday, January 30, 2005

A Simple Tax Analogy

This tax analogy is a real simple way to look out how the federal income tax works. It also may help those who complain that the wealthy are benefiting the most from tax breaks.

Food for Thought:
An Analogy of Tax Cuts and the Federal Income Tax System

Let's put tax cuts in terms everyone can understand. Suppose that every day, ten men go out for dinner. The bill for all ten comes to $100.00. If they paid their bill the way we pay our taxes, it would go something like this:

The first four men (the poorest) would pay nothing, the fifth would pay $1.00, the sixth would pay $3.00, the seventh $7.00, the eighth $12.00, the ninth $18.00, and the tenth man (the richest) would pay $59.00. That's what they decided to do. The ten men ate dinner in the restaurant every day and seemed quite happy with the arrangement until one day the owner threw them a curve (in tax language a tax cut).

"Since you are all such good customers," he said, "I'm going to reduce the cost of your daily meal by $20.00." Now dinner for the ten only cost $80.00. The group still wanted to pay their bill the way we pay our taxes. So the first four men were unaffected. They would still eat for free, but what about the other six, the paying customers? How could they divvy up the $20.00 windfall so that everyone would get his "fair share?"

The six men realized that $20.00 divided by six is $3.33. But if they
subtracted that from everybody's share, then the fifth man and the sixth man would end up being PAID to eat their meal. So the restaurant owner suggested that it would be fair to reduce each man's bill by roughly the same amount, and he proceeded to work out the amounts each should pay. So the fifth man paid nothing, the sixth pitched in $2.00, the seventh paid $5.00, the eighth paid $9.00, the ninth paid $12.00, leaving the tenth man with a bill of $52.00 instead of his earlier $59.00.

Each of the six was better off than before. The first four continued to eat for free. Once outside the restaurant, the men began to compare their savings. "I only got a dollar out of the $20.00," declared the sixth man, but he, (pointing to the tenth) got $7.00!" “Yeah, that's right," exclaimed the fifth man, "I only saved a dollar, too; It's unfair that he got seven times more than me!" That's true!" shouted the seventh man, “why should he get $7.00 back when I got only $2?” The wealthy get all the breaks!"

Wait a minute," yelled the first four men in unison, "We didn't get anything at all. The system exploits the poor!" The nine men surrounded the tenth and beat him up. The next night he didn't show up for dinner, so the nine sat down and ate without him. But when it came time to pay the bill, they discovered, a little late what was very important. They were FIFTY-TWO DOLLARS short of paying the bill! Imagine that!

And that, boys and girls, journalists and college instructors, is how the tax system works. The people who pay the highest taxes get the most benefit from a tax reduction. Tax them too much, attack them for being wealthy, and they just may not show up at the table anymore. Where would that leave the rest? Unfortunately, most taxing authorities anywhere cannot seem to grasp this rather straight-forward logic!


T. Davies
Professor of Accounting & Chair,
Division of Accounting and Business Law
The University of South Dakota
School of Business
414 E. Clark Street
Vermillion, SD 57069
Phone: 605-677-5230
Fax: 605-677-5427

7 comments:

Anonymous said...

I've always loved that analogy. I dig the blog bro. Keep up the good work.

-Brian

rysolag said...
This comment has been removed by a blog administrator.
Jim said...

The problem with this analogy is that it assumes that each man gets the same meal and the same service which is not analogous to the real world.

In "real life", the first four men would be eating crackers and water; the fifth a burger and soda; the sixth could afford fries with that; the seventh a steak sandwich with soup, salad and a beer; the eighth prime rib and a glass of red wine; the ninth filet mignon and a nice cabernet, and the 10th beluga caviar, rack of lamb with mint jelly, lobster, a ceasar salad and baked Alaska with a bottle of Dom Perignon. If the tenth man didn't show up, the other nine would enjoy their typical lunches as usual.

It costs a lot of money to provide the infrastructure of this country. As just one example, think about what it costs to maintain the civil aviation system and think about who gets the most use out of it--those with the money to use it. Typically (there's always the exception) those with more money get more out of the national infrastructure, get more out of government supports and regulatory protections, and have the greatest stake in the economic wellfare of the nation. They pay more and they get more.

Oh, and the other problem with the analogy is what the owner didn't tell the men is that he wasn't really subtracting $20 from their meal. He was letting them pay $20 less now but adding that $20 each day to a running tab that their kids and grandkids were going to have to pay some day.

And that's how the richest guy got his $7 a day now and the kids and grandkids got a bill for $130,000 25 years later.

CCJM said...

Those are some thoughtful considerations, Jim. Now, we could argue this stuff all day long, but instead, I think I'll just thank you for adding some dissent to The Mint Julep. That's great and it makes people, including me, think. Thats what its all about, thinking and opening people's minds.

Anonymous said...

Coley,
This analogy is brilliant and clear. I am emailing it to everyone I know.

Chris Purdy

Jim said...

Thanks for the hospitality, CCJM. I enjoy informed, non-flaming discussion.

I'll try to check back and add my take as long as it's appreciated.

Good luck with the blog!

mattjk said...

Jim you're missing the whole point of the analogy. Your comment about the difference of the meals is a little deceptive. Think of all the things paid for by tax payers. Roads, public schools,libraries, the armed services and the legal system are equaly available to everyone. County health services, public transportation, welfare, these type things are primarily used by the poor. Yes the wealthy have a greater stake in our economic welfare, but that is a result of their hard work and vision that got them wealthy. Yes, the rich live more lavishly, eat better, and enjoy more comfortable lives than the poor. But, guess what, America is the land of oportunity, and most of the wealthy got that way by taking advantage of that oportunity, working hard, making smart financial decisions, and pursuing their dreams. What right do you, I, or anyone else have to tell the rich that they make too much money and they don't deserve it!? But like I said, that isn't the point of the analogy. The resturaunt bill represents federal income taxes, and the reduction of the bill represents tax cuts. The point is that the fifth man saved one dollar, but his share of the bill was reduced by 100%, the sixth man saved a dollar, but his share of the bill was reduced by 50% and so on. The tenth man had the lowest percent reduction, but saved the most money, that's because he was paying so much more. Your counter analogy of the different meals works fine if we're talking about a literal resturaunt, but not if we're talking about the tax code. You have to assume that the meals weren't different because they agreed on the division of the bill based on how much money they had, not by what they ate, which mirrors our tax code. The amount of taxes one pays is based on their income, not how much they use government services. Now the total bill was reduced $20. But,(unlike your idea of the analogy) when the 10th man doesn't show the bill is still $80, which wouldn't make sense in a real restaraunt, but it does in our tax code. This is because if the rich don't show up to "the table" in real life, it's not going to reduce how much money the government needs by 50%, the infrastructure will still be the same price, but the rich won't be around to pay for it anymore. Think about it, you can't argue with fact. And the fact is, in 2005, the top 5%of all wage earners paid 60 percent of all income taxes. So lets look at it logically, (for you liberals logic is necessary connection or outcome, as through the working of cause and effect) take away the top 5% and you still have 95% of the population to provide services for, but 60% less revenue to provide it with. When you use logic it sure does make liberals look silly.