Will Obama and Congress punt on real tax reform?December 7, 2012: 5:00 AM ET
Whether or not the president and lawmakers reel us in from the fiscal cliff, the tax debate is sure to keep going.
By Becky Quick, contributor
FORTUNE -- It's an argument as old as politics itself: How do we responsibly finance the system of government that provides the basic framework of our society? Taxation without representation was at the core of forming this country. Now the rate and distribution of taxes are what's polarizing America.
Congress has yet to reach a deal that would avert the fiscal cliff, the wicked combination of blunt spending cuts and higher taxes set to kick in on Jan. 1 if Republicans and Democrats don't agree on a better plan for tackling our nation's debt. It is likely that lawmakers will enact a Band-Aid solution, giving them time to work on the real problem -- truly reforming the tax code and deciding who in our society should pay what.
It would seem that the wealthiest Americans should brace themselves for higher tax rates. President Obama campaigned on the idea of allowing Bush-era tax cuts to expire on anyone making over $250,000 a year, and some Republicans have started to soften in their opposition to higher marginal rates for top earners.
But that doesn't necessarily mean the wealthiest Americans will actually pay more in taxes. Because our tax code is so bloated and porous, people often don't pay anything near the advertised rate. Nearly half the people who make $200,000 or more pay an effective tax rate of 20% or less. And as you go up the income scale, the picture is even more slanted. Of the 400 people bringing in the highest adjusted gross income levels in 2009, more than half of them paid 20% or less in taxes. And six of those 400 Americans actually paid no federal income tax on their adjusted gross income. That's right -- no federal tax. Keep in mind that the average adjusted gross income for these 400 taxpayers was $202 million.
You may wonder how that can be. For starters, they make their money in a different way. Unlike the average Joe, whose wages are reported to the Internal Revenue Service via a W-2 and whose taxes are withheld from his paycheck, the wealthiest Americans make a disproportionate amount of their income through things like tax-free interest, and capital gains and dividends, which are taxed at lower rates than ordinary income. In fact, of the 400 taxpayers with the highest adjusted gross income in 2009, nearly a quarter of them didn't have any salaries or wages. These people aren't sweating out a potential increase of the top tax rate in the slightest.
Second, those at the top of the income scales are able to employ legions of accountants, lawyers, and advisers to help them come up with trusts, offshore accounts, and other tax shelters. Indeed, as the tax code has become more and more complicated, the art of tax avoidance has practically become a way of life in America. Entire industries have been built around how to legally circumvent our own tax law. (Tax evasion, of course, is illegal.)
All that expert help has tilted the playing field to the advantage of those who can pay for those services. As recently as 1995, more than a quarter of the top 400 earners in America paid income tax rates of at least 35%. Not so today. And that's a basic problem that Washington seems unwilling to confront. The more complicated Washington makes the tax code, the more wealthy Americans exhibit an entrepreneurial spirit in finding ways to circumvent those laws. It's an endless cycle that can be changed only through having the political courage to embrace simplicity and true reform.
So keep an eye out as we approach the fiscal cliff and the looming long-term debate about tax rates -- which is sure to continue past Jan. 1. Will our lawmakers step up to the plate, swallow some tough medicine, and truly reform the tax code to bring fairness to all? Or will this be another political opportunity lost, as our nation continues down a fiscal road to ruin that our children's children will be paying for long after we are gone?
This story is from the December 24, 2012 issue of Fortune.