How Tax Day Became Payday

Heritage Foundation

For just over half of all Americans today is Tax Day. But for the other half it is just another day on the calendar. That's because they pay no federal income taxes. The old saying goes "you can't get something for nothing." But these "non-payers" receive government services and benefits without chipping in. If more taxpayers continue to drop off the tax rolls, we will soon pass the dangerous tipping point where more than half of taxpayers are non-payers. The individual income tax is the main revenue raiser for federal government. Passing the point where less than half of taxpayers pay it would mean a majority of voters could vote themselves more and more government benefits without incurring any of the costs. In this unstable situation, politicians would have no incentive to restrain government spending since they could garner more votes by increasing it. That is a deadly recipe for never-ending increases in government spending that will inevitably lead to fiscal implosion when there are no longer enough productive taxpayers to foot the bill for the expanding state.

The explosion of tax credits in recent years is the main reason that more than half of all taxpayers could soon pay no federal income taxes. Both political parties are fond of credits because they can use them to target benefits at politically valuable groups – think credits for buying hybrid cars or improving the energy efficiency of your home, for instance.

To make matters worse, most non-payers not only pay no income taxes, they actually collect cash payments through the tax code. For these recipients of government redistribution, Tax Day has become pay day. They get this cash because of refundable tax credits. Refundable credits can not only wipe out all of a taxpayer’s income tax liability, but also send them cash for any remaining credit value. President Barack Obama once promised to simplify the tax code, but his agenda has actually made this problem much worse.

The President's failed $862 billion stimulus plan created the Making Work Pay refundable tax credit which redistributes up to $800 to filers earning less than $190,000 per year. The stimulus also: expanded the Hope Scholarship credit (renamed the American Opportunity Education credit) and made it refundable; expanded the child tax credit; and expanded the earned income tax credit (EITC). In 2010, the three largest refundable credits (the earned income tax credit, the Making Work Pay credit and the child tax credit) will redistribute over $114 billion from payers to non-payers.

To fund these giveaways, President Obama campaigned on a plan to raise the top two income tax rates for those earning more than $250,000 per year ($200,000 for single filers). Already the top 10% of income earners pay 71% of all federal income tax revenue. This may seem like a great deal for non-payers, but ultimately there is no such thing as a free lunch. Redistributing wealth through the tax code only stifles innovation and job creation. Small-businesses employ just over half of U.S. workers and a recent study by the Kaufman Foundation found that small businesses have led America out of its last seven recessions, generating about two of every three new jobs during a recovery. But since most small businesses are unincorporated, so business income is treated as personal income, high income taxes hit small businesses the hardest. So while non-payers may enjoy a once a year pay day from the federal government thanks to all their tax credits, they are also the eventual victims of the resulting small-business-job-killing higher income taxes rates.

The income tax code is supposed raise revenue for necessary government functions while distorting economic behavior as little as possible. Congress should do three things immediately to stop the tax code from being used as a vehicle for social engineering and wealth redistribution:

(1) Stop creating new credits, especially refundable ones. This would stop knocking more taxpayers off the income tax rolls and slow the growth of cash payments through the tax code.

(2) Allow the Making Work Pay Credit to expire. Under current law, the Making Work Pay Credit expires in 2013. Congress should let it expire since it removes many taxpayers from the tax rolls and “ because it's refundable - makes more families dependent on the tax code for income.

(3) Extend the 2001 and 2003 tax cuts for all taxpayers. President Obama has long wanted to raise taxes on those making more than $250,000 a year. Doing so would increase the share of income taxes paid by top-earners and facilitate the move to push the tax code faster to the point where a majority of taxpayers pays no income tax. Extending the tax cuts for all taxpayers would prevent that acceleration.

Fundamental tax reform is the only way to ensure that all Americans have a stake in controlling the size of government. Reversing the rapid expansion of dependency that is being facilitated by the tax code will not be easy. Many tax filers have grown accustomed to not paying taxes and receiving cash payments through the tax code. That is why we're conducting a Tax Day Money Bomb today to send our elected officials a message that their reckless spending ways must end. Our goal is to raise $150,000 money that, unlike your tax dollars, won't be wasted.