About Those 47 Percent Who Pay “No Taxes.”

Last June, my colleague Bob Williams posted a TaxVox article that reported 47 percent of American households paid no federal income tax in 2009. Bob was exactly right, but rarely has a bit of data been so misunderstood, or so misused.

Let me explain—repeat actually—what this means: About half of taxpayers paid no federal income tax last year. It does not mean they paid no tax at all. Many shelled out  Social Security and Medicare payroll taxes. In fact, only 14 percent of Americans didn’t pay either income or payroll taxes. Some paid property taxes and, it is fair to say, just about all of them paid sales taxes of one kind or another. So to say they pay no taxes is flat wrong.

However, this class warfare-like rhetoric plays to a perception that the income tax is a chump tax: Only hard-working folks like us pay it. The welfare queens don’t. The super-rich don’t. It is a powerful emotional argument. It is also flat wrong.

So who are these folks who pay no federal income taxes? Mostly, they are people who don’t make very much money. Many are elderly: Think a widow living only on Social Security benefits. Others are parents earning less than $20,000. Only about 5 percent are non-elderly households making more than $20,000. 

It is no accident, btw, that the number of people not paying income tax was so high in 2009. You may have noticed that we’ve had a recession lately. And here is a powerful insight: When people’s incomes decline so too does their income tax (at least most of the time).  At the same time, many working families have benefited from temporary tax cuts aimed at boosting the economy, and as a result some did not pay income taxes last year. As the economy improves and those tax cuts expire, it should also be no surprise that the share of people who don't pay income taxes will likely shrink from half last year to less than 40 percent by 2012.

There is, however, another reason why some people don’t pay. For decades, both Democratic and Republican governments have made conscious policy decisions to remove low-income working families from the income tax rolls. And, guess what, sometimes government policy works exactly as intended. That’s what happened this time.

Let’s take one of the biggest drivers: the Earned Income Tax Credit. Based on an idea (the negative income tax) originated by conservative icon Milton Friedman, the EITC is refundable, so that people who work for low wages can not only wipe out their income tax liability, they can even get a cash payment from the government. The EITC was enacted in 1975 under President Ford, greatly expanded in 1986 under President Reagan, and expanded again under presidents Clinton and Bush (both of them). It's been the very model of bipartisan tax policy (which, I suppose, is why some dislike it so).  

Both the EITC and the child care credit are explicitly designed to encourage people to work—a goal most of us (including Friedman and Ronald Reagan) thought was a very good thing.

While we are talking history, as my colleagues Gene Steuerle and Eric Toder remind me, big changes in the percentage of Americans who pay tax are nothing new. As Gene notes, prior to World War II, almost no Americans paid the income tax, and through the 1950s we paid only a small 3 percent Social Security tax. There was no Medicare tax since there was no Medicare. Today, the combined 15.3 percent payroll tax is pretty stiff, and just about every worker pays it, whether they owe income taxes or not. In fact, three-quarters of us pay more in payroll taxes than in income taxes. 

Let me close with two questions: Do those who reflexively oppose all tax hikes now favor raising taxes on elderly widows and low-income working families? And what would these critics of small government suggest we do with the revenue windfall this tax hike on the poor would generate? Help finance a cut in the estate tax, perhaps?  

So, as you file your last-minute returns on Tax Day, keep in mind what really is going on with the now-famous 47 percent. It may not be quite what you think.