Who Doesn't Pay Taxes and Why

Who Doesn't Pay Taxes and Why

Bill Bischoff
Smart Money
July 30, 2010

For the 2009 tax year, an estimated 47% of U.S. households did not pay any federal income tax. The percentage was a bit higher than normal due to the lousy economy and some allegedly temporary tax breaks that may not be renewed. The long-term percentage of non-taxpaying households is apparently around 40%. This is according to the Tax Policy Center, a Washington research outfit.

Since we all benefit from federally supplied advantages like national defense, the interstate highway system and public education funding, I believe everyone who earns a halfway decent income should pay at least some federal income tax. Freeloading should be against the rules except for those who are truly poor.

How did we get to the point where almost half of our citizenry is excused from paying any federal income tax despite being allowed to vote just like the other half? Keep reading for the answers.

Lower-Income Households Often Pay No Tax

Lower-income individuals often don’t owe any federal income tax thanks to breaks like the standard deduction, the personal exemption deduction, the child credit, and the earned income credit. In fact, they often receive government checks for going to the trouble of filing returns, because they qualify for so-called refundable credits. (The earned income credit is the most common one, but there are others.) You can collect refundable credits whether you owe any tax or not, so calling them tax credits is deceptive. In truth, they are disguised welfare payments that are laundered through the tax system. Our beloved Washington politicians apparently believe that makes them more acceptable to the uninformed public, and they may be right.

Some Middle-Income Households Don’t Pay Any Tax Either

As it turns out, the privilege of not having to pay any federal income tax is not limited to lower-income households.

Example 1: Say you’re married with wage income of $50,250 and two under-age-17 kids. After claiming the standard deduction and four personal exemption deductions, your 2010 tax bill is $2,800. However, it’s zeroed out by the child tax credit ($2,000) and the Making Work Pay credit ($800). So you owe nothing to the feds. If you have income from long-term capital gains or dividends, make deductible retirement account contributions, itemize deductions, or qualify for other tax breaks, your income could be even higher, and you would still not owe any federal income tax. Clearly, folks of relatively modest means should not have to pay a ton to the IRS, but I don’t think it’s appropriate to pay nothing.

Appallingly enough, you can have a much higher income and still pay no federal income tax if you qualify for the right mix of breaks for things like buying a home, childcare expenses, college education costs, and making energy-efficient home improvements.

Example 2: Say you’re married with salary income of $120,000, 401(k) contributions of $12,000, two under-age-17 kids, and a college student with $4,000 in education expenses. Assume you also bought a home this year that qualifies for the now-defunct $6,500 credit for existing homeowners. Finally, assume you’re eligible for the $1,500 credit for energy-efficient home improvements. Believe it or not, your 2010 federal income tax bill will be zero even if you only claim the standard deduction. Your tax bill of $11,950 is completely wiped out by $13,300 in credits ($2,000 child credit, $2,500 education credit, $6,500 homebuyer credit, $1,500 credit for energy-efficient improvements, and the $800 Making Work Pay credit). In fact, you’ll get a $1,350 check from the government because some of your credits are refundable ($13,300 of credits - $11,950 of tax = $1,350 of free money). Congratulations! Despite your healthy income, you’re an official government welfare recipient. If this example doesn’t convince you that our nation’s tax policy is out of whack, I don’t know what will.

But 'the Rich' Pay a Bunch

Despite what some believe, we have a very progressive federal income tax system. That means the “the rich” pay their fair share and more. How could it be otherwise when close to half the population pays nothing? But don’t take my word for it. Here’s another example for doubters.

Example 3: Say you’re married with two kids and $250,000 of taxable income (after subtracting deductible retirement contributions, itemized deductions, and personal exemption deductions). Your 2010 federal income tax bill is a whopping $60,282. That’s a lot more than zero! If your taxable income is $500,000, you’ll owe a staggering $145,309.

Granted, the tax bills in the preceding example will be lower if part of your income is from long-term capital gains and dividends, but please don’t tell me the tax system isn’t progressive enough. According to the National Taxpayers Union, households in the top 5% by income have been paying about 60% of the federal income tax for some time. And if the Bush tax cuts are allowed to expire next year, the system will become even more progressive.

The Bottom Line

For all but the poorest folks, we need to restore the linkage between paying at least some income tax and being a voter. Otherwise, we can run into the dreaded scenario where those who don’t pay taxes can keep voting to raise them higher and higher for those who do. That’s a prescription for economic disaster (and worse), and we don’t want to go there.