A tax story with a lesson

The following story has been circulating inboxes for years now. But, since I enjoy it so much, I'll reproduce it here for those who haven't seen it before. Full credit goes to the anonymous author.

I was having lunch with one of my favourite friends last week and the conversation turned to the government's recent round of tax cuts. “I'm opposed to those tax cuts,” the retired West coast college instructor declared, “because they benefit the rich. The rich get much more money back than ordinary taxpayers like you and me and that's not fair”. “But the rich pay more in the first place,” I argued, “so it stands to reason that they'd get more money back.” I could tell that my friend was unimpressed by this meagre argument.

So I said to him, let's put tax cuts in terms everyone can understand. Suppose that every day 10 men go to a restaurant for dinner. The bill for all ten comes to $100. If it was paid the way we pay our taxes, the first four men would pay nothing; the fifth would pay $1; the sixth would pay $3; the seventh $7; the eighth $12; the ninth $18. The tenth man (the richest) would pay $59.

The 10 men ate dinner in the restaurant every day and seemed quite happy with the arrangement until 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 meal by $20”. Now dinner for the 10 only costs $80. The first four are unaffected. They still eat for free. Can you figure out how to divvy up the $20 savings among the remaining six so that everyone gets his fair share? The men realize that $20 divided by 6 is $3.33, but if they subtract that from everybody's share, then the fifth man and the sixth man would end up being paid to eat their meal.

The restaurant owner suggested that it would be fair to reduce each man's bill by roughly the same percentage, being sure to give each a break, and he proceeded to work out the amounts each should pay. And so now the fifth man paid nothing, the sixth pitched in $2, the seventh paid $5, the eighth paid $9, the ninth paid $12, leaving the tenth man with a bill of $52 instead of $59.

Outside the restaurant, the men began to compare their savings. “I only got a dollar out of the $20,” complained the sixth man, pointing to the tenth, “and he got $7!”. “Yeah, that's right,” exclaimed the fifth man. “I only saved a dollar, too. It's unfair that he got seven times more than me!”. “That's true,” shouted the seventh man, “why should he get $7 back when I got only $2? 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 man and beat him up. The next night he didn't show up for dinner, so the nine sat down and ate without him. But when it came time to pay the bill, they discovered something important. They were $52 short! And that, boys, girls and college instructors, is how our tax system works. The people who pay the highest taxes should get the most benefit from a tax reduction. Tax them too much, attack them for being wealthy, and they just may not show up at the table any more.

12 thoughts on “A tax story with a lesson”

  1. You’re math is wrong. If the bill was $80 for 10 people, it should be $72 for 9 people. They would be $46 short.

    Your story was amusing and only true if it occured in a bubble where corporate welfare wasn’t reaching epic proportions and FICA tax didn’t take a disproportionate bite out of the average worker’s paycheck (of course, the richest among us don’t pay FICA because they earn money from their stock dividends and such).

  2. Perhaps many do not pay FICA but most do. In England you may find many idle rich but in America Corperate exexcutives, entertainers and sports celebs. earn wages. Our idle rich are smart enough to diversify thier investments which means they pay capital gains taxes that far exceed what the average worker pays in FICA by a huge amount. Still, do you not think $46 is a huge amount to be made up by people who were paying little or nothing before? The rich can move out of the county and pay taxes eleswhere if it is your goal to punish them for employing most Americans or providing the money to lend most Americans so they can buy thier houses and cars. It is not just the loss of a huge tax base, it is the loss of the economy that makes it possible for you to earn a living. if no one can buy a house or car., think of how many jobs will be lost. Plastics, steel, glass, fabric, wood, rubber, glue. Thats right even glue. Do you know how much glue is use to attach the price stickers on millions of cars? It comes down to little details like that which seem so small but involves so much.

  3. Actually, as far as entertainers and sports celebrities, you’re wrong. Most of them incorporate their name and take the money in as corporate earnings.

    But I really wish no one had to be taxed. The question becomes,”if you have to get revenue through taxes, what is the fairest way to do it?”

    Many say a straight percentage. The problem with that is that there is a certain level of income where simple survival is a problem, and whatever flat tax is passed, someone is going to be hurt and thrown into poverty – and probably onto the welfare system from which escape is difficult.

    Some say a gradual tax, where those most successful in the current system pay a larger percentage of their earnings. The rationale here is that someone earning $20,000 can’t take a 59% hit (using your example) and afford the necessities of life.

    But the guy who gained the most from the system we have in place earns – let’s say, $1 million. He loses 59% and is stuck with a measly $410,000 – more than 20 times the earner of $20,000, and certainly a comfortable amount.

    Is that fair? No. But the alternative is to make the person struggling on $20,000 live on somewhere near $15,000 (assuming a flat tax of 25%) while the millionaire has $750,000. Who then, is in the position to be able to afford being taxed?

    The other option is to eliminate the income tax and create a federal sales tax. Again though, the burden will not be evenly spread. If they tax everything, the poor will give a much larger percentage of their income to pay taxes on necessities. If the tax is only applied to “luxury” items, the millionaire loses out.

    I was really just poking fun at your incorrect math, and don’t have any answers because I think a satisfactory tax system has never been thought of. We just have to decide where to place the burden.

    The “trickle down” theory sounds so nice, where we give the rich more money to invest and eventually we all get some of it. The problem is that the “trickle down” system doesn’t work in a global community. If you give a millionaire an extra $100,000, he might just buy a villa in Switzerland. Or a factory in China, or a Van Gogh from the British Museum, or a sports car manufactured in Germany. Money goes overseas and disappears.

    I think that if you modified the “trickle down” theory to require that this tax exempted money be used for national investment only within a certain time period, then you might actually be able to make it work the way people pretend it does.

  4. I don’t quite agree with the part of your analysis “If you give a millionaire an extra $100,000, he might just buy a villa in Switzerland…”.

    The situation you describe here is very well quantified by the Marginal Propensity to Consume (MPC), a very well studied figure of merit, whose behavior is very well understood. The MPC describes on-average, how much a person will spend of every extra dollar you give them. This figure varies enormously between different socio-economic groups. At the bottom end of the income scale the MPC is close to 1. That is, you give a poor person a dollar and they will spend (as opposed to invest or save) almost all of that. On the other hand, at the upper end of the income scale the MPC is close to zero, while the Marginal Propensity to Invest (MPI) is close to 1, i.e. give a rich person a dollar and, on average, they will invest almost all of it. It is this behavior of the MPC and MPI which gives rise to the ‘trickle down theory’ you describe, and, in my opinion, makes it credible.

  5. I don’t think the “trickle down theory” has ever proven to work over any appreciable amount of time.

    But your point about MPI vs MPC is still proving my point. The poor person will spend the full dollar in their locale. The rich person will invest, and some of those investments will be foreign and not help the people of his city, state or even country.

    My only real point is that there is no such thing as a “fair” method of taxing people. Some will always feel more squeezed than others. Not taxing the rich creates an additional burden for the middle class.

    Of course, there’s always the theory that we subsidize the poor so they don’t start a revolution … but I don’t know whether I subscribe to that much cynicism.

  6. > I don’t think the “trickle down theory” has ever proven to work over any appreciable amount of time.

    I don’t think you could be more incorrect with that statement. Investment is the driving force between economic growth, which, in turn, leads to the jobs, and unprecedented technology and standard of living we enjoy in the western world.

    > and some of those investments will be foreign and not help the people of his city, state or even country.

    I never understood these protectionist arguments. People from one’s own country/city/state are no more ‘special’ than anyone else. Why should we be so concerned when investment benefits people other than ourselves. Bear in mind also that the reverse process takes place too. That is, we benefit from investment that doesn’t necessarily originate from local investors.

    > My only real point is that there is no such thing as a “fair” method of taxing people. Some will always feel more squeezed than others.

    I couldn’t agree more with that. As you said in your previous post, the question then reduces to how to implement taxation least unfairly.

  7. This story is offensive representation of a democratic society. First of all the idea that the reigning adminstration owns the country and is empowered to treat it as their own business is both horrid and too close to the apparent truth of the Bush administration. (I don’t know if other governments with radically conservative leadership are equally prone to a disproportionate sense of their own entitlement to power and privilege.)

    Another offense against the truth is the idea that the citizens would not take into account the disproportionate level of non-financial burdens that the poor bear. Consider that while the rich pay for our wars abroad, it is the poor who bear most of the burden of sacrificing their sons, daughters, husbands, wives, and friends. In a democratic society everyone bears some cost to maintain the infrastructure that makes the peace and prosperity possible.

    The financial burden is only one of the costs and the rich are rightly taxed more heavily because the benefits they gain from infrastructures like the SEC, the banking system, and others is heavily in their favor. Taxes, along with certain kinds of government service, are the membership dues we all pay to enjoy peace and prosperity.

    I re-wrote this little conservative fable with a more liberalized slant and a few critical points in a blog post a couple years ago, (though I hope that the points of critique above transcend ideological lines):

    http://blog.attitutor.com/2006/06/tax-math-reframed.html

    Enjoy,

    Don Berg

    1. Tell you what, what you did prove is that the trickle-up theory works better than the trickle-down. Because poor people will spend every bit of that dollar, 100% of that money is going to stimulate economy, even if you disapprove of the products they purchase, their purchases ARE STIMULATING the economy. Now, you mentioned that the wealthy invest their money, let us not forget that it was the wealthy people in their executive and Wall Street positions that made the mess from which we are struggling to free ourselves. The money was not invested in real stocks, it was gambled away on derivatives. The intent is very rarely to invest, it is more often to make more money (which is not evil). They wealthy do not spend the money out of necessity…they have the freedom to not spend it, The poor do not. The thing to remember is this…money given to the poor eventually makes its way to the rich through purchases. I don’t begrudge the wealthy their wealth, I despise the fact that for some, it is never enough—No matter how many people suffer around the world, some feel they are entitled to way more than their fair share. If they are not concerned with “equal” and “fair” now, how will they feel when they have had someone strip their world away in much the same way America is doing it to the rest of the World.

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