The Friday gathering – How the US tax system works

By glblguy

Business Meeting Over Coffee

A couple of weeks ago I received a very interesting and though provoking email that I though you might find interesting as well. It’s an analogy put together by¬† David R. Kamerschen, Ph.D., Professor of Economics, University of Georgia. The story attempts to explain how our US Tax system works using an example of 10 men who visit a coffee shop.

I’m not sure I completely agree with it, but I thought it would be fun to share and discuss.

Suppose that every day, ten men go out for coffee and the bill for all ten comes to $100. If they paid their bill the way we pay our taxes, it would go something like this:

The first four men (the poorest) would pay nothing.
The fifth would pay $1.
The sixth would pay $3.
The seventh would pay $7.
The eighth would pay $12.
The ninth would pay $18.
The tenth man (the richest) would pay $59.

So, that’s what they decided to do. The ten men coffee at the shop every day and seemed quite happy with the arrangement, until one day, the owner threw them a curve. ‘Since you are all such good customers, he said, ‘I’m going to reduce the cost of your daily coffee by $20. Coffee for the ten now cost just $80.

The group still wanted to pay their bill the way we pay our taxes so the first four men were unaffected. They would still drink for free. But what about the other six men – the paying customers? How could they divide the $20 windfall so that everyone would get his ‘fair share?’

They realized that $20 divided by six is $3.33. But if they subtracted that from everybody’s share, then the fifth man and the sixth man would each end up being paid to drink his coffee. So, the bar owner suggested that it would be fair to reduce each man’s bill by roughly the same amount, and he proceeded to work out the amounts each should pay.!

And so:

The fifth man, like the first four, now paid nothing (100% savings).
The sixth now paid $2 instead of $3 (33%savings; saves $1).
The seventh now pay $5 instead of $7 (28%savings; saves $2).
The eighth now paid $9 instead of $12 (25% savings; saves $3).
The ninth now paid $14 instead of $18 (22% savings; saves $4).
The tenth now paid $50 instead of $59 (15% savings; saves $9).

Each of the six was better off than before. And the first four continued to drink for free. But once outside the restaurant, the men began to compare their savings.

‘I only got a dollar out of the $20,’ declared the sixth man. He pointed to the tenth man,’ but he got $9!’

‘Yeah, that’s right,’ exclaimed the fifth man. ‘I only saved a dollar, too. It’s unfair that he got nine times more than I!’

‘That’s true!!’ shouted the seventh man. ‘Why should he get $9 back when I got only two? The wealthy get all the breaks!’

‘Wait a minute,’ yelled the first four men in unison. ‘We didn’t get anything at all. The system exploits the poor!’

The nine men surrounded the tenth and beat him up.

The next day the tenth man didn’t show up for coffee, so the nine sat down and had coffee without him. But when it came time to pay the bill, they discovered something important. They didn’t have enough money between all of them for even half of the bill!

And that, boys and girls, journalists and college professors, is how our tax system works. The people who pay the highest taxes get the most benefit from a tax reduction. Tax them too much, attack them for being wealthy, and they just may not show up anymore. In fact, they might start having coffee overseas where the atmosphere is somewhat friendlier.

The gathering

Here are my favorite article picks from the M-Network and the rest of the personal finance blogs on my blogroll this week:

Photo by: maebmij


17 Responses (including trackbacks) to “The Friday gathering – How the US tax system works”

  1. That One Caveman Says:

    I’ve always loved that story. It really highlights a glaring problem with our tax system – it isn’t fair. If taxes are raised on the wealthy, they’re just going to find new and more creative ways of “hiding” that money. (As well they should!) Thanks for the mention.

  2. Bekki Says:

    I’m really glad to see this explained in such simple terms, because I know a few people who really don’t grasp this concept.

    As stated in a previous comment, the US tax system isn’t fair – and it most likely never will be.

    In my opinion, what’s the most fair to everyone is whatever keeps the wealthy people paying the bulk of the coffee bill so that the rest of us can afford to drink it!

  3. No Debt Plan Says:

    A flat tax would fix all of this… except ya know, Congress would lose it’s power, lobbyists would need new jobs, and we’d have a bunch of unemployed tax lawyers and CPAs…

  4. Wendy Says:

    I love this story! I’m gonna share it with some friend who need reminding…..

  5. Jon Says:

    I like this story too, but it has a few problems.

    First, the dollar amount is very small. For all of them, the amount is tiny compared to their income. It makes the indignation of the “poor” ones sound very silly (which is intentional to the story), whereas in real life we’re talking about annual incomes and much larger amounts of money.

    Second, I don’t know about you, but if I were 10 times richer than another friend, I wouldn’t mind paying 100% for a coffee outing.

    Third, everybody is getting the same cup of coffee. In real life, different classes of people get different levels of government service.

    Fourth, the ending is silly. In real life the rich man has much less choice about just not showing up. Taxes aren’t a voluntary payment system.

    Fifth, in real life not everybody is friends.

    etc

  6. Steward Says:

    I certainly wouldn’t mind it if the richest 10% paid for 59% of the services provided by the government. If that is our current system then I think that is great!

    I think the problem is that the top 10% don’t pay for 59% of the services governments provide. But I have to admit that I don’t have any facts to support this so I would be delighted to hear exactly how much the top 10% pay.

  7. Elizabeth Says:

    I think there are two lessons to be learned from the story:

    First, the coffee shop owner should have just kept his mouth shut — after all, everyone was happy with their coffee and how much they were paying. A smart store owner would have invested the money back into the infrastructure of his store.

    Second, that even well-educated economists are capable of presenting half-facts and pandering to the masses.

  8. Robert Murphy Says:

    I agree with Jon. It’s easy to declare something is black or white when you have eliminated the surroundings and made the story based off a set value. Our since of what is right and wrong should not be based on the dollar.

    When we make decisions on the well being of our fellow person and not based on what that person will cost me or provide me, we will have surpassed our base animal instincts.

  9. pksublime Says:

    gblguy, this is funny because i’ve got the same message but instead it’s a bar and everyone is drinking beer.

    @jon
    i don’t mind paying the whole bill, but it sure as hell better be my choice to do so and not a mandate

  10. Justin Says:

    This whole thing misses the FACT that Warren Buffet pays a lower tax rate than his secretary, because he takes all his income as dividends and has creative ways of accounting. His secretary is paying 30% of her income of 60K and he is paying 17.7% of his income of the 46 million or whatever it was. So, while the richest may be paying more dollars in taxes, it doesn’t mean they are paying any more as a percentage of total income.

  11. MITBeta @ Don't Feed The Alligators Says:

    I don’t understand what the $20 reduction in the cost of coffee is supposed to be analogous to. Tax cuts don’t come about because the cost of running the government lessens.

    In reality, the store owner above would offer a cost of $80 for coffee now in exchange for $123 coffee in the future, no?

    I also agree with Justin’s assessment. So many people miss the fact that while marginal rates are high on high income earners and corporate tax rates are high on profitable businesses, almost nobody pays taxes at these rates. So while many cry foul about the high tax rate for the rich, few rich people are stupid enough to actually pay taxes at those rates. So why not overhaul the system to make it more transparent?

  12. CodeSlave Says:

    Another point that is missed out is the earning potential is made possible because of the infrastructure and the remaining 9 guys. While the story sounds nice and great, how did the first guy be poor and the tenth guy get rich? As much as the 10th guy is smart and is more successful than the others, wasn’t the infrastructure and society pivotal for him to make the money? What’s stopping the nine guys from beating him up, taking his money? It takes money to enforce laws. He has to pay more since he is reaping more benefits compared to the others.

  13. Associate Money Says:

    “The people who pay the highest taxes get the most benefit from a tax reduction.”

    So that is why George Bush loves giving tax breaks… to benefit the millionaires and billionaires. Well done, George Bush.

    And if the middle class are not happy, just listen to Phil Gramn: don’t be a nation of whiners.

  14. Dana Says:

    I guess I need to make it my personal mission to persuade every PF blogger I know to read The Millionaire Next Door. I never understood the difference between a high-earner and a wealthy person until I read that book.

    You see, the tax system doesn’t pit the wealthy against the poor. It taxes people according to their income, not their wealth. If you have $1,000,000 sitting in a bank and you made $7825 in income last year, you still got taxed at a rate of 10 percent per dollar earned from zero to $7825. You’re not taxed for the money you hold onto (your wealth) except for property taxes on real estate. You’re only taxed for what you earn.

    This is something neither fiscal liberals nor fiscal conservatives seem to understand and I really don’t get it. Liberals kinda have their heads in the clouds half the time anyway (I can say that, I’m a liberal), but I expected better of conservatives.

    Also, speaking as a low-income person and being familiar with some of the class-warfare rhetoric from the Left, let me school you on a few things.

    1. I wish all I had to complain about was $101,469.25 in taxes plus 35% of the amount I make over $349,700 in a year. Anyone who can’t make it on $248,230.75 a year after federal taxes, as far as I’m concerned, has problems that leaving the country will not solve for them.

    2. While we’re on the subject, it amazes me that so much time is expended using personal finance rhetoric to blame people of little to no means for being in their situations when they have so little wiggle room but when a high earner comes along and whines about that thirty-five percent top marginal rate–35, not 50!–nobody ever stops to ask them why they are having such a tough time when they earn so much. You could buy a nice house in one year with cash on that kind of income. It’s ridiculous. They get a free ride to air their undeserved grievances and just once I’d love to see someone call them on their b.s.

    3. The overall grievance that the poor have with the rich is that a certain level of governmental and social services are needed in this country, and the poor are not making enough income to fund it all–and I don’t just mean welfare, I mean roads, the post office, the military, the public health system, and schools. If the poor can’t pay for those things, and the rich only want to pay for them for themselves, what’s left? If you privatize everything you wind up with what’s happened in private schools, where the average test score is higher than in public schools because private schools can kick anyone out for any reason whatsoever. You’d have high average scores too if you gave up on the problem kids every year. That is what almost our entire culture is built upon, from the highest social classes to the low: looking out for number one, seeking maximum profit, valuing efficiency above fairness and throwing people away when they don’t fit the mold. It is trickling down now into parents giving up their teenaged kids for adoption out in Nebraska because parenting is too hard. Where does it end?

    Anyone who wants to leave this country over a 35 percent top marginal rate that doesn’t even affect most people’s income in this country, well, don’t let the door hit ya. If what you say is true and social class is very elastic here, anyone can make it if they really try, we’ll replace you in no time anyway. Bye.

  15. Tom Says:

    The story also misses the whole picture on taxes, in that income taxes make up only about 1/3 of total taxes. The income tax is progressive, like the example, but other taxes have more regressive behavior. The sales tax is a flat tax, which in practice means it disproportianally affects the poor. The payroll tax (Social Security) is actually regressive, as there is a cap on the income that it is applied to (not sure this is a bad thing due to the nature of the program, but it definitely is this way). So we end up with a flat tax, a regressive tax, and a progressive tax (income tax), which is pretty balanced.

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