The U.S. Tax Code: Is it Fair? What About Capital Gains and Dividends?

James Madison. Library of Congress.

It’s tax season. We’re busy collecting tax forms, receipts, and so on to get ready to do our taxes. That got me to thinking about the history of our tax system, and all the political rhetoric about whether the tax code in the United States is “fair” or “unfair.”

For what little it’s worth (these days), the “Founding Fathers” were vehemently against any notion of a personal income tax. They foresaw that allowing one powerful group of voters – through their elected representatives – to tax any other group for their own benefit would be divisive, and a violation of the true spirit of democracy.

When test cases arose, the Supreme Court leaned on the technicality that such taxes were not apportioned among the states according to each state's population. (The Court did allow some very narrow exceptions.) Note that the court did not rule one whether or not a tax imposed on some persons, but not others, violated other provisions of the Constitution – such as the “equal protection” clause. However, legislators sensed a bonanza and passage of the Sixteenth Amendment, in 1913, over-rode the technicality used by the Supreme Court to reject previous income tax laws.

So the notion of a “fair” tax code depends upon your notion of what’s fair. Is an escalating tax rate “fair” by any common usage? I don’t think so. (By the way, the term “progressive” income tax is so loaded with other connotations, we should abandon it totally.)

As a matter of curiosity, I ran some numbers through TurboTax. I assumed a two-earner couple making $35 thousand. According to the latest wage data, a married waiter and waitress could make about this amount. To keep it simple, I included no investment income, but added a bit of interest from a savings account. TurboTax calculated that their “typical” deductions (for mortgage interest, charity, medical, etc.) would not give them any benefit over the standard deduction. Their tax bill came out to be $1,603.

Suppose the income doubled to $70 thousand? Two school teachers could make this amount in the more poorly-paying states. I doubled most of their common deductible expenses, but they still failed to gain by itemizing their deductions. Their tax bill would have been $6,804 … more than four times (4.2) the base number above. (Keep in mind that they would have also paid double the Social Security and Medicare tax.)

No such outcome in ordinary life would, by any stretch of the imagination, be considered “fair.” In fact, a business transaction where the price varied with the buyer’s income would be consider grossly unfair (and, I suspect, illegal, but I’m no lawyer). Two wait-persons pay $16 for tickets to a show, while some teachers pay $32, or even $68? Give me a break!

How “fair” is it that the top 5% (1 in 20) households pay way over half (58%) the Federal personal income tax bill? The cut-off for that group is around $155 thousand per household, by the way. A junior college teacher and a government lawyer might make roughly that amount. While it’s a wonderful number, I don’t think most of us would consider a couple making $155-160 thou “rich.” Well off, surely, but not rich

College "Mass" Lecture Hall.

Of course, we’ve heard about those few households (roughly one in a thousand) who make a lot of money but pay no taxes. This is “blamed” on lower rates for Capital Gains and Dividend income, plus deductions for investment losses. Of course, the tax laws allow all of us to offset gains by losses when we gamble – and, make no mistake, investing is gambling, no matter how the stockbrokers avoid the term.

As for Capital Gains, a not-insignificant chunk of that is simply inflation. If you held a stock for the past ten years, and it increased in market value from $40 a share to $50 … you lost money on the deal: That $50 stock was worth just $39.40 in inflation-adjusted buying power. But your tax return will show a $1,000 “gain” if you sell 100 shares. Is it “fair” for the government to tax inflation, for which it is totally responsible? (Only the government can “print” money, the root cause of inflation.)

Dividend income is also taxed at a lower rate, which some consider unfair. That ignores that fact that the money one receives in dividends is only what was left after the company has paid over a third (34-35%) of the revenue in corporate income tax. So if an investor gets $650 in dividends, he/she has, essentially, already paid $350 in income taxes. Isn’t that enough?

In fact, “ordinary” people who have the foresight to invest in mutual funds, should complain bitterly about the double taxation of dividends. That includes workers who are vested in retirement plans, which often own big blocks of mutual funds. Dividends are, arguably, the only reliable gains one can count on for a typical mutual fund. (Of course the paper returns of the mutual fund do benefit from inflation.)

What does that mean?! Illinois historical archives.

Clearly, other perversions of the code in favor of narrow “special interest” factions should be examined closely. In fact, there is no doubt that the very complexity of the tax code is “unfair” in that it discriminates against those who cannot afford to hire a tax specialist to sort out its arcane, and often contradictory details.

So the answer to the question posed above is: No, the U. S. tax code is not equitable in any sense expected in common, ordinary life. It may, in some ways, offer “societal” re-distributions that many people approve of … but let’s not kid ourselves that it is, in any way, “fair.” And the unfairness by no means favors just “the rich.”

References: U.S. Census Bureau and The Economist. Standard TurboTax software. "Business Reference Services," Library of Congress.