Who Really Pays Unfair Taxes?
The blogosphere has been throwing a lot of statistics around, trying to claim that one segment of the population or another pays too much or too little in taxes. I’d like to take a closer look at some of those statistics and show how they don’t mean what most of us think they mean.
With respect to the lads from Liverpool, taxes aren't nearly as bad as they sing they are.
Half the Population Pays no Income Taxes At All!
This statistic is true. No, really. Give or take a few thousand people, about half the citizens in this country do not pay any earned income tax. Or rather, they pay it, but they get it all back at the end of the year. This is not because they’re super-rich and have discovered clever tax shelters or whatever. No, it’s mostly because their income tax withholdings fall below the “Standard Deduction,” ($5800 for an individual in 2011) and so they get all of their earned income tax withholdings back in a lump sum at the end of the fiscal year.
Now, the 10% earned income tax bracket goes up to earned income of $8,500, so every dollar earned between dollar one and dollar 8500 gets taxed at ten percent. If Bob earned $8,500.00 last year, his tax withholdings would equal $850. Since $850 is a lot less than the standard deduction of $5,800, Bob gets all of his income tax withholdings ($850) back when he files in the spring. So people in the 10% tax bracket don’t pay any income tax at all! Married couples filing jointly have a higher standard deduction ($11,600), so if Bob and Nancy get married, and they ‘only’ earn $77,400 between the two of them, they will pay no earned income tax.
Check my math*: married couples filing jointly pay taxes of 10% on the first $17,000 they earn ($1,700), 15% on the next $52,000 ($7,800), and 25% on the next $70,350 ($17,587.50). But if they only earn up to $8,400 in the 25% bracket, they only have $2,100 withheld. Add up $1,700, $7,800, and $2100 of withholdings, and you get a total withholding of $11,600, which is equal to the standard deduction. That married couple filing jointly will get all their withheld money back at tax time!
Let’s let that sink in: Between them Bob and Nancy earn $77,400 per year, and still get all of their earned income tax money back in April.
But this fact by itself is misleading.
*All figures in this article assume that no deductions (e.g. dependent children) are claimed on the W2 form and that no creative accounting (asset depreciation, offshoring of accounts, etc.) are used to artificially reduce taxes owed.
Standard Deduction: a set figure that reduces citizens’ tax burden on the assumption that they do things like giving money and goods to charity, but don’t bother keeping records about it.
Wait, What? How Can it be Misleading!?
Observant readers will have noticed that in the section above, I was careful to say “earned income tax” as opposed to just “tax,” or even “income tax.” (Even folks who aren’t paying very close attention might have noticed, since I put the words earned income in bold.) There’s a reason for this. Earned income taxes aren’t the only taxes we pay.
What About Other Taxes?
The big one is the federal gas tax of $0.184 per gallon (that’s 18.4 cents per gallon). Everyone who buys gasoline pays this tax no matter how much they make. How does this disproportionally affect low-earners? Well, have you ever heard of a person telecommuting to a job at a retail store or a fast-food restaurant? Plus, even if the lower-income person (earning $25,000) and the high-income person (earning $250,000 drive the same car (unlikely) the same distance to work every day, and use (for ease of math) 20 gallons of fuel every week, they each pay $3.68/week, or $184/year in gas tax (assuming a 2-week vacation during which they don’t drive).
As a percentage of their incomes, this works out to .7% for the low-income person and .07% for the high-income person. The wealthy guy pays a tenth of the effective gas tax rate of the poor guy.
There are other federal taxes that don't get paid by individuals directly. But as others have pointed out, when corporations get taxed, they pass those taxes down in terms of higher prices. Both the rich and the poor end up paying taxes levied on corporations (but the poor pay a greater percentage of their income than the wealthy do).
Oh, Yeah, FICA…How Does That Work Out?
Glad you asked. According to the IRS’s Publication 15, employees get 4.2% of their pay withheld to pay for social security. Employers pay 10.4% of the employee’s pay into the Social Security till as well. Some would argue that if the employer didn’t have to pay that extra 10.4% to SocSec, they’d pay it to their workers, who would have more income to tax; some argue that there should be no employer contribution to SocSec in any case, etc, etc. It’s a controversy, but not the one we’re examining at the moment. I only mention it to acknowledge its existence. The Medicare tax is 1.45% for employees, and 1.45% of the employee’s pay for employers.
Right, so, the Social Security tax on earned income is 4.2% over and above any income tax you’ve already paid. That’s on all your earned income, from the first dollar up to the 106,800th dollar. So Bob and Nancy, who earn $77,400 per year between them, pay $3,250.80 for Social Security. If Bob or Nancy were to get raises, and earn $106,800 between them, the SocSec tax on their earned income would be $4,485.60. But suppose Nancy‘s boss’s boss’s boss is really impressed with her presentation on the future of her company, and she gets promoted to a higher-paid management position. Now Bob and Nancy earn a total of, say, $250,000 (more than double what they were earning before). The Social Security tax on their earned income is still $4,485.60. That’s because they stop collecting Social Security taxes after the 106,800th dollar of earned income.
As for Medicare, the 1.45% tax on earned income doesn’t stop; it’s a true flat tax (at least as far as earned income is concerned).
So What’s Wrong With That?
On the surface, it seems perfectly fair, doesn’t it? Why should people who make more than $106,800 per year be asked to contribute to Social Security beyond what everyone else does? That tax only pays for those Social Security checks, after all, and they wealthiest folks probably won’t need SocSec anyway, right?
Well, sorry, but no. It may or may not be the case that the top earners won’t want or need to get a Social Security check--that's not important. The important thing is the fact that SocSec tax money doesn’t only pay for Social Security.
What do You Mean?
Well, you know how the US has a bit of a debt problem? Right. So who do you think we're borrowing most of that money from? Yes, some of it (about 7.5%) from China; some of it from other nations. Most of it (almost half) is owed to US citizens and institutions. Did you maybe get a bond or two as graduation gifts? Yeah, that’s money that the US government borrowed from the person who bought the bond, and promises to pay you back with interest 30 years later. But a respectable portion of the debt (nearly 18%) is owed to the Social Security trust fund.
Remember back in the day when President Bush was pushing to privatize Social Security? Remember how he said that the Social Security trust fund was “just a bunch of IOUs?” Well, those IOUs are government debt, just like those savings bonds. The money that was supposed to be held in reserve to cover our Social Security obligation has been borrowed against to pay for things like roads, parks, defense, the War on Terror, Wall Street bailouts, and all kinds of stuff that’s meant to be paid for by other taxes. So really, our SocSec taxes aren’t really paying for Social Security. They’re paying for pretty much everything but Social Security.
That seems okay, until you figure that only the bottom earners pay the full 4.2%, regardless of any deductions. When Bob and Nancy started moving up in the world, their Social Security tax rate actually went down in terms of their total earned income. A married couple earning $250,000 is paying an effective Social Security tax rate of 1.8% (less than half of the rate they paid when they earned less).
Now think about the fact that the government that owes all that money to its own citizens just got its debt downgraded as an investment. The people who most need Social Security might not be able to collect it—not because Social Security was inadequately funded, but because its funds were misappropriated to pay for other things.
What Was That About Earned Income?
Right, so taxes on earned income (like the income tax, Social Security, and Medicare) only apply to money that the worker earned by doing a job and getting paid for it. If Bob and Nancy both work for GM, say, and between them they earn a total of $250,000/year, they pay 10% on their first $17,000, 15% on the next $52,000, 25% on the next $70,350, 28% on the next $72,950, and 33% on the next $37,700, minus the standard deduction of $11,600, for a total earned income tax burden of $48,354.50, or an effective tax rate of a little over 19%. Figure in Social Security and Medicare and you get a tax burden of $56,785.50, or almost 23%.
If they were to get a raise, say, to $300,000/year, their extra $50K would be taxed at 33% for an effective earned income tax rate of 24.67%, including SocSec and Medicare. But what if the raise came in the form of stock?
If instead of another $50,000 in cash, Bob and Nancy are given stock in GM valued at $50,000*, and they don’t sell it the first year, that extra $50,000 will be taxed not at the earned income tax rate of 33%, but at the long-term capital gains rate, which is 15%. Neither the 4.5% Social Security tax nor the 1.45% Medicare tax will be paid on this income, which gives Bob and Nancy a total tax burden of $55,854.50 and an effective tax rate of about 21.4%. Bob and Nancy are getting paid more, but their tax rates are getting lower! And remember, they only pay capital gains tax if they should choose to sell their stock and realize their gain. If they sit on it, they only pay the 15% tax on any dividend checks they get (unless they choose to reinvest their dividends, in which case those taxes are also deferred).
Now imagine that Bob and Nancy get promotions and raises, but work their compensation package so that they get less money in salary and more money in stocks. Together they’ll earn, say, half a million dollars per year, but will only be paid $200,000 cash between them. The rest will come in $300,000 worth of stock. After all earned income taxes (including SocSec and Medicare) and capital gains taxes have been factored in, they will pay an effective tax rate of 17.04%, which is less than the 18.75% effective tax paid by a married couple earning $175,000 between them.
*Yes, I know, it never works out in round numbers like this. If it did, we wouldn’t need accountants, would we?
How Tax Brackets Really Work
“The top tax rate is 35%! That’s an unfair burden on our top earners!” This is the mantra of the Tea-Party backed conservatives in congress, and when you say it like that, it sounds pretty bad. But remember, it’s only the top part of your earned income that gets taxed at 35%. The first $17K only gets taxed at 10%, no matter how much you make. The next $52K is taxed at 15%. And so on. The only money that gets taxed at 35% is money that you get paid by an employer in exchange for work over and above the first $379,150 you’ve earned this year. The effective earned income tax rate (as a percentage of total income) of a married couple earning $400k/year, filing jointly, is 27.22% They only pay 35% on the last $20,850 that they earned, and they pay no Social Security tax at all on earned income over $106,800. This assumes that all of their income comes in the form of a paycheck. If the same couple got half their income from their salaries and the other half from capital gains, their effective tax rate would be 17.54%, which is a lower rate than a married couple who work for less than half as much money per year.
Nobody really pays a 35% tax rate, no matter what the pundits say.
But Don’t 20% of the People Pay 80% of the Taxes?
Sure, that’s true. In 2008, according to the National Taxpayers’ Union, the 20% of Americans with the highest incomes paid over 80% of the taxes in the US.
Looking only at those numbers, it’s easy to see why someone might think there’s a problem with a mere 20% of the nation’s people shouldering 80% of the nation’s tax burden, but let’s take a look at how much people pay in taxes as a percentage of their total income. This is going to take a while; please bear with me.
If your family brings in about $69,000 or less every year, your tax burden is 2.91%. You get all your income tax withholdings back, but you still pay about $2,000 to cover whatever the government has borrowed from the Social Security money to pay for. Remember, these are people who conservatives like to claim don't pay taxes at all. If your family earns $100,000 per year, you pay 11.6%. This is about the bottom of the top 20% of household earnings.
At $150,000 per year, your family pays 16.97% in taxes. At $200,000, you pay 20.09%. At $250,000 of earned income/year, your family will pay 22.72% of your income (about $56,800) in taxes, assuming you do not itemize and all of your income is earned.
As we continue up the income ladder, let’s add an equal amount of income from capital gains (which folks closer to the bottom of the ladder generally do not have access to) and earned income, and see how this affects the percentage of your total income you’ll pay in taxes.
At $300K/year ($25K of which is capital gains) your family will pay 23.05% in taxes. Still more, but not much. At $350K/year, you’ll pay 23.29%. At $400K/year, you’ll pay 23.47%. At $500K/year, you’ll pay 23.72%. At $600K/year, you’ll pay 24.04%. At $750K/year, you’ll effectively pay 24.38%, even though you’re in the top tax bracket (only $120K of your earned income is being taxed at the top rate)!
At $1million/year, again assuming that a sizable chunk of your income is from capital gains, you’ll pay 24.72%. That’s with a $625K annual paycheck. You’re making a million dollars a year as a family, and you’re not yet paying the dreaded 35% income tax rate! What if you made a million five? Again, assuming that you get half of each increase in capital gains and only half in a paycheck, your family’s income of $1.5million will be taxed at a rate of 25%.
Suppose your family’s income were $2million? Assuming you earn $1.125million at a job and get the rest in capital gains, you pay 25.22% in income tax. Remember, this is if you take the standard deduction, with no write-offs or depreciation of assets or other clever accounting.
Warren Buffet is famous for saying that his taxes are lower than his secretary’s. Well, he’s wrong: in real dollars, he pays more in taxes than his secretary does. But he's also right; as a percentage of his income, his taxes are lower than his secretary's.
Now I'll show you why asking the wealthy to pay more in taxes isn’t as unfair as you think it is.
How is it Fair to Ask for More From Those Who Already Give the Most?
Okay, let’s suppose your family brings in the same $2million/year, but only half of it is from a paycheck. The other million comes from capital gains. Your tax burden drops to 23.88% of your income. Yes, if you make more money, your tax burden, as a percentage of your total income, can get smaller! You’re still paying more in actual dollars than you did when you took in “only” $1.5million, but you’re paying 1.34% less of your income in taxes.
Now let’s assume that you get $2.5 million, and everything over $1million is in capital gains. You’d pay 22.1% in taxes. Yes, your tax rate just went down again, by 1.78% Notice also, that you’re paying a lower effective tax rate than you did when you earned $250K at your job (22.1% as opposed to 22.72%). At this stage of the game, it might be possible to stop working for a paycheck entirely and live on the income from your investments. Now, some of those capital gains probably came from your job in the form of stock in whatever company you worked for, so we’ll assume that your $1million in earned income goes away entirely, and that you will only be getting about $500K per year in capital gains from your assets.
What do you think your family’s tax rate will be, assuming you take the standard deduction and don't claim any dependents? You’re taking in $500,000/year remember. Give up?
You have an income of half a million dollars, and because you don't get your income from work and you don't pay Social Security or Medicare tax, you pay a lower tax rate than a family who earns half as much by going to a job. Assuming that both families take the standard deduction and don’t itemize, they pay 22.71%, or $56,785.50 while you’ll pay 12.68%, or $75,000. And you can stay in bed all day if you want to. Ain’t life grand?
Now, back when the Bush-era tax credits took effect, lots of people noticed a disparity in the amount of money that went to the wealthy and the amount that went to the middle class and poor. This disparity was justified, said many people (myself included, believe it or not!), by the fact that the top earners paid a lot more in income tax. So if everyone gets, say 5% of their taxes back, the people who paid $100 in taxes will get $5 back, and the folks who paid $100,000 will get $5,000. That’s perfectly fair.
But let’s take a look at taxes as a percentage of income. Now, as we’ve seen in the sidebar, if you’re paying the 35% tax rate, you’re not paying 35% your total income. You’re not even paying 35% of your total earned income. You’re paying the 35% rate only on your income over and above the first $379,150. If you take home $500k/year, you have an effective tax rate of about 29.07%. Add capital gains to the mix and your effective tax rate can actually get lower as you gain more income. Keep that in mind.
Now, think about the last decade’s tax rebates and how someone with a greater income pays more in taxes and therefore gets a bigger refund. Now take a look at the graph below. Note that the line showing effective tax rate stays pretty flat (it hovers around 22%), while the line showing income gets very steep, and the line showing actual taxes paid kind of flattens out toward the end. This is because at the top of the income scale, the actual percentage of income paid gets lower even as incomes get higher. Note that these numbers don't even take into account the various loopholes and shelters and other ways that the very wealthy are able not to pay taxes on their income. Yes, Americans can get more income, and pay lower taxes, but only if they have incomes in the highest 5%. How is that fair?
Clearly, if there’s an income tax based on a percentage of your income, the greater a person’s income, the more that person will pay in taxes. Nobody disputes this. Some argue that as a person’s income increases, their tax rate should also increase, since they benefit more from the economy and have more money to spare. Some argue that everyone should pay the same percentage, and it shouldn't go up as income goes up (flat tax). I am not going to argue either side of this premise. But even the most rabid anti-tax Tea Partier would be hard pressed to rationalize an effective tax rate of 15% for someone taking in a million dollars a year while someone with less than a fifth their income pays nearly 19%.
- Who Owns The U.S. National Debt?
Data on who owns the national debt comes from here. By the way? It's us, mostly.
- 2011 Federal Income Tax Brackets and Marginal Rates
My data on income tax brackets, income tax rates, and standard deductions comes from this site.
Here you'll learn stuff like the difference between an asset and a liability. (Hint: your car is not an asset. Neither is your home.) There are also hints on how to arrange your income so as to pay very little in taxes.
So What are We Supposed to Take From This?
Well, that’s the kicker. I’m not even entirely sure what I think about it. The article necessarily simplifies some very complicated things. Capital gains income is calculated using a huge number of factors, including how long the asset was held before sale, depreciation, whether the gain is from the sale of stock in a “small business,” whether the taxpayer takes advantage of the various deferment possibilities, selling some assets at a loss to offset gains, inflation, and so forth. Even tax on earned income can be reduced by various methods, if you have enough disposable income to take advantage of them. But if we strip away all the complexities of the tax code, and get to the root of the claims made by various talking heads, we can clear up a few myths.
Myth: 50% of the population pay no taxes.
Fact: They pay no income tax, but they do pay Social Security, Medicare, and excise taxes.
Myth: Social Security is bankrupt.
Fact: Social Security would be fine if the money owed to it were paid back with interest.
Sort-of Myth: The more money you make, the more you pay in taxes.
Fact: This isn't always true. At the bottom of the income scale, your taxes always go up as your income grows. But at the top, while the dollar amount you pay in taxes goes up, the percentage of your income that you pay in taxes can actually drop.
Myth: The top earners pay a tax rate of 35%.
Fact: Nobody actually pays 35% of their income in taxes; even the top earners don't pay much more than 27%.
Myth: Taxes go up faster as you make more money.
Fact: Tax rates start to flatten out at the top of the income scale. Depending on the income source, effective tax rates can even go down as income increases.
Armed with this information, perhaps we can be a little more rational when deciding which tax policies to support.