Bar-room economics proves the rich are not skipping their round on tax

PART of the cure for our economic ills will have to be increased taxes for higher income earners and the rich who own substantial assets. But there is a limit as to what extra tax can be levied from these sources without the intended effect of raising additional revenues being lost.

You may have received the same email recently that I have from a number of listeners to The Last Word. It is called “bar-room economics — how the tax system works”. It is attributed to a professor of economics at the University of Georgia called David R Kamerschen, although I have read also he has denied authorship and disavowed responsibility since the work has gone around the world on the internet.

Nonetheless the theory is interesting, so for what it’s worth, and remembering that it was devised for an American audience and for its tax system, here it is.

Suppose that every day 10 people go out for beer and the bill for all 10 comes to e100. The bill is paid according to income and tax rates as paid in the US, but as we have many people outside the tax net in this country and differing payments for people as they get richer, we’ll stick with the plan as the theory sets out. This is how the bill is divided.

The first four (the poorest) would pay nothing.

The fifth pays e1.

The sixth pays e3.

The seventh pays e7.

The eighth pays e12.

The ninth pays e18.

The tenth (the richest) pays e59.

So, let’s assume that everybody drinks in the bar every day and is happy with the arrangement. However, one day the owner throws them a curve ball.

“Since you are all such good customers,” he said, “I’m going to reduce the cost of your daily beer by e20.”

Drinks for the 10 now cost just e80.

The group still wanted to pay their bill according to the old formula, which meant that the first four were unaffected. They would still drink for free. But what about the other six — the paying customers? How could they divide the e20 windfall so that everyone would get their “fair share”? They realised that e20 divided by six is e3.33.

But if they subtracted that from everyone’s share, then the fifth and the sixth would each end up being paid to drink their beer. So, the bar owner suggested that it would be fair to reduce each drinker’s bill by roughly the same amount, and he proceeded to work out the amounts each should pay.

Here’s what happened: the fifth person, like the first four, now pays nothing (100% savings). The sixth now pays e2 instead of e3 (33% savings).

The seventh now pays e5 instead of e7 (28% savings).

The eighth now pays e9 instead of e12 (25% savings).

The ninth now pays e14 instead of e18 (22% savings).

The tenth now pays e49 instead of e59 (16% savings).

Each of the six was better off than before. And the first four continued to drink for free. But once outside the restaurant, the drinkers began to compare their savings.

“I only got a euro out of the e20,” declared the sixth. She pointed to the tenth man, “but he got e10”.

“Yes, that’s right,” exclaimed the fifth. “I only saved a euro, too. It’s unfair that he got 10 times more than I did.”

“That’s true!” shouted the seventh. “Why should he get e10 back when I got only two? The wealthy get all the breaks.”

“Wait a minute,” yelled the first four in unison. “We didn’t get anything at all. The system exploits the poor.”

The nine drinkers surrounded the 10th and beat him up.

The next night the 10th man didn’t show up for drinks, so the nine sat down and had beers without him. But when it came time to pay the bill, they discovered something important. They didn’t have enough money between them for even half of the bill.

The moral of the tale, as circulated on the internet, is that while the people who pay the highest taxes get the most benefit from a tax reduction, if you tax them too much and attack them for being wealthy they just may not show up anymore. They might even head abroad.

That argument came to mind when I read a report in our sister paper, The Sunday Business Post, this week.

It reported “concern” among government ministers and officials that income tax receipts are becoming too dependent on very high earners, just the people many want to hit for more tax. It reported fears that tax increases could drive away some high earners, leading to a disproportionate effect on income tax receipts.

The report quoted statistics from the revenue commissioners that show half of all income tax — e6.5 billion — is paid by the top 6.5% of taxpayers and that one-third of all income tax is paid by the top 2.5% of taxpayers, numbering just 60,000 out of the total 2.4 million income earners.

In other words, despite the myriad of incentives available to them to shelter their income from taxes, and reports of some wealthy people managing to reduce their annual income tax liability to near zero in recent years by clever use of the legal dodges, the rich are paying their share. Imagine if suddenly their income falls dramatically or stops entirely: not only would they be in crisis but the State’s take of income tax would also fall dramatically.

By contrast, some 38% of all income earners are under the tax threshold and pay no income tax at all. Those below a certain threshold have been exempted from the income tax levy introduced on January 1, but those with income in excess of e100,000 are paying 2% and those earning above e250,000 are paying 3%. The higher income levies are as they should be, but it makes it more difficult to raise further levies from next year or introduce a new top rate of tax.

HIGHER income taxes — and the possible introduction of property taxes, as pushed by trade unions who begrudge people who have invested in providing the best possible accommodation for their families — are going to be the big issues when it comes to the next budget.

The massive shortfalls in capital gains tax — because the rich are not profiting by selling assets — corporation tax and VAT means the Government revenues have become more dependent on income tax than previously.

So when the Taoiseach spoke last weekend of the possibility of introducing new taxes and, more significantly, of bringing more people into the tax net, he may have had those who pay no taxes in mind.

He might like to get more taxes from the infamous exiles, for example, but unfortunately may have left it too late: some of them will have little or no income or taxes during 2009 to tax, such has been their level of losses in recent times.

Politically it will be impossible not to tap the rich for more tax. Even bar-room economics as outlined above will not convince the lower paid and public servants that while they are being punished for the economic slowdown the rich are being allowed dodge the bullets (when, in fact, they don’t).

But it means the Government will have to take great care to get the balance right. Squeeze the “rich” too much and the required income may not be forthcoming.

The Last Word with Matt Cooper is broadcast on 100-102 Today FM, Monday to Friday, 4.30pm to 7pm.