So say that your 5 year old can make money by doing things around the house.
$5 for making their bed $5 for putting away their toys $5 for putting their dirty clothes in the laundry room $5 for going to bed on time
They can do any or all of these chores.
Dad is the government.
For the first $5 you earn, dad will take $1 and you keep $4. Dad will give this $1 to grandpa because grandpa used to do a lot of stuff around the house (social security). So if you do one chore, you get $4 and pay $1 in taxes.
For the second $5 you earn dad will take $2 more and you keep $3. Dad will use $1 to buy food for your baby sister (food stamps). And will give $1 to your brother who doesn't do any chores (welfare). If you do two chores you get $7 and pay $3 in taxes.
For the third $5 you earn, dad will take $3 more and you keep $2. Dad will use this money to buy a new crib for your baby sister (infrastructure spending). So, if you do three chores you get to keep $9 and pay $6 in taxes.
For the fourth $5 you earn, dad will take $4 more and you keep $1. Dad will use this money to buy some new locks for the doors (defense spending). So if you do 4 chores, you get to keep $10 and pay $10 in taxes.
You get to make the decision on how much money to make, and how to spend it. Let's say you're a rich person and will do 3-4 chores. Here are your options:
You can decide that all this sounds fair and do all your chores for $10.
You can do some of your chores because it's not worth going to bed on time for just $1.
You can vote for Mom to be the Government at the next family meeting because she promises that if you do 4 chores you'll get to keep $12.
You can give $1 to your aunt (who's an accountant) because she knows a special family rule about children who do all their chores. She says you'll get to keep $13, pay $6 in taxes, and give her $1.
You can give $3 to your uncle (who's a lobbyist) because he can convince your Dad to not tax you for your 3rd and 4th chores. He says you'll get to keep $14, pay $3 in taxes, and give him $3.
Raising taxes on the rich doesn't work as well as we think it will because rich people find ways to not pay the higher taxes.
Hopefully this example teaches about graduated tax rates (how we try to make rich people pay more), how rich people try to avoid paying taxes, and some of the ways the government spends the taxes it collects. Maybe it also teaches about democracy and why Government (Dad) can't make up bad rules or you'll vote for Mom. Maybe it also makes the 5 year old ask why his/her brother gets $1 for doing nothing.
I can think of half a dozen different ways to put it, but the best is probably the one my dad told me when I was five years old.
My dad, who was a Goldwater Republican and one of the smartest people I've ever met, used the analogy of a careless fire brigade carrying buckets of water up and down hills for miles. As each one passes the bucket to the next, some of the water is spilled on the ground.
You might think that because so many people are involved that each one is watching the other and ensuring they don't waste any water. But it's precisely because there are so many hands involved that, though each one spills only a small amount, it adds up to a massive loss.
No one person is responsible for the lost water, because each one can rightfully claim that he spilled only a little bit. In the end, the final person in the chain gets a tiny splash of water, but it removes a full bucket of water from the source.
You can use the bucket brigade to move water from one place to another, but unlike the natural water cycle (supply and demand), short temporary bucket brigades created in response to disasters (spontaneous charity), well-designed aqueducts (churches, nonprofits, and other permanent charitable institutions), it's a very inefficient process.
(When I was little, I was irritated that this analogy seemed so simple. I thought it couldn't be true, because if it was, people would be too smart to fall for it. When I got older, I gradually realized my dad was right about this, as he was about so many other things. But to this day, I still remember this analogy. I wish I knew if it was original to him or something he read somewhere.)
Knowing what I do now, I would extend this by saying that the economy is like a pool of water. It's all connected. Whether you draw water out at the shallow end or the deep end, the shallow end (the poor) will still go dry first.
My response is: who actually believes it would fix everything?
The two extreme ends are both wrong: you can't just tax the rich and solve fiscal problems, particularly if we're sending water buckets up a hill and losing water each hand (as above). One the other side, you can't just massively cut government spending and social programs and expect that reduced expenses in those areas won't have dramatic negative external effects. It may reduce spending to within the current tax revenues, but then you have a massive - and massively growing - population of citizens which rely on social programs that become even more destitute. With increased desperation comes increased crime - crime for survival - so the cost of not taxing the rich is passed on to the society.
I know this isn't really a direct answer to the question, but I think it's incredibly important that this "compromise" subject is included in any answer. Both sides must sacrifice, find middle ground. That's the key to any human relationship and that fact doesn't just disappear because politicians want to stand on their soap boxes all day.
In terms a five year old might understand, one big reason is that the wealthy will simply go elsewhere. If I can choose to work in the UK and pay 50% tax on my earnings or do the same job in Hong Kong or Singapore and pay just 15%, that's going to be a big factor in where I choose to work. If I leave the country because they hike my tax rate, the government will earn less money because I was paying lots of tax before and now I will pay them nothing. As the very richest people are some of the most mobile and can often conduct their business from anywhere in the world, it won't take many of them to leave to wipe out the gain from the people who stayed. Conversely, if the government reduces the top rate of tax, it might encourage more rich people to come and live in our country and tax receipts could actually go up.
But it isn't just the tax revenue that is the issue. Having wealthy people live in your country is good because they will spend and invest more there. They are spending money in your shops, buying cars and houses. And most important they will probably be employing staff, creating jobs and setting up businesses. All this economic activity will be lost if you chase them off.
Underlying all of this, the most important concept to get across is that there is not a fixed amount of wealth in the world to be shared around. Wealth is created by those who innovate and work smart and it is destroyed by those who consume without contributing. If you keep taking the rewards from those who create wealth then sooner or later it won't be worth their while and everybody loses.
Taxing the rich won't fix every problem but it will fix -- or help fix -- a LOT of problems. Taxing the poor won't fix ANY problem, but it will CREATE a lot. The graduated income tax has worked for a long time in this country, only breaking in the past couple of decades when the graduation sloped off and the race toward income inequality gained real momentum. Now we have a race to the top and a race to the bottom and a disappearing middle. An absolutely guaranteed recipe for economic disaster.
Mom gives 5 dollars every day, for those kids who prepare their beds. The kids faithfully prepare the beds as they have lots of uses for 5 bucks. Things go well on day 1.
The next day, dad walks in and says he has to be paid a commission on the rewards as he thinks $5 is too much for just preparing the bed. He takes away $1 from each kid. Eldest kid John says he can't use the $4, as just an entry to the skating rink costs $5. He thinks, for the 30 minutes spent on preparing the bed, he can work somewhere else and make more than $4. So, he quits making his bed.
Dad then increases the tax to $2 on day 3. Now the next kid, Jane, also quits, as she can't do with just $3 for buying her favorite songs on iTunes.
The process goes on, until dad taxes all $5 and none of the kids make their beds anymore.
When people earn money, taking part of it from them is not a good way to get money for what everyone needs, like public safety and clean water. Instead, people should pay more if they use more natural resources, such as land (not counting the houses or buildings on it), water or oil in the ground, trees that grow by themselves, air and moving water that gets polluted by what they are doing with it, fish in lakes and oceans, and so on.
These are things that people don't make for themselves, so it is fair to charge people for using them. They are very hard to hide and so it's possible to find out exactly how much people use. In particular, the land under buildings in big cities is so valuable that taking just part of what people are willing to pay to use that land is enough to take care of all the needs of society all by itself. If any money is left, it can be given back to everyone.
Short version: "Tax bads (waste and privilege), not goods (income and capital gains)."
No one thing will ever fix everything. Explain to the five year old that every action has unintended consequences, often involving adaptive behavior which confounds the original purpose.
An example a five year old might understand is that if he doesn't share his toys when he is playing with other kids, then they won't want to be his friend. As a result fewer freinds will come to his birthday party and he will get fewer presents.
In some cases rich people make a lot of money unfairly by taking advantage of people and that is wrong. We need to do our best to tell the government ways we can make things more fair.
But sometimes rich people make money by having a really good idea, taking a chance, and working really hard. When that happens, everyone is better off: the rich person because he earned a lot of money and the other people because they got new stuff that they had been wanting.
If taxes go up and up and up for the rich it means that some of their cool ideas would be too expensive to try. That means that the rich person doesn't get a chance to make more money, the normal people don't get cool new stuff and the government misses out of the taxes they would have charged if the rich person was able to afford to try his good idea.
The obvious issue that is being skirted here is that rich people don't actually pay all their mandated taxes. Loopholes mean they don't have to. If they did, there would be less of an issue with some of the problems that make them rich, such as investing in companies that make money from entities such as wars, foreign aid and such.
Poor people don't normally invest in companies that make weapons or who manage logistics of carrying on a modern war.
Poor people don't often invest in Agri-businesses that make money by charging Governments and NGO's spot prices (well above the actual bushel prices) on wheat, rice and other foodstuffs that are sent to fulfil foreign aid orders. Those same Agribusinesses also receive the lions share of Government Farm Subsidies, not small-hold Farmers, which inherently means a double share of Government Aid to Corporations.
The simple issue is that it is not ineffective Government, it is effective Lobbying that keeps ensures Reps and Senators will keep feeding big business, keep open the loop holes that make it possible to not pay the appropriate taxes that are mandated. Here's an industry specific tax break, Hedge Fund income isn't taxable because that income is Capital gains, and that is same as the income when a family home is sold at a gain ... well, am I the only one who can see the inequity of the situation? The Rich don't buy more refrigerators and couches and jeans and music and groceries than the poor. Yet they pay a smaller percentage of a much larger income than their servants and workers and still use Government funded infrastructure to the same extent.
Seriously, check out a video of comedian Tim Slagle and his view on taxation, using the analogy of halloween. I saw Tim perform this at our local comedy stop, and I laughed so hard it hurt! I know the skit is also available on his CD, "Europa" (available on iTunes).