Why Do People Pay No Federal Income Tax?

Much has been made of TPC’s estimate that fully 46 percent of Americans will pay no federal individual income tax this year. Commentators have often misinterpreted that percentage as indicating that nearly half of Americans pay no taxes. In fact, however, many of those who don’t pay income tax do pay other taxes—federal payroll and excise taxes as well as state and local income, sales, and property taxes.

The large percentage of people not paying income tax is often blamed on tax breaks that zero out many households’ income tax bills and can even result in net payments from the government. While that’s the case for many households, a new TPC paper shows that about half of people who don’t owe income tax are off the rolls not because they take advantage of tax breaks but rather because they have low incomes. For example, a couple with two children earning less than $26,400 will pay no federal income tax this year because their $11,600 standard deduction and four exemptions of $3,700 each reduce their taxable income to zero. The basic structure of the income tax simply exempts subsistence levels of income from tax.

What about the rest of the untaxed households, the 23 percent of households who don’t pay income tax because of particular tax breaks? We divided tax expenditures (special provisions in the tax code that benefit particular taxpayers or activities) into eight categories and asked which ones made the most people nontaxable. The conclusion: Three-fourths of those households pay no income tax because of provisions that benefit senior citizens and low-income working families with children. Those provisions include the exclusion of some Social Security benefits from taxable income, the tax credit and extra standard deduction for the elderly, and the child, earned income, and childcare tax credits that primarily help low-income workers with children (see graph). Extending the example offered above, the couple could earn an additional $19,375 without paying income tax because their pre-credit tax liability of $2,056 would be wiped out by a $2,000 child tax credit and $57 of EITC.

Those provisions matter most for households with income under $50,000, who make up nearly 90 percent of those made nontaxable by tax expenditures. Higher-income households pay no tax because of other provisions. Itemized deductions and credits for children and education are a bigger factor for households with income between $50,000 and $100,000. The relatively few nontaxable households with income over $100,000 benefit most from above-the-line and itemized deductions and reduced tax rates on capital gains and dividends.

Policymakers can argue about whether specific tax expenditures serve their intended purposes, whether restructuring them might improve them, and even whether we should have them at all. But they cannot argue that pruning them back or eliminating them all would result in every American paying income tax.

It’s also important to recognize that while tax expenditures push many people off the income tax rolls, they provide much larger benefits to higher-income households than to others, measured both in dollar value and as a share of income (see these TPC studies).  Rather than focusing on how relatively modest tax breaks make many of the elderly and low-income workers with children nontaxable, we should keep in mind that high-income households pay a lot less tax than they would without tax expenditures.