Taxes & Bar Stool Economics
A friend sent me an email with the treatise below in it. As this is the fourth time this particular missive has come to me, I'm tackling it once and for all here and now. The body of the email goes like this:
This piece is variously placed in a bar, a restaurant, and a golf course; the authorship is similarly suspect. But what about the economics? Is that sound?Suppose that every day, ten men go out for beer and the bill for all ten comes to $100. If they paid their bill the way we pay our taxes, it would go something like this:
So, that's what they decided to do. The ten men drank in the bar every day and seemed quite happy with the arrangement, until one day, the owner threw them a curve. "Since you are all such good customers," he said, "I'm going to reduce the cost of your daily beer by $20." Drinks for the ten now cost just $80.The first four men (the poorest) would pay nothing.
The fifth would pay $1.
The sixth would pay $3.
The seventh would pay $7.
The eighth would pay $12.
The ninth would pay $18.
The tenth man (the richest) would pay $59.The group still wanted to pay their bill the way we pay our taxes so the first four men were unaffected. They would still drink for free. But what about the other six men, the paying customers? How could they divide the $20 windfall so that everyone would get his fair share?
They realized that $20 divided by six is $3.33. But if they subtracted that from everybody's share, then the fifth man and the sixth man would each end up being paid to drink his beer.
So, the bar 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.
And so:
Each of the six was better off than before. And the first four continued to drink for free. But once outside the bar, the men began to compare their savings.The fifth man, like the first four, now paid nothing (100% savings).
The sixth now paid $2 instead of $3 (33% savings).
The seventh now pay $5 instead of $7 (28% savings).
The eighth now paid $9 instead of $12 (25% savings).
The ninth now paid $14 instead of $18 (22% savings).
The tenth now paid $49 instead of $59 (16% savings)."I only got a dollar out of the $20," declared the sixth man. He pointed to the tenth man, "But he got $10!"
"Yeah, that's right," exclaimed the fifth man. "I only saved a dollar, too. It's unfair that he got ten times more than I did!"
"That's true!" shouted the seventh man. "Why should he get $10 back when I got only two? 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 the tenth man didn't show up for drinks, so the nine sat down and had beers without him. But when it came time to pay the bill, they discovered something important. They didn't have enough money between all of them for even half of the bill!
And that, ladies and gentlemen, journalists and college professors, is how our 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 any more. In fact, they might start drinking overseas where the atmosphere is somewhat friendlier.
Not really. You see, what this piece ignores is the purpose of the tax code. If you are like most people, you probably think that the idea behind taxes is to pay the government's bills [1]. But, in the words of my structural geology professor, that answer is correct but not complete because taxes do more than pay bills. They also shape our society.
The way the American tax code is structured (progressive, income-based) is intended to increase the number of times that money changes hands, thus creating wealth and increasing the size and prosperity of the middle class. Thus, by taxing those who would use the money to concentrate wealth as opposed to those who would use it to create wealth, the tax code creates a stronger America. This can be seen in many places from unemployment to the size of the deficit [2].
Here's a quick check on the statement. During Clinton's terms, the tax rate was higher on those earning more than $200,000/year than it is now. During Clinton's terms, the deficit became a surplus and the national debt was paid down. During Bush's terms, the tax rate was reduced, most dramatically for those earning over $200,000/year. During the same time period, the surplus became the largest deficits in history, and the national debt doubled. Which of these two eras do you think did the most to strengthen America? Which did the most to strengthen the middle class? Are you better off now than you were ten years ago? If you are like the average American, then your answer to that is probably a resounding "No!". Similarly, during Reagan's tax cut and spend era, the USA changed from the world's largest creditor nation to the world's largest debtor nation. Thus, we can say that lower taxes in and of themselves do not create wealth or a more stable society [3].
There are undeniable problems with the current tax code. It is too complex and incomprehensible [4]. It has too many loopholes for special interests [5]. It treats different types of income vastly differently [6,7]. And, most importantly, it doesn't completely fund the government [8]. Other tax codes have been proposed, but they are usually either impractical or worse for the middle and lower classes than the current code.
The most popular of these is the soi disant "flat tax". Its chief virtue is its simplicity [9]; everyone, from the poorest banker to the richest farmer, would pay at the same rate. This would either be done as a simple tax on income or as a more abstract tax on consumer goods. However, in any variation the flat tax has several problems.
The first and foremost of this is the tax rate that would be needed. Let us assume that we replace the current structure with a flat tax that is "revenue neutral"; that is, one that does not increase the deficit. The proposed 2008 US budget is $2,758,000,000,000 and the mean US income in 2006 was $66,570 for the 116,011,000 households reporting income. That makes a total income of $7,722,852,270 (ignoring corporate income taxes, licensing costs, fines, fees, and so forth). In order to generate the needed amount using a flat tax, we would have to tax everyone at a flat rate of 36%. If we assume that corporations also pay income tax at the flat rate, then that brings the flat rate down to about 28%. In effect, a flat tax is a tax hike for all but the wealthiest.
As a sales tax, the problem is even worse. That's because sales taxes are inherently regressive; that is, they cost more if you are poor than if you are rich, both in absolute terms (as total dollars spent) and relative terms (as a proportion of the household income). Sales taxes are easier on those with abundant resources in absolute terms because they can easily commute to where resources cost less and because they can buy in bulk, allowing them to wait for market prices to decrease. If I have to pay $2 for a 5 lb bag of sugar, and you pay just $8 for a 50 lb bag, my tax rate would be higher than yours. Sales taxes are easier on those with abundant resources in relative terms because the proportion of income used just to survive is lower; if I earn $10,000/year and have to spend $7,000 on my rent, car, and food, but you earn $50,000/year and spend just $14,000 on your rent, car, and food, at a nominal tax rate of 30% on sales, my effective tax rate would be ($8000*.3/$10000=) 24% and yours would be ($16000*.3/$50000=) 9.6%. The situation would lead to concentration of wealth [10], because at the end of the year, I would have but $900 to invest, whereas you would have $31,800.
So where does this leave our mythical rich man drinking with his poorer buddies? Pretty much where they were in the first place. If we assume that the primary purpose of taxation is to fund the government (which protects rich as well as poor) and that the secondary purpose is to encourage the creation of wealth, then here's the way the piece should have been written:
JohnSuppose that every day, ten men go out for beer and the bill for all ten comes to $100. If they paid their bill the way we pay our taxes, it would go something like this:
So, that's what they decided to do. The ten men drank in the bar every day and seemed quite happy with the arrangement, until one day, the owner threw them a curve. "Since you are all such good customers," he said, "I'm going to reduce the cost of your daily beer by $20." Drinks for the ten now cost just $80.The first four men (the poorest) would pay nothing.
The fifth would pay $1.
The sixth would pay $3.
The seventh would pay $7.
The eighth would pay $12.
The ninth would pay $18.
The tenth man (the richest) would pay $59.The group still wanted to pay their bill the way we pay our taxes so the first four men were unaffected. They would still drink for free. But what about the other six men"”the paying customers? How could they divide the $20 windfall so that everyone would get his fair share?
They decided that "fair share" meant changing the amount so that most of them had the chance to save up more and become rich. So, the bar owner came up with the new payment plan. And so:
Each of the six was better off than before. And the first four continued to drink for free. Once outside the bar, the men began to compare their savings.The fifth man, like the first four, now paid nothing (100% savings).
The sixth now paid $1 instead of $3 (67% savings).
The seventh now pay $3 instead of $7 (57% savings).
The eighth now paid $7 instead of $12 (42% savings).
The ninth now paid $15 instead of $18 (17% savings).
The tenth now paid $54 instead of $59 (8% savings)."What should I do with my extra money?" asked the sixth man.
"Yeah, that's a good question!" exclaimed the fifth man. "I've got an extra couple of bucks "“ what should I do?"
"Save it" advised the tenth man. So they all saved their extra money for a month, then went and spent it on another round of beer. As a result, the bar tender was able to make more profit, which allowed him to lower his prices further. And the men were able to drink more often for less money. And that made everyone very happy indeed.
[2] Many people confuse the deficit (how much the annual budget lacks) with the national debt (the total of all deficits and surpluses over time). They claim that because a deficit can have good effects, such as stimulating the economy through increased government spending as the New Deal did, a debt must also be good. What they miss is that a series of deficits can create a debt so large that no country can get out of it [a], crippling the very stimulus that it created in the first place.
[3] If you are truly interested in the questions of the economics of taxes, there is abundant literature in the field on the topic. Happy reading!
[4] You may be aware of the annual "tax challenge" where trained tax preparers, people who fill out these forms for a living, are asked to fill out the taxes for a hypothetical family. These agents typically have results that can vary by as much as $2000. If even the professional players can't figure out the rules of the game, isn't it time to simplify it?
[5] Should we subsidize hybrid cars? What about hummers? Or charities? These special deductions are where the society shaping aspect of taxes becomes most obvious.
[6] If you earn $100,000 at your job, it is taxed at 28%. If you get $100,000 in dividends, it is taxed at 15%. If you get $100,000 in capital gains, it is taxed at 15% unless it is from the sale of property (25%), the sale of small business stock (28%), or the sale of collectibles (28%). Are you confused yet?
[7] The original rationale for this was to encourage people to invest in long-term projects. Now it encourages businesses to churn their stock so that they can take the 15% tax rate instead of the 28%.
[8] Yes, the other side is that government spending should decrease so that there is no annual deficit except in economic emergencies. But, given the way that Congress is set up, there is no way that will ever happen "“ pork is too much fun and too good a way of ensuring re-election for it to ever end.
[9] Though if anyone expects that simplicity to last beyond the first session of Congress, they should put down their joint right now.
[10] Concentration of wealth is generally considered to be a bad thing economically speaking because it reduces the opportunities to generate new wealth. Socially, it is a bad thing as it creates a more rigid class system (think Irish farmers and English landlords, or Southern sharecroppers and landowners), which stifles innovation and invention.
[a] Countries cannot declare bankruptcy under modern international law. Nor can they claim that they are not responsible for the acts of previous rulers, even if the previous ruler was a dictator thrown out by a popular uprising. The bankers want their money and they don't care who pays.
Comments
When I first read that story, I thought I knew where you were going this, and I was prepared to...well, to write basically the rest of the post that you wrote. What a pleasant surprise to find something well written and well considered. You have pleased the almighty GinBaby. Let us have the much-discussed beer now.
Given the subtlety of this point, perhaps I should make it more obvious to non-economics majors. Right after I finish off that beer...
John
I would say what we are discussing here isn't economics so much as is it psychology. And you are on much shakier ground in terms of being able to predict the outcome.
In short, you are making the assumption that these men think about money like you and I do. If you've been paying attention to the world around you it should be easy to see that we are the exception, not the rule.
John
In the real world, these are all good outcomes from the viewpoint of the secondary purpose of taxes (to build wealth by moving money through the economy). But in the fable, they all involve spending their money outside the bar; i.e., putting it in countries other than the US (which was the "moral" of the original). In the fable, the only choices given were drink here, save your money, or drink somewhere else.
Well, I make the assumption that they think about finances as we do, which is not that unrealistic. I doubt that they think about money much more than the average person. After all, if they truly thought about money, they'd ask the bartender how long he can stay open if he sells $100 worth of drinks for $80...
John
Picky, picky, picky. 8:-)
My thinking is it would be too drastic to implement all at once.
If we include rebates for the poor, then this simply increases both the actual and the effective tax rate while shifting the burden from the poor to the middle class. Under the "Fair tax" plan, the consumer unit would have had to spend $69,910 once the new sales taxes went into effect, in order to buy the same amount of consumer goods. So what is the net effect? The middle class sees a huge effective tax rate hike, while the upper classes see modest to no increases - and corporations get off without any taxes at all (as only retail sales and goods are taxed).
Here are the specifics if everybody pays [2]:
Number Spending Income FT=30% ETR FTA FT=50% ETR FTA
23,441,000 $19,120 $9,676 198% $5,736.0 59% $134,457,576,000.0 $9,560.0 99% $224,095,960,000.0
23,477,000 $28,921 $25,546 113% $8,676.3 34% $203,693,495,100.0 $14,460.5 57% $339,489,158,500.0
23,448,000 $39,098 $42,622 92% $11,729.4 28% $275,030,971,200.0 $19,549.0 46% $458,384,952,000.0
23,497,000 $54,354 $67,813 80% $16,306.2 24% $383,146,781,400.0 $27,177.0 40% $638,577,969,000.0
23,494,000 $90,469 $147,737 61% $27,140.7 18% $637,643,605,800.0 $45,234.5 31% $1,062,739,343,000.0
117,357,000 $1,633,972,429,500.0 $2,723,287,382,500.0
Where ETR is the "effective tax rate" (taxes divided by income) and FTA is the "Fair tax Amount" (amount collected under the program).
Let's modify this so that the folks in the lowest 20% are excluded:
Number Spending income S/I 0.33 ETR FTA
23,441,000 $19,120 $9,676 198% $- 0% $-
23,477,000 $28,921 $25,546 113% $9,543.9 37% $224,062,844,610.0
23,448,000 $39,098 $42,622 92% $12,902.3 30% $302,534,068,320.0
23,497,000 $54,354 $67,813 80% $17,936.8 26% $421,461,459,540.0
23,494,000 $90,469 $147,737 61% $29,854.8 20% $701,407,966,380.0
117,357,000 $1,649,466,338,850.0
Notice that the etr has gone up for everyone that pays taxes, but that it has gone up the most for the people who earn the least. If we exclude the lowest 40%, the situation gets even worse:
Number Spending income S/I 0.38 ETR FTA
23,441,000 $19,120 $9,676 198% $- 0% $-
23,477,000 $28,921 $25,546 113% $- 0% $-
23,448,000 $39,098 $42,622 92% $14,857.2 35% $348,372,563,520.0
23,497,000 $54,354 $67,813 80% $20,654.5 30% $485,319,256,440.0
23,494,000 $90,469 $147,737 61% $34,378.2 23% $807,681,900,680.0
117,357,000 $1,641,373,720,640.0
So think about it. If your "consumer unit" (i.e., family) makes $46,000/year, then you would be taxed at 35% under the "Fair Tax" plan, while Romney's would be taxed at 23%. Is that truly fair?
John
[1] The legislation, HR 25, specifically calls for a 30% tax rate (23% of the total bill, tax inclusive); however, this is not enough to make it revenue neutral. The 75% found above is a BOTE calculation; economists have estimated that a more exact value lies near 40%, based on estimated rates of evasion and other factors.
[2] Try turning this into an excel spreadsheet for true geek fun!
John
Thanks. 8:-)