Paying Taxes

"Taxes are what we pay for civilized society.'' — Oliver Wendell Holmes, Jr., U.S. Supreme Court Justice

There are very few political issues that strike a chord with Americans quite the way taxes do.  There are millions of people who vote for politicians based on that one issue alone.  “Are you going to cut my taxes?  Good, you’ve got my vote.”  There are many misunderstandings about taxation in the United States, and the details can be quite complex.

I think it would be helpful to preface our discussion on taxation and tax reform with the simple question: Why do we pay taxes?  The legal part of the answer is that the United States Constitution, in Article 1, Section 8, Clause 1, states “The Congress shall have the Power to lay and collect Taxes, Duties, Imposts and Excises to pay the Debts and provide for the Common Defense and General Welfare of the United States.”  I think it is safe to assume that the vast majority of Americans understand the need to have some form of functional government, along with an army for self defense.  You could argue for anarchy, but that is not within the purview of this discussion.  Let us instead focus on where our tax dollars actually go.

Our nation’s annual budget is made up of mandatory and discretionary spending.  Mandatory spending refers to money that is already accounted for from previously-enacted programs.  These are budget items that Congress does not have to approve or act upon each year.  Mandatory spending includes certain entitlement programs, such as Social Security, veterans benefits, Medicare, Medicaid, the Earned Income Tax Credit, SNAP (food stamps), student loans, unemployment insurance, military retirement benefits, and more.  In 2016, the government spent approximately $2.4 trillion on mandatory spending.

Discretionary spending refers to items that have to be specifically allocated by Congress each year (at Congress’ discretion).  It includes just about everything else, and in 2016 we spent about $1.2 trillion, of which just under half was military spending.  And don’t forget our hefty interest payments on the national debt (another $240 billion).  Here is a list of a few of the things we spend our discretionary money on:

  • Military

    • Missile defense

    • Advanced fighter jets

    • Unmanned aerial vehicles

    • Space-based infrared systems (used to detect enemy missile launches)

    • Aircraft carrier replacement program

    • Military personnel & bases

    • Nuclear Weapons

  • Corps of Engineers

  • Energy

    • Nuclear waste disposal

    • National Nuclear Security Administration

  • Health & Human Services

    • Centers for Disease Control & Prevention

    • National Institute of Health

    • Substance abuse and mental health services

    • Food and Drug Administration

    • Public Health Emergency Fund

  • NASA

    • Manned spaceflight

    • Hubble and James Webb  Space Telescopes

    • Jet Propulsion Laboratory (JPL)

      • Unmanned space probes

      • Mars rovers

  • Education

    • Teacher quality state grants

    • Drug free school grants

    • Reading First Program

    • Pell grants

    • Vocational education

  • Justice

    • Federal Bureau of Investigations (FBI)

    • Federal Prison System

    • U.S. Attorneys

    • Drug Enforcement Agency

    • State and local assistance

  • Agriculture

    • Forest Service

    • Conservation

    • Food and Nutrition Service

    • Rural development

  • Interior

    • National Park Service

    • Bureau of Indian Affairs

    • Fish and Wildlife Service

    • Bureau of Land Management

  • Environmental Protection Agency

    • Superfund (toxic waste cleanup)

    • Clean water fund

    • Drinking water fund

  • Transportation

    • Federal Aviation Administration

    • Federal Highway Administration

    • Federal Transit Authority

  • Housing & Urban Development

    • Housing for the elderly

    • Housing for persons with AIDS

    • Housing assistance for needy families

    • Community development grants

    • Homeless assistance grants

    • Public housing

  • Homeland Security

    • Coast Guard

    • Federal Emergency Management Agency (FEMA)

    • Border Security

  • Smithsonian Institution

  • Institute of Museum and Library Services

  • Federal Communications Commission (FCC)

  • Federal Trade Commission

  • National Endowment for the Arts/Humanities

  • Federal Election Commission

  • Securities & Exchange Commission

  • Labor

    • Unemployment Administration

    • Bureau of Labor Statistics

  • Treasury Department

    • Internal Revenue Service (IRS)

    • Financial Crimes Enforcement

  • Commerce

    • National Oceanic & Atmospheric Administration (NOAA)

    • Bureau of the Census

    • National Institute of Standards and Technology

  • State Department

    • Embassies

    • International Conferences

    • Diplomatic and Consular Programs

  • Veterans Affairs

    • Medical care

    • Burial benefits

    • Pensions

  • National Science Foundation

  • Small Business Administration

  • Peace Corps

  • Famine Fund

  • Global AIDS Initiative

  • Child Survival and Disease Programs

There is an almost endless number of programs and agencies we could be funding.  The government’s revenue – the money it collects to be able to pay for all of these things – comes from a few sources.  They are:

  • Personal income tax

  • Corporate income tax

  • Payroll taxes

    • Social Security tax

    • Medicare tax

    • Unemployment insurance tax

    • Federal employee retirement payments

  • Excise taxes

  • Miscellaneous taxes

There are also plenty of infrastructure projects we could (or perhaps should) be funding.  The nation is replete with aging and deteriorating bridges, dams, levees, schools, roads, sewer systems, water systems, etc.  According to the American Society of Civil Engineers, our overall infrastructure report card grade is a D- in 2017.  They estimate it will take an investment of $4.6 trillion to get that grade from a D- up to B.  And the National Park Service has an estimated $11.5 billion maintenance backlog.

When the government has a year when it brings in more money in revenue than it spends, it is called a surplus.  Conversely, when it spends more money that it collects, it is a deficit.  Deficits that accumulate from year to year are known as the national debt.  More on that in a bit.

So we have established the basic fact that the government needs to collect taxes in order to have the money to spend on a myriad of programs.  This raises two significant questions:

1) How should we be taxed?

2) How much should we be taxed?

Types of Taxation

In the United States, we pay income tax, which is a progressive tax with several income brackets.  A progressive tax is one which individuals who earn higher income pay a larger percentage of that income as tax.  For example, someone earning $50,000 a year might pay 25% of their wages as income tax, but someone earning $200,000 might pay 33%, instead of the same 25%.  The income levels where the percentage changes are the brackets.  In 2017, for a single American taxpayer, the rate would be 15% if you earn more than $9,325 but not more than $37,950.  Then the rate jumps to 25% up through $91,900.  After a 28% and a 33% bracket and a 35% bracket, the top bracket is 39.6%, for those making over $418,400 per year.

One might think that if he earns $38,000, and therefore pays 25%, he would do far better by dropping his salary to $37,000 and moving down into the 15% bracket.  But it does not work that way.  The taxpayer really pays that 15% on his income from $9,326 and $37,950, and then only pays the 25% on the income above that $37,950 threshold ($50, which at 25% is $12.50).  So he really does worse by lowering his salary down to the next bracket.

A regressive tax, on the other hand, is one in which a heavier burden falls on lower income individuals.  Most of us pay regressive taxes almost every day in the form of a sales tax.  Why is a sales tax regressive?  Let’s say two people purchase a new car, with a sales tax of 5%.  A man earning $30,000 a year buys a $12,000 Chevrolet, and his sales tax comes out to $600.  A woman earning $160,000 buys an Acura for $42,000.  Her sales tax amounts to $2,100.  The $600 tax is 2% of his income, while the $2,100 tax is 1.3% of her income.  So the woman making much more money buys a car that is 3.5 times more expensive yet pays a smaller portion of her income as tax than the man.  If she had purchased the same car as the man, her tax burden would have been 0.375%.  Another example of a regressive tax is a set fee (or poll tax).  If everyone in a state pays a $50 automobile registration fee, this tax is tougher for poor people to pay than wealthy people, so it is considered regressive.

A flat tax is one where everyone pays the same percentage of their income.  If every single wage-earner pays 17% of their pay as income tax, that is considered a flat tax.  It is interesting to note that the flat tax proposals that have been floating around the U.S. for many years are actually progressive taxes, in that people earning less than a certain amount do not pay anything.  This means that individuals earning higher wages pay a higher percentage than the poor, who would pay 0% - and that makes these plans all a form of progressive taxation.

Taxation has existed in various forms since biblical times.  Often it was a percentage of your crops or time spent in heavy labor that constituted your tax payment.  Julius Caesar enacted a limited inheritance tax to help pay for retirement benefits for soldiers.  Many progressive taxes were levied in Europe during the Middle Ages, and it was the British around the year 1800 who introduced the first modern-style income tax to help pay for their conflict with Napoleon. 

In America, taxation began in the form of tariffs (import and export taxes), property taxes, and excise taxes (taxes on specific products, like whiskey).  These were mainly regressive taxes, and people often rose up in opposition.  During the Civil War, Lincoln imposed the nation’s first income tax, which was progressive.  It helped finance the war, and by 1872 it was gone.  The regressive nature of the remaining taxes stirred great dissatisfaction from farmers and other workers by the end of the century, however.  In 1913, the 16th Amendment to the Constitution was ratified – thus formally authorizing Congress to levy taxes on the personal income of private citizens.  Tax rates have gone up and down, exemptions have been introduced and repealed, tax brackets have shifted around, but that same general progressive income tax remains in use today.

Does a Progressive Taxation of Income Make Sense? 

We need to start with the poor – those who earn so little that they are currently exempt from most or all taxes.  A true flat tax would impose the same taxation rate on these citizens as all others, say 17% or 20%.  If you are the type of person who blames poor people for being poor, then this approach might seem fair to you.  But even a cursory examination of reality demonstrates that most poor people are not poor because of simple laziness.  There are a plethora of reasons as to why poverty exists.  Millions of Americans, through no fault of their own, live a life in which there are extremely few opportunities to achieve a quality education and a good job.  People at greatest risk are single-parent families, the elderly, people of color, women, and children.  And just as it is wrong to assume that people are only poor because of some negative personality trait, it is equally wrong to assume that wealthy people are necessarily rich because of their intelligence and drive.  Plenty of wealthy people were born into wealthy families.  I believe most Americans would agree that our tax policy should exempt those at the bottom of the economic ladder from paying most or all taxes. 

A flat tax system in which individuals earning less than $35,000 are exempt is really just a progressive income tax with one, big tax bracket for everyone else.  For purposes of simplicity, the term “flat tax” will now refer to this type of progressive flat tax and the term “progressive tax” will refer to an income tax with graduated tax brackets (like we use today). 

The next question is whether everyone else should be taxed at exactly the same percentage of their wages or should higher-income individuals pay a greater share of their earnings.  Advocates for a flat tax say that it would simplify the tax system drastically (thus saving money), and it would be more fair because everyone (except the poor) would pay the same rate.  Proponents also argue that tax loopholes aiding corporations and rich individuals would be removed in a flat tax plan, so it would actually generate more revenue for the government.  This last argument, however, is really independent of the flat tax versus progressive tax debate – loopholes could be removed in either system.

Those who favor a progressive tax point to the relative value of each dollar earned.  For a family of four bringing in $50,000 a year, almost all of that income is used for essentials – housing, clothing, heat, education, food, etc.  Most every dollar is critical.  For a family of four where the parents earn $300,000 a year, the essentials are pretty easy to afford.  Let’s say each family takes a 10% pay cut.  The first family now makes $45,000 a year, possibly making life quite difficult.  Does our son really need braces?  How can we possibly afford piano lessons for our daughter?  How can we cut back on our grocery expenses?  If it’s a really cold winter, how much lower should we set our thermostat?

The second family now makes $270,000.  Does losing that $30,000 really affect this family the same way that losing $5,000 affected the first?  Of course not.  And it is this disparity in how much each incremental dollar is worth that highlights much of the reasoning for progressive taxation.

In a flat tax scenario, the percentage paid by higher-income workers decreases, lessening their tax burden relative to the middle-income earners.  Also keep in mind that the flat tax takes a set percentage of wages.  Wealthy individuals are much more able to earn income from other sources, including stock options, bonds, and other investments.  You don’t see too many people earning $40,000 a year with extensive investment portfolios.  These folks are earning wages.  Now picture a business owner who makes $4 million a year, but sets his actual salary at $50,000.  He would pay the fixed rate (17% or 20%) on the $50,000 amount.

On the surface, a flat tax rate sounds more fair, in that everyone except the poor pays the same exact rate.  This previous example shows, however, that a flat tax may also not always be fair.  It can also be argued that our other taxes are regressive, so that having a progressive income tax balances things out.  We have already discussed that a sales tax is a regressive tax, but so are the wage taxes such as Social Security.  They are considered regressive because they are only taxed up to a certain income level - $118,500.

The course of action that makes the most sense is not always the one that is most fair, unfortunately.  If a flat tax plan existed in which the rich actually paid that flat rate on all of their income (not just wages, but their entire portfolio) so that the tax burden did not shift drastically towards the middle income earners - and if the new flat tax rate could be implemented in such a way that would allow for a balanced budget, then that might make a lot of sense.  Otherwise, it seems that a progressive tax should remain the law of the land. 

One of the main reasons people want to reform our tax code is for simplification.  A progressive tax code with limited or no deductions or exemptions would be almost as simple as a flat tax plan with limited or no deductions.  Our tax code is millions of lines long because we keep making changes in how we define “income.”  Deductions for how many dependents you have are a way of modifying your defined income, and therefore how much tax you pay.  These income adjustments exist for a few reasons, including giving some relief to middle-class working families, providing loopholes so that wealthy individuals can shelter much of their money from taxation, and encouraging or discouraging certain behaviors in our society.  For example, charitable giving is tax-deductible.  Money you give to charity is not considered part of your income, and this tax rule encourages citizens to give money to charity.  You might say that Americans give to charity because they want to give, but that does not explain why each December there is massive flurry of charitable gift-giving in time to make it on that year’s tax returns.  There are tax deductions for savings for education, encouraging Americans to go to college.  You might receive a $2,000 tax break when you purchase a new hybrid car, like a Toyota Prius.  There are tax incentives to encourage businesses to locate new facilities in economically depressed areas.  Depreciation deductions encourage businesses to invest in long term assets and buildings.

So before we simplify everything and throw out all of this complex tax code, there ought to be a discussion as to whether or not these incentives are in fact good for society.  Perhaps we will decide that they are good in principle, but there are just too many of them.  Others will likely say that the government has no business trying to influence our behavior, so all deductions should be eliminated.  It would be a fascinating debate.

Are My Taxes Too High?

“People who complain about taxes can be divided into two classes: men and women.” 
— Unknown

There are plenty of Americans who do not care whether their tax system is flat, regressive, or progressive, or any other detail about the tax code for that matter, as long as their taxes go down.  Year after year, people complain that their taxes are too high, and it is therefore politically expedient for a candidate to declare during an election that he plans to lower taxes.  It is quite popular.  You never hear a politician proclaim, “If I am elected, I will work hard to raise your taxes!”

When taxes are too high, or when the tax system is too progressive (putting too much burden on the wealthy), it threatens to destroy the incentive to work, invest, save, and innovate.  It also lowers the spending on capital goods.  Capital goods are items used to produce other goods, and include things like tools, machinery, factories, gas turbines, research, training, etc.  Consumption goods, on the other hand, are items which are actually purchased by consumers.  Lower income individuals spend most of their money on consumption goods, while higher income individuals also spend their money on capital goods.  That does not mean that wealthy individuals are all running around buying factories, but they do invest their money, which in turn is used to build factories.  Therefore, a decrease in higher income earners’ ability to invest their money in capital goods can eventually affect the entire economy and lead to a lowering of the standard of living.

When taxes are too low, there are different consequences.  One is that the government is unable to pay for its programs, services, and other expenditures, so it must borrow the money it needs and thereby put the country into debt.  Congress also has the option of cutting back on the services provided by the government.  Some people think that taxes are never too low, and they can always be cut further.  But imagine if, due to exceptionally low tax rates, we had to disband our Marine Corps, Coast Guard, and Navy.  There just would not be enough money in the treasury to pay for them.  We could keep a watered-down Army and Air Force.  And if the rates continued to fall year after year, eventually the government would cease to exist.

Those who advocate aggressive tax-cutting counter that even though the government would be bringing in less money in tax revenue, the extra spending on capital goods by the wealthy would create enough economic growth to make up for the shortfall in the long-run.  This theory is known as supply-side economics (incentives to the suppliers of goods and services), and it suggests that when companies and wealthy individuals have more money to spend, they will create new businesses and expand old businesses.  This will in turn lead to improved productivity and employment, thus improving the overall economy.  It is also known as trickle-down economics, in that the benefits will trickle down from the top and eventually reach everyone.  Critics of supply side economics argue that it is nothing more than a hollow ploy for the rich to make more money, or that the data shows that real productivity actually fell under supply-side taxation regimes on a unit-worker basis.  They also call into question whether or not this new-found money will actually be used for investment, or will much of it simply go into the wealthy individuals’ own savings.  Perhaps the most heated aspect of the debate focuses on the massive deficits that have occurred under the Ronald Reagan and George W. Bush tax cut plans.

What makes economics so much fun is that you can always find a pair of Nobel Prize-winning economists who will reach completely opposite conclusions when viewing the same data.  If you believe that supply side economics really work, then there are plenty of economists who will show you the facts that prove it.  And if you believe that supply side economics amount to nothing more than “voodoo economics,” you will also have your pick of experts who will prove you correct.

I am not a Nobel Prize economist, so I will not attempt to explain how supply side economics is either brilliant fiscal policy or a complete disaster.  I am going to take a simpler approach.  If we agree that tax rates for middle and upper income citizens need to fall somewhere between 0% and 100% in order to have a viable society, then perhaps we can agree on this:

Tax rates should be neither too high nor too low – they should usually be the precise amount necessary in order for the government to pay for its programs and services.

The idea here is quite simple.  In a normal year, the government should be able to raise enough money in tax revenue to pay for its expenses, leaving us with a balanced budget.  If Congress decides to cut back on some wasteful government programs, then taxes can be lowered.  If Congress wants to spend a little more, like to rebuild hurricane-ravaged New Orleans, then it should raise taxes to compensate for the shortfall.

Sometimes we need to buy something big – like financing World War II.  When Congress needs huge amounts of money for something, and raising taxes a little just will not suffice, that is when it makes sense to borrow money.  Think of a family budget.  In a normal year, your salary should be able to cover all of your expenses and hopefully leave a little extra for savings.  But then you want to buy a house.  You can’t make enough money in your profession to simply purchase the house, so you take out a 30 year mortgage.  Now you have a debt, but you also have a structured plan to pay off that debt over time.  Of course some people habitually spend too much, piling up credit card debt.  Invariably, that path leads to trouble.

The national debt is growing because we are spending more than we earn in revenue.  At the beginning of 2001, measured as a percentage of our gross domestic product, spending was 17.4% and tax revenue was 19.8%.  Revenue was higher than spending, so there was a budget surplus.  For 2016, spending was around 20.8% and tax revenues were 17.6% - thus creating a deficit and growing our debt.

The Gross National Debt currently exceeds $19.9 trillion.  That is $19,900,000,000,000!  That works out to over $61,303 per American citizen, including children.  When the U.S. government borrows money, it does so both from American citizens and from foreign governments.  The domestic money that is borrowed is money that would have gone into investment savings.  And the enormous interest payments on our existing debt take even more money away from where it belongs.

Former Federal Reserve Board Governor, Edward M. Gramlich, said in a 2004 speech to the Concord Coalition, “When the government runs deficits, it siphons off private savings (reducing national saving), leaving less available for capital investment. With less capital investment, less new equipment is provided to workers, and, all else being equal, future productivity growth rates and levels are lower."

Another way to look at our debt is that we are borrowing money today that our children are going to have to pay back.  If we are happily making money, but at the expense of our children, is that really what we want?

Sometimes, the government wants to perform some specific action in order to spur the economy and generate new growth.  Suppose the country is heading into a recession, and our leaders decide they want to jumpstart the economy.   Often in recent years that has meant tax cuts, in line with supply side economic policy.  As previously described, the idea is that tax cuts for high income citizens will increase investment savings and capital expenditures, which will in turn pump up the economy.  The downside of this approach is that it increases the nation’s debt (less tax revenue), and there is no guarantee that the wealthy will not spend much of that money on savings accounts in the Cayman Islands or purchasing a new vacation home in the south of France.

There is another way to pump money into the economy, however.  During World War II, President Franklin Roosevelt launched the Manhattan Project – a program whose goal was to create an atomic weapon before the Nazis did.  It was an undertaking of monumental proportions, gathering the brightest minds in the free world in total secrecy in order to achieve a single goal in the shortest amount of time.  At the beginning of the 1960’s, President John Kennedy challenged the nation to send a man to the moon and return him safely before the end of the decade.  Thus, the Apollo program was initiated.  Both of these programs cost the government enormous sums of money.  Both programs achieved their goals.  And both programs left us with technological advances that have played major roles in our lives to this day.  The Apollo and subsequent space programs of the 1960’s and 1970’s have directly contributed to the following technologies: CAT scans and MRI medical systems, kidney dialysis machines, cordless power tools, water purification improvements, freeze dried food, hazardous-gas detection systems, improved insulation, packaging technologies, scratch resistant lenses, enriched baby food, and much more.

Spending money to achieve a national goal gives money directly to companies and workers.  While supply side solutions trickle down from the top, national goal projects are more of a bottoms-up approach.  Both solutions cost money, but the bottoms-up method guarantees new jobs, new manufacturing plants, etc.  There is an old saying: people who live in the basement never worry about a leaky roof.  This simply means that trickle-down economics might work partially, but there is less of a guarantee that the workers at the bottom will benefit than a bottoms-up approach.  When new factories are built with the bottoms-up money, there are more workers, leading in turn to new restaurants, new housing construction, etc.

Keep in mind the most basic of economic catchphrases – supply and demand.  If there is no additional demand, then there is no need for more supply.  In other words, if the top 1% are given boatloads of additional cash, why would they use that to increase production (supply) if there is no additional demand?  A bottom up approach puts money in the hands of people who will spend it, thus creating demand for more supply – everyone wins.

Of course, this is only helpful if there is a national goal – a huge challenge to be overcome that will benefit the nation.  Two obvious answers are infrastructure and investing in a sustainable, green energy economy

So if there comes a time when the economy definitely needs a push, and we are willing as a nation to spend some money to do so, there appear to be certain advantages to the national goal/bottoms-up approach.  They are:

1) Money is pumped immediately into jobs, research, and capital expenditures in order to meet the goal in a short amount of time.   With the supply-side tax cuts, there is no guarantee that all of the money is going into these types of investments in our economy, nor would there be any special expediency to do so.

2) We would be solving a major problem that faces our nation’s future growth and well-being.  This, in turn, would enable us to develop new technologies and lead the world in innovation.

Corporate Loopholes

A tax loophole is "something that benefits the other guy. If it benefits you, it is tax reform.'' 
— Russell B. Long, U.S. Senator

It is worth a look to examine the role of corporate tax revenue.  Companies, by law, pay income taxes just as private citizens do (supposed to be 35% of their income).  Some might be surprised to learn that, according to the IRS, tax receipts from corporations made up only 10% of the total tax revenue in 2013, down from 33% in 1952.  When going through the numbers we find that most companies do not pay that 35% rate.  Through a combination of tax breaks, incentives, and tax shelters, large American companies find creative ways to avoid paying their share of taxes.

In fact, in 2012, an astonishing 20% of U.S. corporations paid no Federal income tax at all, even though profits were soaring!  From 2008 to 2015, 39% of Fortune 500 companies paid zero or less in federal income taxes in at least one of those years. 

So how do they do it?  Large corporations can afford very expensive tax attorneys, who are able to assist them with accelerated depreciation, tax deductions on stock options, tax credits that are received from the government for engaging in certain activities (known as corporate welfare), and off-shore tax shelters.  The tax shelters in particular have become more and more popular in the last several years.  What typically happens is a company re-incorporates in Bermuda, where there is no income tax.  All they really need is a PO Box on that island and they are able to shave millions - sometimes hundreds of millions – of dollars from their tax payments.  There are also tax write-offs that can be found by moving profits made in America overseas.  And money moved off-shore is less accountable to shareholders and U.S. courts.

Between tax credits and off-shore tax havens, here are a few examples of how corporate giants in America have faired in the past.  Keep in mind that American corporations are supposed to pay 35% income tax.

We often hear from Washington that America has the highest corporate taxes in the developed world, and that would be accurate if corporations actually paid that rate.  But the effective tax rate is much lower - one study of Fortune 500 firms pegs it at around 21%.


Just think about how much additional money would be in the U.S. treasury is American companies actually paid their taxes.  The off-shore tax shelter loophole itself might be costing the country $111 billion each year in tax revenue.  As citizens complain about their taxes being too high or the debt going through the roof, it would be helpful if Americans really understood what our major corporations were getting away with.

Inheritance Tax

Some taxes just do not seem fair.  One particular tax that has gained an enormous amount of enmity is the inheritance tax, also known as the estate tax.   The estate tax takes a chunk out of money that is inherited.  The rate is typically 40% - 50%, and is applicable to the value of an estate that exceeds a certain amount, $5.45 million per individual in 2016. 

Opponents of the estate tax have renamed it the “death tax.”  It was this publicity move that sparked the growing, widespread dissatisfaction with the tax.  It evokes images of an IRS tax man hovering over someone’s death bed, and it certainly sounds unfair to have to pay taxes just for dying.  Citizens who clamor for repeal of the estate tax give arguments such as:

  • It is unfair to tax someone for dying

  • It reduces the incentive to save money

  • The money was already taxed once, so this is double-taxation – which is unfair

  • It is not fair to keep piling taxes on the rich

When a law, or in this case a tax, seems completely unfair, it helps to take a step back and try to understand the reasoning behind passing that law (or tax) in the first place.  In 1906, President Teddy Roosevelt suggested that the estate tax was designed to limit the amount of wealth that could be passed down from one generation to the next.  Back in Europe, an aristocracy flourished over the centuries because huge amounts of concentrated wealth could be transferred through hereditary inheritance.  In other words, all you had to do was have the good fortune to be born to a wealthy family, and you and your descendants could perpetually reap the benefits.  This type of noble class is considered un-American.  The idea is that in the United States, you should have to do something to earn your money, or at least there should be some penalty for becoming wealthy as an accident of birth.

One can argue against the estate tax in that it is unfair to tax money that was already taxed when it was first earned.  When you delve down into the facts you learn that the value of an estate comes from many sources, including salaried income, stocks, real estate, bonds, and other holdings that may have appreciated tremendously over the lifetime of the estate owner.  Certain types of these assets were not taxed during the estate owner’s lifetime because they were never sold with the profits turned into cash.  This “unrealized” profit is then passed down to the heirs, who also do not pay tax on it until it is “realized.”  For estates worth over $10 million, it is estimated that over half of this money was never taxed, and therefore the estate tax would be the only time it was subject to any kind of tax.  That does mean, of course, that some percentage of the estate value has already been taxed once, so there is some double-taxation involved.

Proponents of the estate tax, including William Gates, Sr., the father of Microsoft billionaire Bill Gates, point out that individual wealth is not attained by intelligence and hard work alone.  Society as a whole contributes to the conditions that enable someone to strike it rich.  Society is at least partly responsible for health care, education, economic development, property rights protection, and other factors that can help sow the seeds of fortune.  They also argue that the estate tax provides an incentive for individuals to contribute to charitable organizations throughout their lifetime.

For an example using the current $10.9 million threshold for a married couple and a 50% rate, the heirs of an estate worth $12 million would pay 50% of $1.1 million, or $550,000.  The heirs would thus receive $11.45 million after taxes.  $550,000 out of $12 million comes out to an effective tax rate of 4.5%.