Can You Explain How Taxes Work?

While scrolling through Facebook this evening, I noticed a link to “Chicks on the Right“, which in turn linked to The Federal Papers Project. The subject of the post was a “perfect” explanation of how taxes work. Having arguably a working knowledge of the federal tax arena, I immediately read the article, expecting some farcical take on taxes – poking fun at the system. What I read was indeed a farce:

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Over the years, I’ve realized I’m something of a libertarian – I’ve got certain conservative leanings and have developed liberal tendencies as well. My inner-conservative screamed when I read this, but not in support of the idea behind the post, but the egregious oversimplification and lack of understanding of basic tax system. No – there’s no logic here, just intellectual dishonesty.

Let me put forward a more realistic, albeit not perfect, example of how taxes work, at least from a federal level (state and local taxes are another beast entirely):

Ten friends go to a club. At the door, the bouncer tells everyone to open their wallets and pay their cover charge of 8.5% of whatever is in their wallets. This is the Social Security / Medicare payment.

Friend #1 gets into the club for free because his wallet is empty. These are your unemployed, disabled, or student citizens. Everyone else pays their cover and gets into the club.

Once in the club, the manager, Iris (get it?), welcomes everyone and asks to look inside their wallets. Iris writes down the amounts in everyone’s wallets and starts leading them through the club. They walk up to a set of velvet ropes, where Iris turns around and says that Friends #2, #3, #4, and #5 need to stay here in the front of the bar. There are free chips/pretzels (they might be a little stale) as well as some complimentary domestic beers (in plastic cups), but they can’t go any further into the club. This is the approximately 40% of Americans who don’t make enough to pay federal income tax.

Friends #6 through #10 are led into a more prestigious VIP Lounge of the club where they are free to stand, but can pay for all kinds of seating to be more comfortable: bar stools, comfy chairs, and cushy couches. There aren’t any free chips/pretzels or beer. Instead, they’re told they can order anything they want out of a kitchen at the menu price. At the end of the night, Iris will take a percentage out of their wallet as a “service fee” – and no, they can’t go back out and join their friends. As a consolation, if they order any “specials” of the menu, they’ll get a discount on their bill. Welcome to the progressive tax system.

Friends #6 through #10 all have a different income and different expenditures throughout the night, but on average, hand over another 10% of what’s in their wallets at the end of the night.

So how do tax breaks play into all of this?

Well, the next week when the friends return, they still have to pay the same cover charge. Iris greets them again and leads them to the velvet rope. Before separating the group as she did last time, she lets them know the service fee in the VIP Lounge has been reduced. However, this means there are no longer any free chips/pretzels or domestics at the front of the bar. Now, the friends at the front of the bar have access to the same menu as the friends in the VIP Lounge, but still won’t be charged a service fee. All the friends are left looking at one another as Iris smiles and backs away.

That’s one of the dilemmas we face as a society: balancing “public welfare” (and that’s not a naughty word, in most cases) with the ideals of capitalism. If you cut taxes, you have to cut something else – but what? That’s basic fiscal responsibility. Personal income tax cuts are a short-term stimulus when the economy is doing well, and other tax revenue is coming in, but in the current economic state, the focus should turn elsewhere: what is Iris really spending on overhead?