Debunking five myths of the American tax system

Every April, Americans spend more than 7 billion hours filing taxes and roughly the same amount of time arguing over them, almost entirely on the basis of several common myths. Here are the five most consequential.

Myth No. 1: The rich don’t pay their fair share

This is the most repeated claim in American tax politics and one of the least supported by actual data. The top 1% of earners take in 22% of total income and pay 40% of all federal income taxes. The top 10% earn about half the nation’s income and pay 72% of its taxes. The bottom half of earners, collectively, pay roughly 3% of the tax revenue. The United States, in fact, has the most progressive income-tax system in the developed world.

Myth No. 2: We’ll fix the budget deficit by taxing the rich

We simply cannot. The collective net worth of every American billionaire is estimated at somewhere around $8 trillion. The projected federal deficit over the next decade alone approaches $25 trillion. Even a one-time total confiscation of every billionaire’s wealth wouldn’t come close, and you only get to do it once.

The real driver of America’s fiscal crisis isn’t a shortage of tax revenue from the wealthy. It’s the structural growth of Social Security and Medicare. The Congressional Budget Office projects that such mandatory spending and interest payments will permanently exceed all federal revenue starting next year. No amount you could tax the rich will correct an imbalance like this.

Myth No. 3: If you can’t tax the rich, tax corporations

Corporations are the next most likely target for those who want large government without the middle class paying for it. The problem is that corporations don’t actually pay taxes. Once you understand why, this starts to look like one of the worst ideas in America’s tax code.

Corporations write checks to the IRS, but they don’t bear the tax burden. Every dollar collected for the corporate tax comes from a human: the worker who’s paid a lower wage, the shareholder who earns less and the consumer who pays higher prices at checkout. Research shows that workers bear somewhere between one-third and two-thirds of the corporate tax burden through lower wages. If you have a 401(k), you’re paying it too, quietly, through lower returns on every stock in the fund.

Further, corporate profits are returns on investment. Tax them and you get less investment. Less investment means lower productivity, which leads to lower wages over time. Decades ago, economists Robert Hall and Alvin Rabushka showed a better way: Replace the corporate income tax with a consumption-based system under which businesses deduct all wages and capital investment immediately. No double taxation, no penalty on investment and revenue without unintended economic damage.

The corporate tax survives because voters mistakenly believe someone else pays it. This belief is expensive.

Myth No. 4: Capital gains should be taxed like ordinary income

This proposal sounds like common sense, but it’s bad economics. When a company earns a dollar of profit, it pays roughly 26 cents in combined federal and state corporate taxes before distributing the rest to its shareholders. When it’s all said and done, the government has taken close to half of every dollar the company earned. That’s not a tax on the rich — it’s two taxes on the same income.

Those who want to raise capital-gains rates assume the U.S. is a low-tax haven for investors. It’s not. America’s combined federal, state and net investment income tax rate on capital gains already sits at 29.2%, well above the average of 19.1% in fellow OECD democracies. We’re already an outlier, and not in a good direction.

Myth No. 5: Tax cuts pay for themselves

Politicians on the right have said this for 40 years. But it’s not quite true. Tax rates affect behavior. Cut the marginal rate on work and investment and you get more of both, which generates more revenue than a static calculation predicts. But generating more revenue than expected is not necessarily enough to cover the cost of the rate cut. The 2017 Tax Cuts and Jobs Act proved it. Growth picked up, wages rose, business investment increased and yet the deficit still widened.

The honest argument is different: A tax cut that costs real revenue but improves the allocation of capital and raises long-run productivity is still the right policy. The question is not whether tax cuts pay for themselves, but whether the economic growth is worthwhile. That’s harder to fit on a bumper sticker, but it’s the version of the conservative tax argument that actually holds up.

That said, we should always offset the loss of revenue when possible. There is plenty of spending to cut and there are plenty of tax breaks to close for that.

Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University. This article was produced in collaboration with Creators Syndicate.