How Taxes and Tax Policy Really Work

This basic story has been around in various forms for some time. However, since taxes, tax cuts, and the future of the IRS are a hot topic right now, I thought I would share my version of it so you could get a real-world example of how the U.S. tax system and our tax policy currently works.

Suppose every week, a group of old friends get together and the ten of them go out for dinner. The bill for all ten comes to $100. Most of them are pretty progressive, so like our taxes, it was thought fair by the group’s majority that the richer you were, the more you should contribute towards the meal? After all, that’s the progressive way, isn’t it? As a result, after some quick calculations, the share each paid for the meal turned out something like this:

1. The first four (who were the poorest) – paid nothing.
2. The fifth – $1.00
3. The sixth – $3.00
4. The seventh – $7.00
5. The eighth – $12.00
6. The ninth – $18.00
7. The tenth person (who was also the richest) – $59.00

The group ate together once a week for several months. The restaurant owner, being a good businessman and wanting to keep the group coming to his restaurant, one week said to them, “Since you are all such good customers, I’m going to reduce the cost of your meal by $20 every time you come in. Dinner for the ten of you will now only cost $80.”

The group of friends did a quick calculation and realised that $20 divided by 10 is $2.00. However, it was quickly seen that if they subtracted that amount from everybody’s share, then the first four would be paid $2.00 and the fifth would be paid $1.00, just to eat their meal. That wouldn’t do, so to be fair, the 10 friends decided to share the good customer windfall using the same formulae that was used to calculate their taxes. After a little basic math, this is how the new apportionment went:

1.The first four still eat for free. (Hey, how much more can you save when its already free?)
2. The fifth, also ate for free. (100% savings and one more added to the growing list of special friends who felt entitled. That happens after a few months of free meals.)
3. The sixth now paid $2.20 instead of $3. (He got a 33% savings which made him very happy.)
4. The seventh now paid $5.20 instead of $7 (28% savings).
5. The eighth now paid $9.20 instead of $12 (25% savings).
6. The ninth now paid $14.20 instead of $18 (22% savings).
7. The tenth now paid $49.20 instead of $59 (16% savings).

Now, five of the group of friends were eating for free and the remaining diners were all better off than when they started the weekly dining. Towards the end of their meal, their waiter, who was hoping to get on their good side and get a better tip the next time they came to eat, suggested that maybe some of the group wasn’t getting what they deserved from the unexpected discount.

As a result, once the group of friends got outside of the restaurant, they began talking and comparing their savings. “Wait a minute,” declared the sixth diner, “I only got 80 cents out of that $20.” Then he pointed to the tenth diner “Didn’t you get $9.80?” “Hey,” exclaimed the fifth diner, “now that I think of it, I only saved a dollar!” . “That’s true!!” shouted the seventh diner, “Why should the richest person get $9.20 back when I only got $1.80? This proves that the wealthy get all the breaks!” Then, a very loud “Wait a minute!” came from the first four diners. “Don’t you realize that we didn’t get anything at all. That’s can’t be fair. The richest person in our group got almost all of the savings that the restaurant owner offered us. This just goes to show that given a chance the poorest members always get the raw end of the deal!”

Suddenly, eight of the nine diners surrounded the tenth diner and beat him up, taking back his $9.80 in savings. The ninth diner didn’t know what to think.
Well, the next week the tenth diner didn’t show up for dinner. So, the nine remaining diners sat down and ate their meal without him. However, when it came time to pay the bill, they discovered something important that had slipped their notice. After looking at the cost of the meal, which hadn’t changed from the previous week, they realized that by using their accustomed method of dividing up the bill they couldn’t collect enough money between the remaining nine to pay for even half of the meal! So, the eight ganged up on the ninth diner, since he was now the richest and said, “You’re the richest, so you have to make up the difference.”

Because it was too late to do anything about it, and because he didn’t want to start another argument that might get him beat up, the ninth diner paid the remainder of the bill. As he was walking to his car he shouted back to the rest, “I’m out of here. Next week you can take care of the bill yourself.”

The remaining eight were dumbfounded and didn’t know what to do, since the two former friends who had previously paid 78% of the bill were now gone and the remaining eight could no longer afford to eat at the restaurant. Reluctantly they returned and told the owner they wouldn’t be back. As they turned to leave they began to discuss what they should do, and as a group they realized that they weren’t sure where they could afford to eat next week. On the way out of the restaurant for the last time, one of them muttered, “Where did we go wrong? We only wanted our rich friends to pay their fair share.”

  2 comments for “How Taxes and Tax Policy Really Work

  1. Greg Morneau
    August 13, 2004 at 8:05 am

    Great post. As you mention I had seen this several years back but welcome the refresher. This concept should be taught to our children and in our schools.

  2. August 13, 2004 at 8:49 am

    Yes, life is like baseball we always need to remember the fundamentals. I reworked the specifics of the story and the last two paragraphs are completely my own thoughts.

    One thing that most people forget is that those at the top tend change from generation to generation. Even Teresa Heinz, who inherited her wealth from her husband is an example, as is Bill Gates, Larry Ellison, and most of the current crop of the really rich. While some families are able to maintain their wealth across generations, many do not and there are new ones taking their place. An example of a currently successful family is the Waltons and their deceased father is an example of middle class to great wealth.

    From the arguments you hear you would think that the rich are like the old aristocracy with perpetual largess pretty much limited to the same families of people. That is just not true. Instead what we see using that model is whole new aristocracies created out of thin air and the constant change of economic power.

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