The Dirty Secret of How Income Taxes Really Work

For the sake of this argument, let's divide the population into three groups. The first group consists of children, dependents, retirees, and those who manage to live off government handouts like disability, food stamps, etc. This group does not earn enough income to contribute to income taxes. The second group consists of people with regular employment, either with employers or in their own businesses. They earn enough income to pay taxes, but they generally compete for interchangeable jobs in a transparent, free job market. As a result, individually, they do not have a lot of influence over the level of income their jobs generate. Also, due to their large number, if they manage to increase income through collective bargaining, any increases are immediately absorbed by inflation in the prices of the goods and services they purchase from each other.

The third group consists of people with a specialized skill or education. These individuals can more or less set their own income: when you ask a Harrison Ford or a Hillary Clinton what you need to pay her to do some work for you, she is not easily replaced, and she does not need to know what the prevailing wage is for the job. This is where the dirty secret comes in: people in the third group typically set an expectation for themselves of how much money they want to take home. Then they add taxes to that and set the result as the price of their services. They do not really "pay" any taxes from an "income" that is limited in some way. Their taxes are paid by their customers, and they merely "pass them along" to government, exactly as a retailer does with sales taxes. This is true also of the people in the second group: their taxes are included in the level of their income and are paid by their employers or their customers. But the people in the second group do not have the flexibility to decide how much they want to take home. If they do that, they run a high risk of losing the job to somebody else who is willing to work for the income offered. It is useless to try to get the "rich to pay their fair share" through progressive taxes. If we doubled the highest federal income tax bracket from 39.6% to 79%, Mr. Ford would merely charge $34.9 million per movie instead of $25 million. He would still take home the same $15 million, but now middle-class theatergoers, DVD buyers, and movie streamers would be charged an additional $9.9 million to see him in action. With movie stars and celebrity politicians, at least we have a choice: to buy their services or not. But what of the surgeon you need to save your life or the accountant you need to make sure you file your taxes correctly so you don't go to jail? The bottom line is that all income taxes are paid (deducted from an inflexible income) only by the people in the second group, or the "middle class." Any tax increase is ultimately paid by them only, in the hard day-to-day facts of higher taxes and higher prices. Government handouts eventually rise with inflation. The third group can charge what it wants to. But what of the other taxes, you say? Sales taxes, property taxes, capital gains taxes, estate taxes? What if we limit their tax deductions? The third group can easily factor those things into their prices as well: if Mr. Ford needs a new helicopter, that cost is what he'll charge for his next movie. If there are sales taxes, they are easily included. A new home for Mrs. Clinton with new real estate taxes? Included in the fee for the next speech about the need for higher taxes. So isn't there anything we can do about this? Yes, we can implement schemes like the new proposed "single-payer health care system" (Senate Bill 562) in California. If we make it illegal for all those third-group professionals to set their own prices, then we can surely get them to work for less, can't we? History shows us what we would have to do to maintain such a system: Communist countries, where everything is essentially single-payer, have to imprison, torture, and murder on average 20% of their population to get the others to cooperate for the "greater good of the workers." No, the only things proven to contain third-group prices are increased competition and increased free-market transparency. Stock brokers used to belong to the third group. Now their income is fiercely competitive. Here is an idea: each year, we take the amount that our politicians spend, add any budget overruns from prior years, and divide it by the value of everything that has changed ownership that year. Then we get the banks to deduct the tax for each dollar that changes hands equally. Now everybody (and every corporation) pays "his equal share" of the policies, defense, and handouts we vote for. The three groups still operate the same way, but at least the middle class no longer penalizes itself for its class envy.