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The Prince and the Paupers: a Tax Fable

12/14/2010 05:02 pm ET | Updated May 25, 2011

The recent tax deal brings to mind a fable that I've told my young daughter to explain the current tax system.

In a far away land lived one prince and forty-nine paupers. The prince and the paupers all had jobs and each earned $10 of wages from those jobs. The prince, however, also received $1,000 from investments in the form of interest, dividends, capital gains, rents, royalties, and property-value appreciation.

The supreme governor, who ruled over the entire land, needed $150 of tax money to provide basic public services such as national defense, police and fire protection, infrastructure, care for the less fortunate, and education -- services that would make the country strong. He collected it by taxing all income at ten percent.

At that low rate, the paupers had $9 after tax and were able to live on their earned wages and save a little extra, just in case. They hoped that they and their children could become wealthy, like the prince, one day.

The prince paid $101 in tax and had $909 left over. He lived a very comfortable life, and had plenty. Yet, he reasoned, if he could have more, why not try? He met with his tax advisers to devise a plan. They decided to use his influential position and donate money to the supreme governor and his friends to convince them to enact a law that taxed only income from wages. The supreme governor agreed.

After the law changed, the supreme governor increased the tax rate on wages to 30 percent to raise the same $150 of tax. The paupers then paid an extra $2 in tax and had only $7 left over. They had more difficulty providing for their families and were unable to save any money.

The prince, however, paid only $3 in tax and had $1,007 left over. The new tax policy shifted $98 of the tax burden from the prince to the paupers. It also shifted $100 of the tax burden from $1,000 of investment income to $500 of income from wages.

The prince assured the paupers that everything was fine, saying "The benefit I receive from paying less tax will benefit you paupers because I will invest my extra money in additional resources." The prince used his wealth to promote that idea, and some of the paupers believed him.

Other paupers considered the argument to be self-serving. They reasoned that the new tax policy gave the prince control over spending an extra $2 of every pauper's income. They thought they were better able to decide how to spend the $2.

The supreme governor told the paupers that if they worked hard and saved, they could obtain the same tax benefits that were available to the prince. The tax had become too burdensome, however, and the paupers could no longer save.

Some paupers challenged the tax-burden shift, but the prince declared they were starting class warfare. The paupers scratched their heads because their efforts to shift the tax burden were the same as the prince's.

"So, Dad, the prince paid less taxes and caused the paupers to pay more even though they made less money?" my daughter asked.

"Yes," I explained. "The prince was able to influence the law and hire tax advisers to help reduce his taxes."

"But the paupers couldn't," she interrupted.

"Right."

"That doesn't seem fair," she said. Then she asked, "Do we have princes and paupers in America?"

"Most people in America are more like the paupers." I replied. "They have income from working, which is generally taxed. A small percentage of the people are, however, like the prince, and they have a lot of income from their investments, which is taxed less or not at all."

"Did the prince invest the money to benefit the paupers, like he said he would?" she asked.

"I don't think so," I replied.

"Why couldn't the supreme governor just spend less?" she wondered.

"If the Supreme Governor spent less, he would have to cut services. At some point, the government can't cut services anymore. Besides, spending less wouldn't make the taxes fairer."

Finally, she asked the difficult question: "If so many Americans are like the paupers and could pay less money if everyone paid a fair share, why don't more people tell Congress to change the tax law?"

That is an excellent question for which I do not have an answer.