What Is Tax Fairness? And Why Does Tax Fairness Matter?

December 13th, 2013

What is “fair”?

There are lots of different ways to see it. According to the Americans for Tax Fairness tax fairness means making corporations and wealthy individuals “pay their fair share.” For those at CATO, tax fairness is an Alternative Minimum Tax (or flat tax).

Ultimately, though, tax fairness is a normative–and subjective–concept.

It’s helpful, then, to consider what society as a whole considers fair. People’s opinions about this question matters, not only in a theoretical sense, but also because we want to maximize society’s happiness overall. To accomplish this, we need a tax system that aligns with society’s preferences.

While people do not have homogeneous preferences on tax fairness, economists have found that people generally prefer greater societal equity established through the tax code.

Senator Tom Coburn, a Republican from Oklahoma, has articulated tax fairness this way: “An individual’s or corporation’s tax rate shouldn’t be dependent on their ability to hire a tax lobbyist. It’s especially wrong to ask families who are struggling to make ends meet to subsidize special breaks for corporations.”

Are taxes in the United States “fair”?

The top income tax bracket in America is now about 30 to 50 percent below what it was under Eisenhower, Nixon and Ford—when the country was a great deal more equal. The top marginal income tax rate is a little below 35%–compared to 70% before Reagan took office.

The marginal tax rate, the rate on the last dollar earned, is not the same as the effective tax rate, which includes taxes on capital gains and pensions, and removes money on government payments, including Social Security. According to the IRS the effective federal income tax rate for the Fortune 400 fell from almost 30 percent in 1995 to just below 17 percent in 2007.

Yet the true effective rate is even lower than government statistics suggest because those figures fail to include income generated by tax avoidance strategies. In many of these strategies, the earner will borrow money against their assets and then never (or indefinitely push off) repay. Other executives—like Phil Knight of Nike, Jeffrey Immelt of GE, and James Gorman of Morgan Stanley—have left future earnings to children without paying estate tax by setting up Grantor Retained Annuity Trusts.

And then there are the many complicated accounting strategies involving secrecy jurisdictions that also contribute to millions in evaded and avoided taxes. In 2008 the Government Accountability Office found that of the 100 largest corporations, 83 have subsidiaries in tax havens.  In 2004 U.S. multinational corporations paid about $16 billion of U.S. tax on approximately $700 billion of foreign active earnings – an effective U.S. tax rate of about 2.3%.

Why does it matter?

A regressive tax system raises money from those who have the least of it. Beyond the distributional impacts and ethical implications of a regressive system, these tax systems generally increase income inequality and may contribute to lower economic growth.

In America, an unfair tax system is particularly important as society has become more stratified. Meanwhile, generally society would prefer more equality, not less. Over the last few years, median incomes in America have actually fallen. In fact, since the end of the 2008 economic recession, 95% of the economic gains have gone to the richest 1% of Americans.

There is also evidence that tax fairness can promote a better functioning society. While it is difficult to separate correlation from causation on this issue, tax fairness may influence people’s willingness to comply with laws.

The concept of tax fairness is tightly entwined with equality and society’s perceptions of fairness. As our tax system has become easier to exploit and more regressive, our society has become more unequal. While one does not necessarily drive the other, they are highly related. To achieve a society that aligns more closely with our preferences, we should reform our tax code and eliminate offshore tax loopholes that allow corporations and wealthy individuals to substantially reduce their tax burdens.

Written by Ann Hollingshead

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