How almost half of all taxpayers pay nothing in federal income tax

Congressional leaders have been battling over the soon-to-expire Bush tax cuts for more than a year. Yet, there's still no word on whether Congress will vote to extend the cuts, allow the cuts to expire or work out some compromise package that might do a little of both.

At the center of the tax cut debate, is one key problem facing the current economy: Tax revenues are decreasing. With less income available to tax thanks to record levels of unemployed workers, there are only two ways to increase tax revenues -- increase the taxpayer base or raise taxes for the existing taxpayer base.

Raising tax rates is unpopular and unlikely to happen in an important election year and expanding the tax base would be just as unwelcome. That's because an astonishing number of taxpayers currently pay no federal income tax at all. Earlier this year, the Tax Policy Center reported that nearly half -- 45% -- of all households paid no federal income tax for the 2009 tax year.

At the time, the headlines made for great commentary, and accusations flew. While it may be politically popular to place the blame squarely on the shoulders of President Obama or former President Bush, depending on your leanings, no one politician is to blame. In fact, the number of non-payers has increased steadily since the mid-1980s. Most dramatically, from 2000 to 2008, during which the number people who did not pay federal income tax climbed a whopping 59% even though the number of filers increased by 10%. During that same time, the nation enjoyed a relatively healthy economy. So what gives?

It would be easy to just look at tax brackets in a vacuum and assume that those in the lower tax brackets are the sole beneficiaries of tax breaks that result in a zero federal income tax bill. While there is a substantial number of low-income individuals who pay no federal income tax, the actual amount of tax paid -- or not paid, as the case may be -- is often less about the amount of income and more about the amount of deductions and credits.

Here are a few tax perks that contribute substantially to the declining numbers of taxpayers in America:

1. Credits and Deductions for Homeowners. Owning a home is the American dream, right? So much so that President Reagan delivered an impassioned speech vowing to protect the rights of homeowners to deduct home mortgage interest on their taxes. The result is a tax system that continues to promote home ownership at the cost of tax revenue. In 2008, the first-time homebuyers credit allowed 1.4 million taxpayers to take credits totaling $1 billion per month. Together with the mortgage interest deduction, housing credits allow taxpayers to "save" an estimated $130 billion each year on taxes.

2. Earned Income Tax Credits. Another popular tax credit is the Earned Income Tax Credit, which is targeted at low- and middle-income taxpayers. The IRS estimates that 24 million filers (about one in six) took advantage of the EITC in 2009, claiming about $50 billion. The EITC "saved" taxpayers $42.9 billion in tax in 2008. Even more controversial, the EITC is available to those filers who may not even owe tax -- and it's refundable, meaning those who file may receive a check from the government even if they didn't pay in a dime of federal income tax.

3. Deferrals and Deductions Using Retirement Plans. A number of retirement plans allow for tax deferral of income. Depending on the types of retirement plans you use and your level of income, it's possible to shield thousands of dollars in income from taxation in any given year. In addition to tax deferred growth, you may be able to claim a deduction or exclusion from income for contributions made to a retirement plan. If you pay the tax now for your retirement plan, as with a Roth IRA, you can make tax-free withdrawals in the future. Restrictions and exceptions apply, but using retirement plans is a popular strategy among taxpayers looking to shave dollars off their tax bills in April.

4. Tax Favored Status for Non-Wage Income. While it's true that the wealthy pay a higher tax rate as income increases, the rate is dependent on the type of income. According to the IRS, less than 20% of the income reported by millionaires is attributable to salary. Most of the income at the top is characterized as capital gains, which is taxed at favorable rates. While the tax rates for ordinary income may climb to 35%, capital gains tax rates are capped at 15% for long-term capital gains. This perk isn't just for the wealthy -- those at the bottom of the tax scale benefit, too, since long-term capital gains are taxed at 0% for those ordinarily in the 10% or 15% tax brackets.

5. Employee Benefits. Under the current tax laws, employers may provide a number of benefits to employees, from transit to certain kinds of stock options to health insurance, completely tax-free. Despite a number of misleading e-mails making the rounds, your health care benefits won't be taxed any differently for the 2010 (or 2011) tax year as they were for 2009. In fact, there are no provisions in the new law to tax health care benefits for individual taxpayers. Health care insurance is just one of a number of benefits for employees that provide substantial perks while legally skirting or deferring taxation.

These are just a few of the popular credits, deductions, and deferrals that allow some taxpayers to increasingly pay less come tax time. Add to the mix deductions and credits for college education, job expenses, and child and dependent care costs, and it's easy to see how taxable income can quickly shrink toward zero. Even as existing laws allow taxpayers to reduce their overall tax bill, Congress continues to add new tax breaks, like the recent Making Work Pay Credit.

We all want to pay less in taxes -- but at what price? If the consensus is that half the country shouldn't shoulder the tax burden for all, something has to give.

Which tax breaks are you willing to give up?
Let us know in the comments section.

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