Who Among Us Doesn't Pay Income Tax?

Approximately 140 million federal tax returns were filed in the weeks and months leading up to April 18 this year. While the final statistics for 2010 are not yet available, we know from past years that over one-third of taxpayers will file "non-taxable returns," meaning that they will not owe any federal income tax.

This tax season in particular, there has been talk from both the Left and the Right about tax filers who don't pay any tax. "Loopholes in the tax code" has become a popular refrain as budget battles are waged in Washington, and a general discussion of "tax fairness" percolates through the debate as well.

A poll conducted in February 2009 asked if "everyone should be required to pay some minimum amount of tax to help fund government," and two-thirds of respondents answered yes. However, this seemingly simple issue is sometimes confusing and fraught with misinformation. Here, therefore, are a few key facts.

First, federal income taxes are just one tax we pay. All workers with wage income pay payroll tax to fund Social Security and Medicare. States impose either income taxes, sales taxes, property taxes, or all three. Those who don't pay federal income tax undoubtedly pay other taxes used to fund other government activities.

Second, in addition to those tax filers who pay no federal income tax, there are households that don't even need to file a tax return. Roughly half of households don't file because they had little or no taxable income.

Third, there are different reasons why law-abiding taxpayers may owe no federal income tax. For some who do not pay, their incomes may simply be too low to be taxable. In 2010, a single person without a child did not generally owe income tax if her income was below $13,400. For others, tax credits such as the $1,000 child tax credit and the earned income credit wipe out their tax liability. In 2010, a married couple with two children generally did not owe any income tax unless their combined income exceeded $50,250.

Rarely do "the rich" pay no tax, but it can happen. The complex Alternative Minimum Tax was enacted in part due to a concern about wealthy taxpayers avoiding the income tax. Of the 2 million tax filers in 2008 with incomes between $1 million and $2 million, about 1,200 owed no federal income tax. Furthermore, 22,000 of the 4.4 million taxpayers with incomes over $200,000 paid no federal income tax in 2008. Most likely these tax filers are retired individuals who have invested exclusively in tax-exempt bonds.

What does this all mean for tax policy, tax reform, and our future budget outlook? First, these numbers are concerning for some policymakers because they recognize that households that pay no federal income tax also have less concern about the other side of the ledger-- federal spending. Not owing federal income tax can severely mitigate one's concern for the size and efficiency of government. As the number of non-taxable returns rises, constraining the size of government becomes more difficult.

Furthermore, it is important to understand that channeling frustration over the unfairness of the current system at the people who don't pay income tax would be misdirecting the blame. The 52 million nontaxable returns represent families and individuals who only availed themselves of the tax system that Congress established for them. The political popularity of a broad swath of tax credits ranging in purpose from education to energy to adoption and childrearing have the effect of pushing more and more households to zero (or even negative) tax liability.

Now a renewed debate on tax reform has begun. House Budget Committee Chairman Paul Ryan and Ways and Means Committee Chairman Dave Camp have both endorsed a tax reform agenda that includes a broader tax base and reduced statutory tax rates in conjunction with holding tax revenues near historic levels. President Obama has also advocated for the elimination or curtailment of some tax preferences but has instead suggested higher marginal tax rates for high-income individuals and a greater overall tax burden.

This debate exposes a fundamental difference between the political parties with regard to the size and financing of government and the appropriate tax obligation for those with the highest income, a debate that will only get louder as the next election nears. But there are other perspectives on this debate that matter too, and one lesson that is clear from a review of the data on nontaxable returns is that we don't need a tax code that has fewer people paying tax.