Tax Analysts Blog

The IRS Giveth, the IRS Taketh Away

Posted on Jul 22, 2009

When we last discussed the inadequacies of the U.S. tax system, I pointed out that roughly 43% of households paid no income tax. The Wall Street Journal picked up on the theme a few days later. Peter Ferrara's July 14 editorial The 0% Tax Rate Solution observed that the bottom 40% of households, as a group, have a negative effective income tax rate. You read that correctly -- a negative tax rate. That means instead of paying the government, the government pays you.

I'll be sure to adopt that idiom next time anyone asks whether I've put on a few pounds. "No", I'll respond, "it's just negative weight loss."

How can this be? The explanation lies in the numerous refundable credits made available through our tax code. The most prominent of these subsidies are the earned income tax credit, the child tax credit, and the recently enacted "making work pay" credit. These credits were designed, in part, to make up for the regressive aspects of our payroll tax system. The wide availability of these refunds underscores the point that our tax system functions not only as a revenue raiser, but also as an expenditure program.

That fact surprises a lot of people, and understandably so. It's difficult for most of us to picture the IRS as anyone's sugar daddy. Each year the IRS must devote a chunk of it's internal resources to giving money away, rather than collecting it. Presumably that drains IRS resources away from useful activities like catching tax dodgers who hide money in offshore bank accounts. That's a puzzling allocation of agency resources given our country's $1.8 billion deficit and skyrocketing national debt. Reasonable minds might ask whether -- if the payroll tax is not utterly intolerable -- it makes more sense to confront those regressivity concerns head on.

Ferrara notes that the total tax refunds paid to the poorest 40% of households is equal to 3.6% of all federal income tax revenues. The next segment of society -- the middle 20% of households -- pays only 4.4% of all federal income tax revenues. When you net those two amounts (receipt of 4.4% and a giveaway of 3.6%) the result is almost a wash. The bottom 60% of the country collectively pays a mere 0.8% of all income tax revenues. The wealthiest 40% of us pay the remaining 99.2%.

Should we, as Americans, be enraged over this situation? No, not really. That's how progressivity works. The lack of any meaningful income taxation on the bottom half of society shouldn't be viewed as a design flaw unless one clings to the assumption our income tax was meant to be a broad-based revenue raiser. That, my friends, is decidedly not the case.

So as our political leaders struggle to control our national debt -- which is a genuine crisis -- where should they look for the necessary revenues? Whose income taxes should be increased? Moreover, is the income tax the correct place to be looking for additional revenue?

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