Bar Stool Economics Show Why A Progressive Tax System Is Wrong

No matter how long it takes, I will fight for equality.  The best system for taxation equality is providing a flat tax above a certain poverty level or income level so that everybody pays something to support our country.  If the poverty level is $20,000 for a family of four, let’s keep federal taxes low to nothing since there are already state taxes, social security taxes, and medicare taxes to pay.  However, we should probably encourage further education on why it’s probably not a good idea to have any more children if one is having difficulty taking care of themselves, despite the misplaced policy of a $1,000 child tax credit for certain income earners and below.

Perhaps the flat tax income threshold is at $33,000, the halfway point between the top and bottom 50%.  After $33,000, everybody pays a flat tax rate of 20% on all income, which includes investment, dividend, and interest income.  No loopholes, no deductions, 20% is 20%.  If you’re making under $33,000, your tax rate is lower.

Or perhaps the income threshold is above $106,800, where social security and medicare taxes disappear.  We tax people progressively up to $106,800 and then a flat tax afterward.  One of the big arguments some have against a flat tax is that it’s regressive, since the rich don’t pay any more social security and medicare taxes after $106,800.  Well guess what?  Although you don’t have to pay those taxes above $106,800, you also don’t get any benefits either!  Do you really think there is a free ride with our government of waste?  Of course not.  Please understand this point.

With a flat tax system after a certain amount of minimum income, the person who makes 10X more, pays 10X more in absolute dollars.  Nobody can logically argue against equality.  But, for those of you who feel that discrimination is the way to go, here’s a story of Bar Stool Economics which I stumbled across on online that hopefully sheds some light.

BAR STOOL ECONOMICS

Suppose that every day, ten men go out for beer and the bill for all ten comes to $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 $1.

The sixth would pay $3.

The seventh would pay $7.

The eighth would pay $12.

The ninth would pay $18.

The tenth man (the richest) would pay $59.

So, that’s what they decided to do. The ten men drank in the bar every day and seemed quite happy with the arrangement, until one day, the owner threw them a curve ball.   ‘Since you are all such good customers,’ he said, ‘I’m going to reduce the cost of your daily beers by $20. Drinks for the ten now cost just $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 drink for free. But what about the other six men – the paying customers? How could they divide the $20 windfall so that everyone would get his ‘fair share?’

They 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 drink his beer. So, the bar 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.

With the new system:

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 pay $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).

Each of the six was better off than before and the first four continued to drink for free, but once outside the restaurant, the men began to compare their savings. “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 I!” “That’s true!” shouted the seventh man. “Why should he get $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 drinks, so the nine sat down and had beers without him. But when it came time to pay the bill, they discovered something very important.  They didn’t have enough money between all of them for even half of the bill!

The people who pay the highest taxes get the most benefit from a tax reduction.  This is called, “No shit Sherlock”.  Tax them too much, attack them for being wealthy, and they just may not show up anymore. In fact, they might start drinking overseas where the atmosphere is somewhat friendlier.

For those who understand, no explanation is needed.

For those who do not understand, no explanation is possible!

Recommendation: I’ve been using H&R Block’s Premium Tax Software to do my own taxes for the past 11 years. It’s inexpensive and very easy to use for novice to advanced tax filers. The software always updates with the latest tax rules so you’re never behind. They also have audit protection service as well.

Regards,

Sam

Sam started Financial Samurai in 2009 during the depths of the financial crisis as a way to make sense of chaos. After 13 years working on Wall Street, Sam decided to retire in 2012 to utilize everything he learned in business school to focus on online entrepreneurship.

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Comments

  1. says

    Bar stool econ makes everything easier to understand. I’m not a fan of the 9, 9, 9 plan I keep hearing about from the media, but I really like the idea of a flat tax system. We have an even more progressive tax system than yours. At just $130K/yr you will already be in the highest tax bracket where almost half your income at that point will go towards taxes [:0( Hmm, I wonder why so many surgeons, lawyers, successful entrepreneurs, and other high income individuals who grew up here eventually all move across the border to the US ಥ‿ಥ Maybe to some being discriminated against is worth it if it means they can be wealthy. I only wish Canada would adopt a similar tax system. Maybe one day we will.

  2. David M says

    Sam,

    I agree with you concept of a flat tax 100%!!!!

    I love that you have 1) made some allowance for the lowest wage earners and 2) decided there would be, “No loopholes, no deductions”. I think number 2 is crucial!

    With this simpleness I actually think this plan could get enacted. However, once we start allowing any deductions, credits, etc, it becomes a political nightmare. As everyone wants to defend those deductions and credits that arre helpful to them – that is what created the tax code disaster we currently have and what keeps us from scrapping it and starting over.

    Now, can we create a movement out of this?

    What will it be called? What is our simple sound bite?

    I know this is not great for a sound bite but will throw it out – I would love to see what others can come up with.

    No deductions, No credits, 20% for all! (You sort of need to chant it).

    Keep the great posts coming,

    David M

  3. says

    Why 20% and a threshold of $33K? Why not 25% and a threshold of $60K. Better yet, why not 75% with a threshold of $200K? Your bar stool econ example would argue that then the 25% at the top wouldn’t show up for beers the next day in this last proposal, but that’s where the analogy breaks down. Besides, isn’t your version of a flat tax just a binary form of a progressive tax system? Apparently you do see some need for this.

    The problem isn’t taxes, it’s the legislation that has allowed the distribution of wealth to get so out of whack. Take a look at Figure 3 here:

    http://cbo.gov/ftpdocs/124xx/doc12485/10-25-HouseholdIncome.pdf

    I would prefer to see the focus be on improving the distribution of wealth (not through taxes that just pay for wars that the 1% want), and removing corporate lobbying and donations.

    • JR says

      I’m behind the notion of ending lobbying and big corporate financing of politicians. I’m no poli-sci, but I am aware that our founders had in mind citizens in Washington for a set time who then returned home.
      I am curious how you mean “improving the distribution of wealth.” We cannot motivate the unmotivated. Our current system of enabling encourages waiting on the system for support. Until that fundamentally changes, people will not change.

      • says

        Why do you assume most people near the bottom are unmotivated?

        Back in the day (industrial revolution), jobs were needed and jobs are an excellent way to distribute wealth. The more/harder you work, the more you make. But now, in this more efficient world we live in, there is far less need for human labor. Machines and computers can do the work faster/cheaper. Thus less need for blue collar jobs, and to some extent white collar jobs. Thus, reduced distribution of wealth.

        The government takes a simple approach – welfare (and medicaid, etc). I’m actually OK with this- I see no reason to create needless jobs (bridge to nowhere) so that we can test who’s motivated. The problem is, the money that could go to the poor gets thrown into a giant pool of taxes and gets redistributed where the rich want it (lobbying, donations).

        • JR says

          Perhaps life and experience have jaded my outlook. I regularly see so many who are content to sit back and collect from the system. Yet are the first to complain about that very system. We all live in the same society, I have made my own errors; I own those as mine. I do not blame others. Yet I am succeeding where they are not.
          I suggest a major reason for this is motivation. My work week started at 40 hrs. I’ve known many who complain that work is not available, yet refuse to look. They state that the job listing is “beneath” them, or for [another demographic].
          But perhaps motivation is just misplaced. I’ve known others who have worked harder to not have a job. Too many I think who lack motivation; too many more who lack education.
          I submit that we should succeed or fail on our own merit. Not on our ability to lie to and con others. The more I learn, the more I favor natural consequences.

      • Janna says

        The distribution of wealth was not always this out-of-whack, as Brave New Life’s graph shows. I just heard on the news today that the top 1%’s income has increased by 275% since 1979, whereas the middle class (middle 3/5) has increased 40%, and the lowest 1/5, 18%.

        Similarly, in 1980, a typical CEO made 42 times the pay of the average worker. In 2010: 343 times the average worker.

        Those of us who are a littie older than some of those on this site, and who were adults in 1979 remember this, and we may be more shocked than some of you who apparently think this is normal.

        • JR says

          Is it possible that the top strive harder to not spend so frivolously? Or perhaps to better educate themselves? I am not saying that many CEO’s are not over payed; or at least that many big companies are poorly run. I theorize poor leadership is a reason why “the big 3″ domestic car manufacturers went broke.
          However, they just followed many of the constituency; sort of a “hey, I’ll just go on welfare” mentality. I cite again and again Natural Consequences for our behavior.

        • Edward says

          See the problem with a full on “to the victor goes the spoils system” is that most people won’t and can’t win. By definition there can only be a few full winners. There’s only so many slots in the major leagues, in the C suite or on the partner track. Even if everyone worked 100% harder that wouldn’t change. Everyone isn’t going to be a CEO since if everyone was there would be nobody to do the work day to day.

          We had it right in the 70s where you were rewarded for hard work (20x the median wage is a lot of money) but not to the extent where anyone not at the apex went decades with minimal if any wage increases. We need the masses, even the ones without C suite potential to make a decent living since they have the highest propensity to spend and spend locally. Success should be rewarded but being a mid level worker shouldn’t mean poverty as it increasingly does. Like Henry ford, hardly a liberal, said be paid his workers a living wage so they could buy the products they made.

          We’re in a rut because the rich who get ever more don’t spend all they make (after that first million there’s not much more to buy) and the people who do spend lose out on wage increases to make winning worth ever more. Millionaire is winning enough, billionaire is just wasting resources.

    • Chris says

      Give us an example of legislation that is stopping you from working hard and becoming rich. How would you better “distribute wealth”? Have you ever thought that the current system that rewards people money for doing nothing might actually be holding people back from really attaining their true potential?

  4. says

    Why do you want to tax investment and dividends? That money is already taxed when it is earned. I don’t believe in double taxation, especially when it discourages something so positive as saving money. One flat tax (I don’t care if it’s an income tax or a sales tax) with a rebate for everyone, no matter your income. It’s too simple to ever be implemented.

    • says

      Double taxation makes people happy, especially those who don’t pay one of the two taxes. I agree that it makes little sense. Obviously the best case outcome is that people invest, and invest, and invest, but never consume. Sure, such an investor would be a multimillionaire who never pays taxes on his or her income, but everyone benefits from investment EXCEPT this multimillionaire, who does not consume with the money he or she earns.

      I wish anyone the best of luck in explaining that concept to the “Occupiers.”

      • says

        @JT – Most of the occupiers have a better awareness of our economic and political state that what I’m seeing in the comments here. The occupiers understand that we do not have true capitalism, we have plutonomy wrapped in a mask of capitalism. These guys are out there fighting for the freedom of you and I. They see the truth, which is that our government is a puppet that they control. And I’m not talking about the top 1%, I’m talking about the top 0.05%. They control the laws,and they control the media. They control our education.

        As for taxing cap gains and dividends, if we don’t do that then the inequality will hit critical mass. Think about it,the super rich make 90% of their money via cap gains and dividends – not going into the office and working.

        • says

          The occupiers rally around “regulations,” which are the REASON we the super-rich have so much power. When you create a regulator, you create the possibility to skip over the courts and the rule of law to instill, in one corrupt government institution, the ability to decide arbitrarily who has committed fraud and who hasn’t.

          Dodd-Frank nearly put an arm of my business in bankruptcy. There’s nothing like waking up to a new law that makes it illegal for you to operate what is a very legitimate business model.

          You think the “Occupiers” are great because they’re not coming after you yet. Just wait until there’s a collective that wants to make your job illegal. Then you can tell me how you feel about this “us vs. them” mentality.

        • says

          @JT – When you say “we the super-rich” are you saying that you make greater than $380K per year? I’m going to assume that you don’t, and you can correct me if I’m wrong.

          The occupiers aren’t rallying around regulations. Though that is one item that a fraction of the group is talking about, it’s not the only or the biggest objective. They didn’t have a formal agenda from the beginning of the revolt (as you probably know, because the corporate owned media made the point to criticize again and again). If you’d like to learn more about the emerging objectives, there is a great 6-part series here:

          washingtonsblog.com/2011/10/occupy-this-us-history-exposes-the-1%e2%80%99s-crimes-then-and-now-1-of-6.html

          Assuming you are not truly a part of the super rich (I am rich by pretty much every definition, but not super-rich), then you are being played. The super-rich will keep feeding you information to believe in the Protestant work ethic and that poor = lazy. And you’ll work hard for these super rich as they control the education you are fed, the media you read and watch daily, and the legislation that governs money, and they’ll laugh all the way to the bank. In the words of Johann Wolfgang von Goethe:

          “None are more hopelessly enslaved than those who falsely believe they are free.”

          As for having someone “come after me” – I welcome it. As someone in the top quintile of income earners (about top 5%, actually), I’m part of the only 20% group that has not decreased in relative wealth over the past 3 decades. I’m all for sharing my wealth with others. I do NOT believe I work harder than the man who picks up my trash.

          I’m going to leave this conversation alone now. I don’t expect to convince you of something you don’t already believe, and that’s OK. I just want to get the counter-argument out there for those who haven’t made up their mind.

        • says

          “We” wasn’t supposed to be there. It should read just “the super-rich.”

          I agree with most of those platform issues the WaPo lays out. The difference, however, is that I do not believe for a second that big government will keep me safe from big government. That’s ridiculous.

          Ask yourself why the super-rich have the capacity to control government, and you’ll soon realize it’s because we allow big government. Government is corrupt by its very nature; to give it power to regulate the evils of the world is to give a monopoly to one of the least friendly institutions on earth. Regulators routinely miss the problems. We create an artificial economy out of feel-good policy like the OWS people wish to create.

          You don’t understand the scope of what’s really going on in the financial industry unless you see it. There’s really no counter-argument to be made of that rambling block of text, just that you’re secure with your wealth–which, if it was your goal to broadcast that message, then mission accomplished. Otherwise, I don’t expect you to convince you of something you already believe, nor do I expect to convince you of something you’ve never experienced. No one has yet moved to make your job illegal–to make everything you ever accomplished or worked for absolutely worthless under a false pretense.

          I’ll leave this conversation alone as well, and, for the sake of following the template, leave you with a quote, “First they came for the smokers, and I said nothing, because I was not a smoker…”

        • says

          Damnit. I really wanted to let this go, but your quote is totally unfair. I am speaking up for a financial class that I am not a part of – which is the polar opposite of your quote.

          I’m assuming the quote was meant toward the fact that I am not speaking up in your industry’s defense (which was allegedly threatened on a false pretense), because I have never had my job threatened. Also unfair, given that you’ve provided no details of your specific industry and what was threatened. I’m a logical guy, and I respect that you’re standing up and having this conversation. It’s very possible that I agree with you on your specific situation, and that you were unfairly targeted. Let’s assume that is the case, and that we are now friends. :)

      • says

        I hope everybody else spends their money, consumes and invests so I can keep all my money and reap the rewards. Oops, that’s what everybody is thinking / hoping now, which is why spending is sluggish.

    • says

      I was wondering the same thing. I would argue instead, that a sales tax is a much better tax that will not distort the market. In theory, it provides a negative incentive to spend on luxury goods, and save instead.

  5. JR says

    I understand the premise here of a flat tax. I like “No loopholes, no deductions, 20% is 20%.” It would certainly make the tax code a lot simpler. I still think that everyone deserves out of a system what they put into that system (i.e. nothing in, nothing out.)
    We’ve studied, we’ve struggled, we work hard. We contribute both in taxes and volunteer activities in our community. If we should have a need for police, fire, medic, whatever else I submit that we are deserving above those who do not contribute. Not only who do not, but who will not. Our system of enabling successive generations has created an unable generation.
    Taxation is but a small piece of the equation. What must change is the overall psychology of those leeching off the system. Fundamental change of the system is required. We can start anywhere, a flat tax is as good a place as any.
    I think we need to hold people accountable; natural consequences should be allowed to follow naturally. Newton, Darwin, Neitzche, et al had only natural consequences.
    I apologize for the tangential arc I took here. My point is: for the first 6 nothing will ever change unless the entire system is changed. They will always see “the man” or “them” keeping them down. The first 6 will never see their own input into their situation.

    • says

      Sadly, I have to agree. It’s incredibly HARD to see the point of view of the taxpayer, or the person who went from nothing to something huge if one is still not paying, or paying very little and not making much.

      This is why we have a debate today.

    • Janna says

      @JR – You stated ” If we should have a need for police, fire, medic, whatever else I submit that we are deserving above those who do not contribute. ” Do you mean you think the police and fire departments should ensure the safety of rich neighborhoods more than poor neighborhoods? Or that a poor woman who is raped should command less attention than a rich woman who was robbed?

    • says

      I’m not sure I’m buying that chart. First off, 0.5 Gini coefficient would be even worse that it is. Secondly, every data source I’ve read has shown a rising gini since 1979 with one exception, 2008. And that’s no surprise since the market tanked- so the wealthy would be hit harder (they’ve since recovered).

  6. says

    The nice thing about a flat tax with a generous carveout is you can’t really argue it’s regressive (although you *can* argue it will be more expensive for {insert demographic here} than the current tax code.) For example, if there are three dudes in the USA and taxes are 0% on the first $20,000 and 20% on everything after that:

    Dude 1 ($20,000): 0% Tax ($0)
    Dude 2 ($50,000): 12% Tax ($6,000)
    Dude 3 ($150,000): 17.333% ($26,000)

  7. says

    From the story it looks like everything was working out fine until he reduced the cost. Perhaps we just shouldn’t lower taxes and everything will be good?

  8. says

    Interesting post. But you left one very important thing out. When the government is talking about taxing the rich they are talking about the income bucket not the portfolio bucket. Most wealthy people make their money as portfolio income via long term capital gains. So they are not taxed anything but a “flat 15%”. If you’re proposing doing away with the 3 income buckets in return for a flat 20% tax on all sources of income. I would definitely be in favor of that. 20% on all income is fair trade. Hell I would be willing to give up 30% on all income if that’s the case. :-)

  9. says

    Personally, I am in favor of a flat tax. The problem is the impact of all the different issues. Mortgage interest, EIC, Capital gains etc. Changing all these things will have a huge impact on the economy. If you retain these deductions it destroys the purpose of a flat tax. The solution is far more complicated than it appears because of the impact of the changes. Homes are subsidized by the government in the form of tax deductions. Just taking it away will affect home ownership, home building and banking. A flat tax may even create unemployment of all the IRS employees as well as the tax professionals (tax lawyers, CPAs and tax preparers).

    • says

      You hit the nail on the head. It would cause a lot of change. But would it be for the best in the long run? It is because of subsidies soda cost more than water to make. It is because of subsidies we haven’t developed any energy alternatives. Subsidies stifle creativity and innovation. They also make certain industries / assets expensive. In you example housing is subsidies by government. IF the mortgage interest deduction didn’t exist housing would be much cheaper.

  10. says

    I may be way off base here, but doesn’t a consumer tax (sales tax) make way more sense? It won’t hurt job producers, and it’s much easier to collect. It is similar to a flat tax, discourages spending, and encourages saving/investing (which would compound in an environment where there was little-to-no tax on capital gains and dividends).

  11. says

    I think that most people do see the tax system as fair – because most people arent getting soaked. They think those who make more than them should pay more, because somehow they are using more services than anyone else (probably not true).

  12. changeonabudget says

    I think the problem with a true flat tax on all income is it assumes that $1 of buying power affects everyone the same. Someone making $200,000 a year just won’t feel the same effect of a flat tax as someone making $50,000.

    The bar stool economics example has been pretty widely discredited by economics because it doesn’t actually describe the real taxation system at all. In the United States, taxes for the highest income bracket is actually lower than the previous bracket and is still less than 35%. So no one is paying 59% of the bill because with the loopholes, they usually pay around 19% which is less than the middle class. As well. the top earners are certainly not drinking the same beer/getting the same services/benefits as the poorer men.

    Closing loopholes and preventing lobbyist from having such a large influence on policy would help make things a lot of equal in real terms, not just in taxation terms. The US tax code has tripled in length since Reagan was in office and under him, the actual tax on the rich was 50%. The poor certainly do not have ‘equal’ access to hire lobbyists and lawyers to find or create more loopholes that prevent the rich from currently paying their fair share.

  13. says

    I would love me so flat tax!

    Your bar stool example perfectly describes how everyone cries about how the rich have benefited so much from tax cuts.

    I still wonder why people hate the rich so much. I don’t know one rich person that didn’t work themselves to death to get the wealth they have accumulated. The rich donate, they pay a ton in taxes, yet they are reviled. It is never enough.

    • says

      How do your kids feel about the situation you think? I heard that kids basically take up what their parents believe. I couldn’t care less about this topic until I started making money of course.

  14. Travis says

    I know a lot of rich people, but I’ve never met one that’s been so “punished” by having to pay higher taxes, that they want to stop being rich. I don’t buy the argument that a progressive tax system encourages laziness and punishes success. Sure, there are a few people that will take advantage of the system, but I believe there are exponentially more people that want more financial success than a welfare check.

  15. says

    I’m still trying to get my head around those who equate income with wealth. It’s not the same thing. Buffet’s wealth is over 100X the size of his income. I suppose in a socialist economic system income is wealth because you can’t own economic assets.

    As for something new, my company is now adjusting the cost of health insurance by how much you earn. I thought governments were the only ones allowed in the redistribution game?

    sfi

  16. says

    I have heard the barstool story before and agree with its premise. At the end of the day, it is up to me to figure out what works best for my life regardless of the rules that exist. If that means emigration, then so be it.

  17. German says

    Wow, that is a really nice explanation for the stupid argumentation which is going on in germany.
    The government announced a tax reduction for the next years and many people complain, that the higher income people will save more tax than the lower income people. They all should read this article and think again.

  18. Ray says

    I’m of the notion that everybody pays, regardless of income. At the bare minimum, people should be responsible for their own Social Security and Medicare. Figure 4% across the board for everyone. Then institute a flat 16% federal tax on any income over the poverty threshold. This would make effective tax rates range from 4% to ~20%.

    Businesses would be taxed at 20%, still very competitive worldwide, and a disincentive for rich folks to incorporate for tax purposes. No more deductions, credits, or AMTs, period.

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