Financial Opinion and Insights

How Tax Increases and Redistribution Really Works

Jim Lorenzen, CFP®, AIF®

Jim Lorenzen, CFP®, AIF®

It seems every election cycle brings with it the issue of who should bear the cost of government spending and to what degree.  For many, the discussion begins with taking it from the rich and giving it to the poor.  It’s as old as Robin Hood – probably older.  And, since there are more poor people than rich, it plays usually plays well at the ballot box.    

While most voters may not understand economics, they do know when they’re out of work; and they don’t like seeing their jobs going overseas.[i] Unfortunately, the U.S. tax code has become a ‘book of favors’ – a virtual  ‘jobs protection act’ for elected officials primarily concerned with raising money for the next cycle and insuring votes for re-election.  

How do tax cuts really work?  IMHO the following little story[ii] – entirely made-up – provides a good example of how capital follows opportunity.

Here’s our scenario: Every day, ten men go out for dinner. The bill for all ten comes to $100  (I know, that couldn’t happen, but we’ll pretend).  If they paid their bill the way we pay our taxes, it might look something like this[iii]:

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

So, the ten men ate dinner in the same 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 $20.”

Now the dinner for all ten cost only $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, the paying customers?   How could they divvy up the $20 windfall so that everyone would get his ‘fair share’?

The six men realized that $20 divided by six is $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[iv].

Here’s how it turned out: 

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

Seems fair enough.  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.

“Hey!  I only got a dollar out of the $20,” declared the sixth man. He pointed to the tenth man “but he got $10!”

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

“That’s true!!” shouted the seventh man. “Why should he get $10 back when I got only $2?”   He became upset at the injustice.  “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.  Apparently, tax breaks for the wealthy aren’t popular. 
You can probably guess what happened after that.    The next night the tenth man didn’t show up!   So, the nine sat down and ate dinner without him.   

Alas, 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!   Oops.

It’s a simple lesson many journalists and college Keynesian-schooled professors have problems grasping, yet this is how our tax system actually works!    Tax laws have historically been used to direct the flow of capital.   And, the ones who get the most money back from a reduction are – or should be – those who paid-in the most to begin with.   

Here’s the lesson of our dinner group story:  

Increasing taxes on those we feel have too much capital, simply because they have wealth, destroys their incentive.  As in our story, they just may not show up “at the table” anymore.   They will remind us all there are lots of good restaurants in China, India, South Korea, Europe and the Caribbean.    They know – and we should too – jobs are created where capital is directed.  If we provide incentives to direct capital someplace else, we will simply be draining capital from the economy and the rest of us will be stuck with a bigger bill.


The Independent Financial GroupJim Lorenzen is a CERTIFIED FINANCIAL PLANNER® and an ACCREDITED INVESTMENT ADVISOR® in his 21st year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California.   IFG provides investment and fiduciary consulting to retirement plan sponsors, and retirement and wealth management services for individual investors. IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description.  IFG also does not provide tax or legal advice.  The reader should seek competent counsel to address those issues.  Content contained herein represents the author’s opinion and should not be regarded as investment advice which is provided only to IFG clients upon completion of a written plan.  The Independent Financial You can reach Jim at 805.265.5416 or through the IFG website, www.indfin.com, the IFG Investment Blog and by subscribing to IFG Insights letters for individual investors.  Keep up to date with IFG on Twitter: @JimLorenzen

[i] Recommended reading:  The World Is Flat, by Thomas Friedman, a volume on the economic impact of globalization – the leveling of the playing field –  and America’s new place in this paradigm.  Should be required reading for anyone interested in this issue. 

[ii] Not original and I don’t know the author.  It was relayed to me by a colleague about six years ago.

[iii] This is a hypothetical example of a progressive tax system and its impact on a population of taxpayers.

[iv] The restaurant owner figured, as an example, that if the eighth man was paying 12% of the tax before, he should be entitled to 12% of the savings.  12% of the $20 savings is $2.40.  Since he decided it should be ‘roughly’ the same and to make it easier on the diners to figure the bill, he rounded-up (in this case) and decided man #8 should get $3 of the savings.

Written by Jim Lorenzen, CFP®, AIF®

October 18, 2012 at 8:00 am

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