Understanding Tax Cuts – The Logic

I had got this as an email somedays back. With the latest Budget plans of the Indian Government, I thought this would be the right time to share this with all. It made a lot of sense to me. I have customized it a little bit to fit to India scenario (I hope the original author doesn’t get offended by this). Check it out.

“Understanding Tax Cuts” By: David R. Kamerschen, Ph.D

Sometimes politicians, journalists and the critics exclaim; “It’s just a tax cut for the rich!” and it is just accepted to be fact. But what does that really mean?

Just in case you are not completely clear on this issue, I hope the following will help. Please read it carefully. Let’s put tax cuts in terms everyone can understand.

Suppose that every day, ten men go out for dinner and the bill for all ten comes to Rs.100.

If they paid their bill the way we pay our taxes, it would go something like this:

  • The first four men (the poorest) would pay nothing.
  • The fifth would pay Rs.1.
  • The sixth would pay Rs.3.
  • The seventh would pay Rs.7.
  • The eighth would pay Rs.12.
  • The ninth would pay Rs.18.
  • The tenth man (the richest) would pay Rs.59.

So, that’s what they decided to do. The ten men ate dinner in the restaurant every day and seemed quite happy with the arrangement, until one day, the owner threw them a curve. Since you are all such good customers,” he said, “I’m going to reduce the cost of your daily meal by Rs.20.” Dinner for the ten now cost just Rs.80.

The group still wanted to pay their bill the way we pay our taxes so the first four men were unaffected. They would still eat for free. But what about the other six men – the paying customers? How could they divide the Rs.20 windfall so that everyone would get his ‘fair share?’

They realized that Rs.20 divided by six is Rs.3.33. But if they subtracted that from everybody’s share, then the fifth man and the sixth man would each end up being paid to eat their meal. So, the restaurant owner suggested that it would be fair to reduce each man’s bill by roughly the same amount, and he proceeded to work out the amounts each should pay.

And so:

  • The fifth man, like the first four, now paid nothing (100% savings).
  • The sixth now paid Rs.2 instead of Rs.3 (33% savings).
  • The seventh now paid Rs.5 instead of Rs.7 (28% savings).
  • The eighth now paid Rs.9 instead of Rs.12 (25% savings).
  • The ninth now paid Rs.14 instead of Rs.18 (22% savings).
  • The tenth now paid Rs.49 instead of Rs.59 (16% savings).

Each of the six was better off than before. And the first four continued to eat for free. But once outside the restaurant, the men began to compare their savings. I only got a rupee out of the Rs.20,” declared the sixth man. He pointed to the tenth man,” but he got Rs.10!”

“Yeah, that’s right,” exclaimed the fifth man. “I only saved a rupee, too. It’s unfair that he got ten times more than me!”

“That’s true!!” shouted the seventh man. “Why should he get Rs.10 back when I got only two? 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!”. The nine men surrounded the tenth and beat him up.

The next night the tenth man didn’t show up for dinner, so the nine sat down and ate without him. But when it came time to pay the bill, they discovered something important. They didn’t have enough money between all of them for even half of the bill!

And that is how our tax system works. The people who pay the highest taxes get the most benefit from a tax reduction. Tax them too much, attack them for being wealthy, and they just may not show up anymore.

In fact, they might start eating overseas where the atmosphere is somewhat friendlier.

[ David R. Kamerschen, Ph.D, Professor of Economics, University of Georgia ]

  1. #1 by little indian on March 1, 2007 - 6:13 pm

    I wouldn’t mind paying in Rupees if I got back $$ as Tax cuts 🙂
    On a serious note

    I am realising how few people
    understands the importance of paying their full income tax,
    but even more surprised at the lack of understanding of a sustainable and fair tax system.

    To get something from the state,
    everyone has to give something in first.
    To rely on those few who do pay
    to keep paying more and more for those who don’t
    is the perfect disincentive.
    The goose is bound to fly off, golden eggs and all.
    The state coffers will remain ever empty.

    I read so many blogs (from India)
    that perpetually blames the administration and politicians
    for anything and everything
    that is now wrong with the state of our nation
    the lack of civic amenities and state support.
    But there is a (convenient) denial that
    everyone of the general public has a duty
    to be honest in their declarations and pay their just dues.
    (My father was in Indian Revenue Service, I have seen it all)

    I accept that none of these politicians will ever deserve a halo over their heads,
    but if the government treasuries are empty, there is nothing, absolutely nothing
    that even the most efficient and honest administration can ever do.

    That we do not have honest politicians,
    is because no honest person want to take the job
    of running a country on empty treasuries.
    We deserve what we have.

    Nothing in life is free.

  2. #2 by udayms on March 2, 2007 - 7:02 am

    Ok. Agreed. But, the corrupt administrators and politicians why some people get away with tax dwindling. If the top level were strong, honest and stable it would go a long way in solving most of the problems we have as a country.

    Moreover, look at it. Recently, Karunanidhi of Tamil Nadu Government gave away many thousands of COLOR TVs to poor people. This was fulfilling an earlier promise (made as part of the election campaign). Now, Where did this money come from? IT’S MY MONEY! The money I PAID as tax by working 20 hrs a day!

    Today, when these damn ministers fly by in their convoy vehicles surrounded by atleast 3 escort vehicles and an ambulance(Yeah! its true. An Ambulance!!!), I am stopped on my way to office and made to wait for upto 20 mins to let them pass. Who is paying for those vehicles and that fuel. I AM! And These Ba$tard$ are flying around on my money while I have to wait and give way for them when they want me to.

    I am a disgruntled tax payer! I dont mind paying tax if I get something back in return. But, all i get in return is problems if I step out on the streets!

    I maybe wrong here. But, I feel Democracy has failed miserably in India.

  3. #3 by little indian on March 2, 2007 - 10:20 am

    So what is your favoured solution?

    Everyone stops paying taxes? Level playing field?
    Every Rupee you earn you keep.
    In return not have any public services.
    None at all.
    Buy every single service you need.
    Including personal protection.
    Each man and woman to him/herself.

    Get rid of democracy, if it has failed.
    every Administrator or Politician
    In fact get rid of any form of Government
    as there will be no public money to pay for one.

    Not even a military government,
    there will be no money to spend on defence
    no Army Navy or Airforce.

    The perfect westernisation ….the good old American Wildwest. 🙂
    The quicker is your draw, the more power (respect) you achieve.

  4. #4 by udayms on March 3, 2007 - 9:50 am

    😀 …. nice one…. the last bit about “quicker you draw”…. hmmm… I would look good in a cowboy hat!! 😉

    Well, actually my post kind of railed off the main topic when i mentioned that democracy has failed. What I meant was – year after year some new government comes to rule in every state in India. But, none of them have really done much towards development of the state or the country. yeah, some of them have been decent enough not to cause harm though…

    And my solution to this would not be stop paying taxes. But, to eliminate TDS (Tax Deducted at Source). Today, they take my money from me first. Then, I am left at their mercy. They can choose to provide me service. If they don’t, I still can do nothing. I can sit and blog like this but no one would care.

    Imagine a scene where they don’t take TDS from the population. But, have a mechanism to ensure that everyone is paying taxes. Now, for some reason when a society of people in a locality is angry because the road conditions are pathetic and the government is not acting…. they can come together and not pay tax for the month… This should mean no pay for the local concerned authority…. This will force the government to take some action against those lazy a$$es…

    Yeah. I agree it will be chaos in a short while… but, I see this as a war. A war between the common man and the elected leaders of the state and country. And there will be chaos and there will be casualties. But, in the long run, i think it would turn good. The politicians should realize that they have been elected to do a job – to run the country. And if they don’t do that properly, people still have control over them.

    Today, I – the common man – have no control over this. I pay my taxes properly and then i go through all the difficulties for every trivial service I require from the government. Hey… I walk to office everyday because I really don’t want to drive in this indisciplined chaotic traffic. Why are we not able to make the system better? because the enforcers – Cops – are themselves corrupt. At the end of the day it all boils down to one thing – bad management at the authorities. And thats because somebody is not doing their job properly.

    So, Tax is the root of some problems – as I see it. Because, I give them the money to go have fun and then complain that they are having fun. Say, I don’t give them the money? Most of today’s politicians would quit politics and go for something else. It will give way for a educated younger generation to atleast step into politics. Today, they cant do that. Politics is a dirty pond no one wants to step into it. Once all the bad fishes are out, atleast then people would be ready to step in clean up the mess.

    There may be pros and cons with this approach. Also am no expert in economics. But, since the knowledge experts are keeping mum, idiots like me come out with theories like this 😉 .

  5. #5 by little indian on March 3, 2007 - 2:32 pm

    In a white Stetson?
    Fanning the silver six-shooters,
    you betcha. 🙂

    I will come back to this, keep it open.
    With the world cup cricket coming up,
    I am struggling with my cricket site.

    And I am with you,
    I happy to stay an honest idiot
    than a hypocritical knowledge expert.

  6. #6 by Eric Smith on March 28, 2007 - 12:21 pm

    from http://www.truthorfiction.com/rumors/t/taxcuts.htm

    Summary of the eRumor
    This is an attempt to use a story to try to explain the complexity of taxes and tax cuts.

    The Truth
    The biggest question about this eRumor is not so much whether it’s an accurate picture of taxation as to who actually wrote it.

    The most recent version that has circulated on the Internet attributes it to David R. Kamerschen, a professor of Economics at the University of Georgia. On his web site, however, he denies that he wrote it and says he doesn’t know who did. How his name got attached to it, he does not know.

    Different version says it was written by another university professor, T. Davies of the University of South Dakota. He too denies that he wrote it.

    So its origins is [sic] still a mystery,.

  7. #7 by Geechee on April 27, 2007 - 5:02 pm

    Under the inspired leadership of our national and state governments we have seen the Welfare rolls cut in half (not an all together bad thing, a subject for another day), so the first four have now been reduced to two, numbers three and four are working for minimum wage and therefore pay most of their income in the form of a tax to live (subsidizing the business owners tax payments with their wages going to pay for the necessities of life) and contribute more than their perceived share by way of the regressive use and sales taxes. Also, at least in South Carolina their support of the lottery helps to pay the higher education expenses for the sons and daughters of five through ten.

    Numbers five through seven received no reductions since they are the working middle class and their main source of income is in the form of wages. They have very little opportunity to invest (except through 401K’s and that just delays the tax payments) and therefore little or no capital gains, interest and/or dividend income to receive a tax break on.

    Numbers eight and nine while seeing a reduced tax rate on their capital gains and interest/dividends, also saw it eroded due to loss of some deductions. They faired better than one through seven as they still managed to save a buck or two.

    Numbers nine and ten never paid any taxes due to their diligent investment in politicians, tax lawyers and offshore bank accounts. They are the recipients of the resulting de facto government program I call Wealth-Fare. Therefore in the end only numbers nine and ten just keep getting richer, but not from tax reductions, but from tax avoidance. However, the real winners are the congressmen, who continue to receive bigger and bigger payoffs to massage the tax codes to allow numbers nine and ten. Now they can enjoy, what for us is imported beer, in its country of origin. It makes absolutely no difference which party is in control, the highest income levels always benefit from the tax code.

  8. #8 by DWayne on October 11, 2008 - 12:06 am

    Bar stool economics – with one additional assumption

    The discussion below based on the assumption that the budget is balanced, and the 10 men only drink what they can afford collectively as a group. The only question then is how to divide up the bill fairly among the people.

    But what if the bar bill costs $120 each week, and the ten men agree they will pay $100 of it now and $20 in the following week.

    The bartender says “OK – I’ll give you an IOU” but you’ll have to pay interest on it and that will decrease the amount of beer that you and your friends can buy in the future.

    And if you don’t pay the IOU off – and the debt keeps getting larger – then your kids will have to assume the debt and it will be passed from generation to generation where it will impact their life. At some point, your kids won’t be able to buy any beer at all, because they are continuing to pay for the beer that you drank in years before. As well as the interest on the IOU. And at some point, I may just have to cut you all off as a group because you owe me too much.

    So now the ninth and tenth richest men at the bar push for paying as little as possible – they want the tax cuts ! – and the benefits of the lower bill will go directly to them. They won’t ever pay the IOU – that is someone else’s problem – and they really don’t care about the next generation and their ability to buy beer.

    The truth is – it was all about them. The ninth and tenth richest men were so focused on paying the bartender as little as possible each week, that they didn’t realize that their greediness and short-term thinking would eventually shut down the whole system and close the bar.

    In the end, the bartender stopped accepting IOUs form the group and the credit dried up. He started by firing half of his waitresses since there were fewer customers to serve. In the end, he couldn’t pay his bills to the supplier and had to go out of business. And this left the nine and tenth richest men with no friends and no place to go out to each week.

    And the ninth and tenth richest men looked at each other and said –

    “How could this possibly have happened?”

    “Could my selfish tax cuts and foolish spending policies over the past eight years have contributed to this?”

    And they sat there as if they didn’t know the answer.
    And they STILL asked for more tax cuts, because they couldn’t think of anything that was be beneficial for the group.

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