May 122016
 

Bar Stool Economics

Capitalism in the United States is in serious disrepute. The Bush tax cuts have been said to give the top 0.1% of Americans an average of $520,000. That is over 400 times the average tax cut received by middle-class households. Many people are upset at how tax cut policies seem to disproportionately benefit the upper class. If anything, shouldn’t tax breaks help the poorest people? 😕 Well to understand how the tax system works let’s take a look at bar stool economics.

16-05-bar-stool-economics

The origins of this parable have been attributed to Professor T.Davies from the University of South Dakota and R. Kamerschen from the University of Georgia. The following is a modified version of the original.

Suppose 5 friends go out for drinks and the total bill comes to $100. If they paid their bill the same way we pay our taxes, in proportion to income, then it would go something like this:

  • The first 2 men, the poorest, pay nothing.
  • The 3rd man pays $4.
  • The 4th man pays $19.
  • And the 5th man, the richest, pays $77

The 5 men are happy with this payment arrangement so that is what they decided to do. 🙂 Then one day, drinks at the bar were on sale, and the total bill for the 5 gentlemen came to $80. To make it fair the men still wanted to pay their bill the same way taxes are paid. So the bartender reduced each man’s bill by roughly the same amount based on their economic status. The first 2 men were unaffected because they simply continued to drink for free. The remaining 3 patrons split the $20 in savings, and paid the following amounts:

  • The 3rd man paid $2 instead of $4 (50% savings)
  • The 4th man paid $14 instead of $19 (26% savings)
  • And the 5th man paid $64 instead of $77 (17% savings)

Each of the paying 3 men spend less for their drinks than before. And the first 2 men continued to drink for free. But once outside the bar, the men began to compare their savings. “I only got $2 out of the $20 in savings,” complained the 3rd man. “Don’t look at me,” replied the 4th man. He pointed to the 5th man and said, “he received the majority of the $20 savings. The wealthy get all the breaks.”

“Wait a minute,” yelled the first two poorest men who didn’t pay. “We didn’t get any savings at all. *harumph* The system always exploits poor people like us.”

Similar to wine tasting, the discount for the men can be seen as good or bad depending on their mental frame of reference. The first 4 men ganged up on the 5th man and patronized him for being too greedy. Then they went to a Bernie Sanders rally without inviting their rich friend. 😛 Feeling betrayed and ostracized the 5th man didn’t show up to the bar the following night. The 4 remaining men decided to drink without him anyway. But when it came time to pay they discovered an unpleasant surprise. They didn’t have enough money between all of them for even half of the bill. 🙁 It appears they were in a bill pickle. 😀

That’s pretty much how the progressive tax system works. Naturally, those who pay the highest taxes benefit the most from a tax break. If we tax the rich too much, or attack them for being wealthy, then they might start drinking in other pubs where the atmosphere is less hostile. According to the WSJ, the numbers used in the bar stool economics above are not far off from the actual share of income tax paid by Americans in 2014.

16-05-us-tax-income

The bottom 40% of income earners actually paid negative income taxes meaning they received net federal transfers. For those who earn the top 5th (quintile,) one way to reduce your taxes is to collect income from multiple sources so that you can maximize any deductions, expenses, and preferential tax treatments. In the U.S. the average multi-millionaire has at least 7 different sources of income.

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Random Useless Fact:

16-05-consistency bar stool economics

 

 

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Finance Journey
Guest

What a nice way to explain the tax treatment. Hey there is a error in your numbers in the second part (after reduced price).

The people who mostly complain are poor by mind, they don’t go to work or work hard. They spend most of the time in front of the TV/computer and get free money from government in name of social security, and keep complain like rich get richer, and poor get poor :D.

Best regards,

Anon
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Anon

What an asinine comment.

J Chris
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J Chris

To Anon – I don’t see anything wrong with above comments. This blog educates, inspires and shows you the way to get rich. Liquid is doing great job on this! Get rich or stay poor all depends on people mindset. You could become rich if you follow rich people steps OR stay poor, complain and keep asking rich people to pay 80% of their hard earned income as tax to fund your welfare program. So, you could watch your TV all day long, and protest/complain against rich whenever you get bored with TV.

Anon
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Anon

Not surprising to see the uneducated agree with the asinine. Facts and proof are mere inconveniences standing in the way of opinion and bias. Well done.

Ben
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Ben

Yes! Thank You!

Josh
Guest

This is a good way of explaining “trickle down economics.” I suppose whoever offers the lowest beer prices will be elected the next President.

Taylor Lee @ Yuppie Millennial
Guest

I disagree with you and feel that parables like these are harmful to fostering both empathy and real understanding of the economic complexities of our society. First, this parable ignores the fact that in addition to income taxes, most people also pay payroll taxes, which are actually regressive. So everyone is actually contributing somewhat to the general welfare. Second, the parable ignores that the rich man actually has great influence over the bar and its offerings. What’s on tap is mostly his favorites, much like our legislation largely caters to well-monied corporate interests. Third, the parable ignores that, at least how capital gains taxes are structured in the US (the means by which the wealthiest earn their “income”), often the rich man is taxed on less proportionately of his wealth than the second or third. In absolute terms he pays more while in relative terms he may be paying much less (see e.g. Warren Buffet’s comments about paying less in taxes than his secretary). Fourth, the parable ignores that, actually, providing for men 2-5 are in the richest man’s best interests. They are often HIS employees and neighbors. Making sure they are sufficiently educated to provide him utility in business,… Read more »

Anon
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Anon

Nicely done.

DivGuy
Guest

Hello Taylor,

I think we can’t assume what happens in the life of the 5 men. Maybe the richest guy is just someone who had worked very hard all his life, took everything he had to invest it in his own business and assume the risk he could lose it all. He made it and got rich. I say good for him. I think it’s unfair to think that most rich people got it lucky (or are crooks) and all poor people are just full of bad luck.

I agree we should all pay taxes according to how much we make (meaning that if you make lots of money, you should be paying lots of taxes too), but judging riches or poor for based on their wealth?

I’ve read this parable many on many sites and most people agree with it or judge the rich for not giving more. But rarely we asked ourselves why men #1 and #2 keeps drinking for free all the time? Why can’t they contribute to the economy, even with a few hours of work just to say they contribute? I think that if we all work, our economy system will be much better off 🙂

Taylor Lee @ Yuppie Millennial
Guest

Hello DivGuy! I don’t know if you’ll see this comment, but I figured it’d be useful to respond in case someone later reads this post and turns to the opinion of the commentariat. Plus, I love (trying) to change people’s minds about progressive taxation schemes and income inequality, even if it means sometimes I feel like I’m yelling into the ether. I believe there are a few pieces of cultural baggage you’re throwing on me that I didn’t quite earn. Let’s get those out of the way first. You mention the following: “I think it’s unfair to think that most rich people got it lucky (or are crooks) and all poor people are just full of bad luck.” And, “but judging riches or poor for based on their wealth?” From these comments, it seems you believe I dislike wealthy folks or consider them in a negative light. Can you point out what in my comment led you to that conclusion? Just because I advocate for higher taxes on the wealthy doesn’t mean I dislike them, only that I think it is better fiscal policy. Let’s be clear: I don’t hate rich people. Some people might even say I’m one myself.… Read more »

Investing Pursuits
Guest

As they say, the worse thing to do is work at a job and get paid for it. A lot of tax advantages to being an investor or business owner.