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Income Tax Myths

"Income taxes just pay interest on the national debt."

Some people claim that 100% of the money the government gets from income tax goes to pay interest on the national debt.

Not true. In fact, not even close.

This myth is easily debunked by just looking up the numbers involved. Unfortunately, looking things up is a skill many tax protestors lack.

Let's look at the Budget of the United States.

The amount collected from income tax greatly exceeds the amount spent on interest on the national debt every year. For example, in 2006, the individual income tax raised $1.04 trillion (click this link and see page 30 of the historical tables). The government’s net interest expense in 2006 was $226 billion (see page 54 of the tables). That’s about 20% of individual income tax revenues, not 100%. (See the update below for more recent figures.)

Twenty percent of all income taxes is a lot of money. Interest on the national debt is a big amount and the national debt is a legitimate concern. But it’s not remotely true to say that all income taxes go to pay interest. Net interest is only about 1/5 of annual income tax revenue. (And that’s not even counting $353 billion in corporate income tax revenue.)

(By the way, the “net interest” figure is used because quite a bit of the interest goes to government trust funds. The interest paid to the trust funds essentially amounts to the government paying interest to itself (by moving money from one government account to another), so it makes sense to disregard that interest in calculating the amount of interest the government pays. But even if you look at the “gross interest,” that was $406 billion in 2006. That is, again, a big amount, but still only about 40% of income tax revenues, not 100%. See page 72 of the tables.)

So the claim that 100% of income taxes pay interest on the national debt is completely not true, as anyone can see by just looking up the figures. (Similar percentages can be seen in the figures given by the privately run national debt clock -- compare the "interest on debt" figure to the "income tax" figure.)

So where did this canard get started? It goes back to a report prepared by the Grace Commission appointed by President Reagan in the 1980s. Many Internet sites will tell you that the Grace Commission said that all income taxes go to pay interest on the national debt.

The Grace Commission was predisposed to try to make income tax look bad, because President Reagan wanted a big cut in income taxes. But even with this bias, the Commission didn’t claim that all income taxes do is pay interest on the national debt.

Here’s what the Commission actually said (this is from the cover letter accompanying the Commission's Report):

Excerpt from the Cover Letter to the Grace Commission Report:

"Resistance to additional income taxes would be even more widespread if people were aware that:

One-third of all their taxes is consumed by waste and inefficiency in the Federal Government as we identified in our survey.

Another one-third of all their taxes escapes collection from others as the underground economy blossoms in direct proportion to tax increases and places even more pressure on law abiding taxpayers, promoting still more underground economy -- a vicious cycle that must be broken.

With two-thirds of everyone's personal income taxes wasted or not collected, 100 percent of what is collected is absorbed solely by interest on the Federal debt and by Federal Government contributions to transfer payments. In other words, all individual income tax revenues are gone before one nickel is spent on the services which taxpayers expect from their Government."

Thus, the Commission first claimed that one-third of income tax revenue is wasted by the government. Another third, the Commission claimed, is not collected because of underreporting of income. Then the Commission said that, with one-third of income tax wasted and another third not collected, the result is that all income tax is absorbed by interest on the national debt and transfer payments.

So even accepting the Commission's word as gospel, the Commission didn’t say that all income tax goes to interest. The Commission said it goes to interest and transfer payments. “Transfer payments” are payments for programs such as welfare. You may or may not like welfare programs, but many people regard them as an important government function. So there’s a big difference between saying that all income tax goes to interest and saying it all goes to interest and transfer payments.

Moreover, the Commission put its statement in a misleading way. In the last quoted paragraph, the Commission said that “all” income tax goes to interest and transfer payments, but the prior paragraphs show that the Commission meant "all the income tax left over after the part we regard as wasted." The Commission wrote off 1/3 of income tax as wasted. That’s obviously pretty contestible. Moreover, because the Commission regarded 1/3 of income tax as “not collected,” the 1/3 of income taxes that the Commission regarded as wasted represents 1/2 of all collected income taxes.

So what the Commission really said is “half of income taxes collected by the federal government go to interest on the national debt and welfare.” Again, even accepting the Commission's word, that’s pretty different from “all income taxes go to interest.”

So the statement that 100% of income taxes go to pay interest on the national debt is completely wrong.

This statement is sometimes paired with the statement that 100% of income taxes go to the Federal Reserve. That's even more ridiculous. As demonstrated above, only about 20% of income taxes go to pay net interest on the national debt. And then, of the national debt not held by the government itself, only about 16% is owned by the Federal Reserve. (The rest is owned by individuals, private corporations, state, local, and foreign governments, and others.) So only about 16% of 20%, that is, between 3 and 4%, of income taxes go to the Fed. So the statement that all income taxes go to the Fed is another completely false statement.

And what is the point of these statements anyway? Protestors who say that 100% of income taxes go to pay interest on the national debt seem to be responding to the argument that we need the income tax to fund the government. They appear to be claiming that we could eliminate the income tax without affecting any government programs that people might want. I guess they reach this conclusion by thinking something like this: "the income tax doesn't fund any government programs that anyone might want, because 100% of it just goes to pay interest on the national debt. Some other source of revenue funds the programs people want." But even if that were true (which it isn't), so what? It's not as though we can stop paying interest on the national debt. That's mandatory. If income tax weren't available to fund that interest, some other revenue would have to be used to pay it, and the programs that rely on that other revenue would suffer. So we can't conclude that we could eliminate the income tax without hurting government programs that people want.

Think of it this way: suppose you had a large credit card debt, and you said to yourself, "too much of my income is going to pay interest on my credit card debt -- not enough of my income is going to pay for things I really want." In such a case, the solution would not be to stop earning income! Eliminating your income wouldn't get rid of your debt. You'd just have to keep paying that credit card interest anyway, and you wouldn't have income to fund it. You'd be even worse off. The solution would be either to increase your income somehow, or to cut down on your discretionary spending, and pay down your debt.

Similarly, you may think that too much of federal income taxes go to pay interest on the national debt, but, again, eliminating the income tax wouldn't get rid of the debt. The debt has to be paid for somehow.

This myth is different from most myths covered on this website. This website is primarily about debunking the crazy claim that the income tax doesn’t exist or that most Americans aren’t legally required to pay it. Questions about income tax policy – whether the income tax is a good idea, whether it’s fair, or whether the government spends tax revenues wisely – aren’t the main point of this website.

So anyone who wants to criticize government spending should go right ahead. But they should get their facts straight first. Yes, the government does some stupid things with our tax dollars. Eliminating stupid spending and lowering income taxes would be great. But it’s absurd to claim that all income taxes go to interest on the national debt when such interest actually accounts for only about 1/5 of individual income tax revenue.

 

Update (March 2010): Given the substantial increase in deficit spending over the last few years, the above figures could change. Calculations based on the tables in the proposed 2011 budget (pages 31, 54-55, and 75-76) show that the figures have not changed much so far, but change is projected for the future:

Fiscal Year
Net Interest as % of Income Tax Revenue
Gross Interest as % of Income Tax Revenue
2008
22.1%
39.4%
2009
20.4%
41.9%
2010 (est.)
20.1%
45.4%
2015 (est.)
32.9%
51.2%

So there wasn't much change in 2008 and 2009, and even for the 2010 estimate, net interest stays about the same, although gross interest increases somewhat. The percentages are substantially up in the 2015 estimate. (Of course, estimates for figures five years out are often inaccurate.)

In any event, the figures are still much less than 100%, and it's still true that we need to fund the interest on the national debt somehow.