Econ 120: What Taxes and Splitting the Restaurant Bill Have in Common
April 15, 2009 by Joseph Ansanelli
Filed under Economics, Recent, Startups
Since it’s tax day and all, I figured why not post something that I am sure will spur lots of conversation (or maybe controversy?)
There are so many (mis?)perceptions on the tax system, I decided to get some facts about how it all works, or at least, to see what of the rhetoric is true. In particular, in most of the press and political speak out there, the common perception is:
- Tax cuts only benefit the “rich”
- The “rich” actually pay fewer taxes
Darren Hester
Now, without commenting on what the tax system should look like I figured it would be interesting to share a funny story to help explain why people perceive the first point and then share some data from the Congressional Budget Office on whether the the top income earners actually pay fewer taxes. (By the way, I am a first generation American and the son of Italian immigrants. My grandfather came through Ellis Island when he was 16. In other words, I come from very humble beginnings and I figure that might help in any emotional responses this post might trigger.)
Splitting the dinner tab
The following is a story about if we split the dinner tab like we split the tax burden and helps explain the misconception that tax cuts only benefit the wealthy. This parable has floated around the internet in various forms and no one is sure of its true origin though some trace it back to Don Dodson and a letter to the Chicago Tribune. Anyway, the story goes like this.
Suppose that every day ten 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 (Editorial: this is not exactly how we pay taxes as you will see below, but its generally indicative of how it works), 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 ten men ate dinner in the restaurant every day and seemed quite happy with the arrangement until the owner threw them a curve.
0 + 0 + 0 + 0 + 1 + 3 + 7 + 12 + 18 + 59 = 100 cost of dinner
“Since you’re 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 proceeded to work out the amounts each should pay under the same assumptions: Now the fifth man also paid nothing, the sixth pitched in $2, the seventh paid $5, the eighth paid $9, and 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 the $20,” complained the sixth man, pointing to the tenth, “and he got 7!”
0 + 0 + 0 + 0 + 0 + 2 + 5 + 9 + 12 + 52 = 80 reduced cost of dinner
“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!”
0 + 0 + 0 + 0 + (-1) + (-1) + (-2) + (-3) + (-6) + (-7)= (-20) savings on dinner
“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.”
And that is why there is a perception that tax cuts benefit the highest income earners versus the lowest quintile. It’s because the percentages are already progressive, that is that the highest income earners pay a greater share of tax as well as a greater percentage of their income.
Just the facts
I am sure some of you are saying, “that’s not true” or quoting Warren Buffet who said something to the effect that his tax rate is lower than that of his secretary. Now I don’t know about Warren’s tax rates, but I figured a few charts would at least get the facts out there.
All the following data is from the Congressional Budget office using the latest tax year made available which is 2006. The data goes back to 1979 for folks that are interested. Links to everything are at the bottom of the post.
To start, I wondered what is the effective tax rate for various income levels. Do the rich pay a lower tax rate as Warren Buffet suggests?
The first chart is the Effective Tax Rate for all federal taxes paid (Income, Social Insurance (Social Security, Medicare, et al), Corporate Income Tax, and Excise Taxes. The second chart is just income taxes.
Effective Federal Tax Rates (2006). Source: Congressional Budget Office
Effective Federal Income Tax Rates. Source: Congressional Budget Office
I think the data shows pretty clearly, that contrary to common perception, the top income earners pay a greater percentage of their income. That is to say, the tax system is quite progressive both in total taxes and even more so with respect to income. Approximately, 40% of households pay no taxes on their income or actually receive additional money above their income.
The second question I wondered is on a dollar for dollar comparison, how do different income levels pay as a percentage of their total income. This graph is a comparison of total income earned compared to total taxes paid.
Share of Total Before Tax Income and Total Federal Tax Liabilities (2006). Source: Congressional Budget Office
This too shows how the highest quintile pay a higher share of the total tax liabilities in comparison to their income. Again, the system is progressive.
So what?
Of course the more interesting question for discussion is if this is the best and right way for taxes to work. Without tackling that question today, one other fact to share. Prior to the 16th Amendment being passed in 1916, it was unconstitutional to apportion direct taxes in any way other except equally based on the census. So is it right? Is it the best system? I will leave that for a future post but hopefully we can all start using the real facts versus common misconceptions.
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Source for chart data: Congressional Budget Office
The illustration might not be the best example because if you compare what the individual was paying, compared to what they are now paying … the following people are now paying the following % less.
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INDIVIDUAL
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1. 2. 3. 4. 5. 6. 7. 8. 9. 10.
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MEAL COST BEFORE
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$0 $0 $0 $0 $1 $3 $7 $12 $18 $59
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MEAL COST NOW
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$0 $0 $0 $0 $0 $2 $5 $9 $12 $57
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MEAL REDUCTION COST (%)
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n/a n/a n/a n/a 100% 33% 29% 25% 33% 12%
You’ll notice the 9th person is the outlier. The trend was % reduction from the 5th person to the 10th person, but the 9th person benefited % more than the 6th & 7th person.
While I too don’t know what kind of taxes Warren Buffet pays, I know this: Warren Buffet gave his money to Bill Gates (Gates Foundation) to spend not the federal gov’t. He knows where it will be better spent (or for that matter, given away).
In a moderately related topic, a few years ago Bill Gates and Warren Buffet had dinner at a little restaurant in Saratoga CA called Sent Sovi. The owner, at the time, was David Kinch of (current) Manresa fame. David likes to tell the story of how they split the bill: neither paid! Each apparently assumed their handlers who arranged the dinner paid the bill. Nope. David ate the cost of their dinner, apparently too embarrassed to call either. To think, the richest guys in the world played “dine and dash”.
I’m also puzzled where do people get populist ideas that you mentioned? They are clearly not true and I don’t understand why we need all the data and charts to prove it. In my opinion this is all so obvious.
That said, I think that progressive taxation is not wrong and it’s a landmark of post-industrial developed society. World before 1916 was very different from the one we live in now, and hopefully it’s better.
What Buffet wanted to say is that if he pays more taxes it will benefit society as a whole. Of cause the fact that he gave money to Gates foundation and not to the government is telling, but he didn’t really have an option to ‘donate’ it to feds, did he? I do think if he personally had that option he would still give to Gates foundation. But as the first/second richest man in the world his situation is hardly applicable to even the highest quantile of taxpayers as a group.
The real question to debate is if more progressive taxation benefits or impedes everyone in the long run. Or as it’s also known if trickle down economics works. It has been a long running debate of the 20th century and we are carrying it to the 21st. I believe these days the question should be posed in a context of worldwide economy and long term social implications, as the current crisis vividly illustrates.
I have to agree with Michael on this one. While it’s totally entertaining to tell 99% of a joke, you must include the punch line. It’s usually the best part.
But seriously, one cannot reduce a phenomenally complicated issue down to a silly story about who pays a dinner tab. Too many people focus effort towards coming up with an easy answer to very complicated issues. The charts and so called ‘facts’ are littered with all sorts of assumptions about which even the best and the brightest argue fervently. So, let’s not even go there.
Since you dismissively mentioned Warren Buffet, let’s use him as an example. He surveyed 15 of his employees. While his total taxes paid was 17.7% (payroll + income taxes), the average tax rate for his office was 32.9%. I think this is the issue that we should be focusing on and not so much on the guy who makes $18K/yr versus the guy that paid 4 times that in taxes (and is somehow bitter). Joe, your oversimplified explanation helps emotionally fuel that latter guy which makes for a totally different discussion. I’m sure that is not what you intended.
So, Warren went on to offer a $1,000,000 donation to charity to any of the Forbes 400 richest people who can show that on average, they pay a higher tax rate than their secretary. Now, you know he’s not just going to throw a million dollars away. In reality, no one would actually take him up on it. Why? Because he/she would have to disclose how much taxes he/she paid – and not just on some SEC filing. Therein lies the problem!
It’s very easy to oversimplify a solution – which is in essence what the dinner story is. In this case, it’s almost impossible to over simplify the problem. Why? Because in order to even understand the problem, you would need full disclosure – and that you’ll never get. The tax code as it stands today does not function to collect a fair amount of taxes from individuals. It serves more the people who have figured out how to avoid paying taxes.
Right now, you have all these charts and figures which include the tax system abuses – Capitol gains vs. Ordinary income, S-Corp vs W-2 – and for that reason, they are pretty flawed. If everyone were to put their income up on a website and what percentage he/she paid in taxes – AND WHAT DEDUCTIONS HE/SHE TOOK, you’d get a better understanding of how to solve the problem. And that will never happen.
So, what does this mean?
If tomorrow there were a new law that imposed a 55MPH speed limit on everyone, there would be 3 possible outcomes to that law:
The worst outcome would be if everyone broke the law. Complete chaos!
The better outcome would be if everyone obeyed the law. How nice is that?
The best outcome would be if everyone obeyed the law – except me. I can drive 60.
Joe, get a better accountant or I’ll make you pay for dinner the next time
Dear Mr. “Contact” – ok, Greg, I know its you.
Seriously, thanks for the comments. Unfortunately, the data is the data. Warren Buffet may have the best accountant in the world which is why his effective tax rate is much lower. Or he only is making money on capital gains which are taxed at 15-20%.
However, the top quintile of all income earners (and that is all sources of income) pays an effective tax rate of 25.8%. That means for every dollar from any source, 25 cents gets paid to the government in taxes. The lowest quintile pays an effective tax rate of 4.3%. That means for every dollar of income from every source, only 4 cents is paid in taxes. And if you look at just income, w-2 and dividends, the lowest quntile has a negative tax rate, i.e. they get an additional 6% given back to them on top of what they earned.
I think the reason that no one took Warren Buffet on his bet is that it’s not an accurate representation of the facts either way. The Oracle of Omaha is a great investor, but the facts are still facts. The data clearly shows that those who make more pay, a greater share both in terms of dollars which makes sense, but also they pay a greater percentage of every dollar they make. I am not commenting on whether it is right or wrong. I simply want everyone to at least agree on the facts first.
Yes, the data is the data. But, as i said, the data is flawed. So, I don’t agree your notion that “the facts are the facts.” My whole point is that you can’t simply reduce something as complex at this matter down to a few stats and attempt a simple solution. The parts themselves are much greater than their sum.
And as far as being in the lowest quintile and getting an additional 6% back – Exactly how much is that? $18,500/yr? $355/week? The sad part is that 20% of Americans do make that – and I’d bet you that ALL of them would disagree with your statement.
And Warren doesn’t have an accountant.
1:20 seconds into the clip:
http://www.youtube.com/watch?v=3z_UrOKtjHk
You should host a little tax symposium…maybe at your place? (do you have a pool? cause i’d so be there in a second!)
My good friend – don’t try to change the subject… The facts are the facts. The wealthy pay most of the taxes and many people don’t pay much if any taxes especially on income.
Now you are raising a different issue which is how to provide opportunity for people to work hard and get ahead. And that is a topic for a much longer discussion and blog post…
Lastly, tax symposium sounds like a great idea. No pool, but you bring the pizza and I’ll serve some good wine…
sounds like a plan. i’m in!
Joseph, I appreciate the attempt at clarifying matters. I have a few issues with your analysis though:
1. Have you only considered ordinary income, or have you also considered investment incomes, stock options, etc?
2. How have income distributions changed over the last several years?
Personally I believe the whole issue isn’t so much about taxes, it is about income inequality in take-home pay. Those at the highest incomes have had their incomes rise substantially, while most of the country has had their incomes stagnate.
Sunil –
Let me tackle both of your questions.
1. The first graph is effective federal tax rates (this by the way does not include state taxes) on ALL income. The second is simply taxes on Income only.
2. In general, income averages have increased across all groups over the past twenty years both on a before and even more so on an after tax basis. you can see the data for this at http://www.cbo.gov/publications/collections/tax/2009/average_after-tax_income.xls
Your last comment is a different question. The question about income inequality is both a factual and philosophical one.
The fact is that there is no Constitutional or other legal right to income equality.
The philosophical question is whether there should be a legal right of income equality. Unfortunately, it tends to be more of a belief of more Socialistic and Communist governing models – none of which have historically been successful. In general, Capitalism has done more to increase the wealth of everyone overall than any other system to date. While the wealth creation might not be equal, it is proven to be a better system than any other alternative.
Again, thanks for the comments.
joseph
Hi Joseph,
I took a look at the spreadsheet you pointed out. Here’s another take on the data: if you look at the ratio of the 2006 income to the 1979 income, you will see that the lowest quintile has increased by 10% during that time. The income of the highest quintile has increased by 86%. The difference becomes much more dramatic as you examine the top 10% and the top 1%: 112% and 256%. So during the period that this spreadsheet covers most of the benefits have gone to the top income groups. My guess is if you adjusted this for inflation, you would find that the bottom half of the economy hasn’t moved in terms of income over this time period.
Your post is about taxes, and not about inequality. But, given this income profile, it should be no surprise that the top earners pay an increasing share of the taxes. That’s where the majority of the income’s gone.
As for a “legal right to income equality”, I made no such claim. I merely made the observation that far fewer people would be upset about the upper income getting a larger tax break if it weren’t for the accelerating income disparity. Here’s another paper that looks at this issue in a great deal more depth:
http://www.irp.wisc.edu/publications/focus/pdfs/foc261e.pdf
Sunil
A friend added this comment on facebook and figured I would share here as well.
http://www.capmag.com/article.asp?ID=5494
On Restaurant Governance:
Suppose that every day, ten men go to a restaurant for dinner. The bill for all ten comes to $100. There’s a byzantine system for dividing the tab which none of them really understands. The waiter tells them what they owe, and, though they each pay different amounts, they all feel about equally ripped off. The men argue, often angrily, about who’s paying what, and who’s getting a bigger portion, and so on, but then the food arrives, and they’re all very hungry, so they move on to eating.
The men have been having dinner at this restaurant for years, only vaguely aware that the actual cost of providing the $100 meal is about $135. The waiter, who the men have selected for his obsequiousness, is terrified that he’ll be fired for poor service. He is very motivated to keep the bill low, and often finds ways to increase the portions a bit here and there, especially for the men who are most influential to his appointment. Who pays the additional cost? The men have told the waiter to just put it on their tab.
Over dinner, the men have lively discussions about the menu. They pay fervent attention to differences in what each pays but seem comparatively unaware of the top few line items in the cost of their meal. The men have been sitting and eating ever larger portions for some time, and they’ve asked the establishment to offset the cost of some remedies for their unhealthy lifestyle. They’ve also asked the restaurant to accumulate enough cooking oil to blow every other eatery on the block to kingdom come, though they still feel a nagging sense of vulnerability. Then there’s the interest on that tab.
Talking about all of this, arguing about what to do, the men begin to feel bitterness towards one another, and enraged at the restaurant. When this happens, the waiter knows what to do: bring out dessert and knock a few dollars off the bill.
You are missing the most imporatnt part of the story…
After hearing the gripes of those that are not paying anything, and their demands that the richest share his $7 savings, the richest person quits the dining group.
The next time they all go out, there is only 9 of them. They enjoy their dinner and when the bill comes they each pay their share.
BUT…their total only comes to $28 and the bill is now for $72. They end up washing dishes for a month.
Beware…if you constantly keep taxing the rich more, they may just leave and take their business elsewhere (and all the employees that their business employs!), leaving you to mop up the mess.