As your income increases, your taxes increase - and the percentage increases as well. But there is more to progressive taxes that we pay than meets the eye.
The more money you make, the more you pay in taxes. In a progressive tax system, the more you make, your taxes increase nearly exponentially. But if you look at the tax rates, the real sharp increase in taxes occurs at a fairly low rate - where the middle class and lower middle class lives.
Progressive tax rates are a religion in the US and most Western countries. The theory is, the more money you make not only should you pay more in terms of higher taxes, but in higher tax rates - your increased income should be taxed at every increasingly higher rates.
Most people have no idea what this means, even if they have strong opinions about our tax system. They are convinced, for example, that the "Bush era tax cuts" gave them a big break. But the reality of our present tax rates is that the real increase in rates kicks in right at about your income level, if you are a typical middle-class to upper-middle-class person.
Once you start making the REALLY big money, the tax rates increase only marginally. And as a bonus, above $106,800, you stop paying Social Security taxes - so your effective rate drops by several percentage points.
All of this is fairly complicated and hard to understand for the average person, because, as you know, "You don't need to know mathematics in Real Life" as Peggy Sue told us. So people believe tea party slogans without understanding what progressive rates are, or even having a clue what rates are like.
This site illustrates the tax rates for 2010. At first glance, it appears to be a "fair" system, in that the rich pay more, as a percentage of their income, than poorer people do. And as charted out on the graph above, you can see rich folks pay a lot of taxes. But they make a lot, too.
But if you blow up part of this chart, you can see an unfairness in part of the graph:
The same chart blown up. Notice how the tax rate jumps from 15% to 25% right at $34,000. This is the single largest jump in the tax rate, right at the " sweet spot" of middle-class income.
As you can see, Joe Middle class, who may be making from $34,000 to $82,400 a year is paying 25% taxes on that portion of his income. This is a huge increase in the marginal rate - 10% - which affects the largest numbers of Americans.
1993 saw a tax hike on the wealthy (via two new brackets at the top), and then 2001 through 2003 saw a series of tax cuts (the so-called Bush tax cuts) that lowered the tax brackets as follows:
| 1992 | 1993 - 2000 | 2001 | 2002 | 2003 - 2010 | 2011 - 2012 | 2013 ? |
| 15% | 15% | 15% | 10% | 10% | Same as 2010 | 10% |
| 15% | 15% | 15% | ||||
| 28% | 28% | 27.5% | 27% | 25% | 25% | |
| 31% | 31% | 30.5% | 30% | 28% | 28% | |
| 36% | 35.5% | 35% | 33% | 36% | ||
| 39.6% | 39.1% | 38.6% | 35% | 39.6% |
As you can see,the tax cuts ended up cutting the rates that the very wealthy pay - in the four highest brackets, but left the lowest brackets alone. It truly was a "tax cut for the rich".
Now throw Social Security into the mix. You pay 6.2% Social Security on the first $106,800 of income only. Once you make over that amount, you pay no Social Security taxes.
So, if you look at these marginal rates to include Social Security taxes, you see that between $82,400 and $106,800, your marginal rate will be 28%, plus, you will pay 6.2% on all of your income.
But between $106,800 and $171,850, that 6.2% drops off, meaning that your marginal rate decreases by 6.2% - your effective marginal rate is now LESS than 22%! The savings continue all the way up the line, until you are in the 35% bracket. So in effect, not only is our tax system not "progressive" but it actually goes regressive as you make more money.
The chart above attempts to illustrate this effect. The blue line is the same as the first chart - illustrating the amount of ordinary income taxes you'd pay with increasing income. The pink line adds in the Social Security tax. As you can see, the pink line collapses onto the blue line as income rises and Social Security tax disappears. Note the slope of the pink line nearly flattens between $106,800 and $171,850, representing the decrease in marginal rate. Slope of a curve - more of that "math stuff" you don't need to know in "real life". (Note: The pink line would actually drop down at $106,800, representing a negative change in marginal rate, but the graph above shows a point-to-point plot).
The last line, the yellow one, represents how much taxes a person would pay if Social Security taxes were assessed on all of your income. Now many of you don't realize that Social Security is basically a regressive tax (the poor pay more, as a percentage of their income, than do the rich) and most folks don't make over $106,800 a year. And I have to say, the first time my paycheck exceeded the cutoff amount ($80,000 back then) I was puzzled why my bi-weekly check went up and my taxes down.
The mythology is that Social Security is a "trust fund" that we "pay into" and "get out" what we "pay in" - all of this, is, of course, sweet lies. It is just a tax, like any other, and the money is paid out to retirees and other beneficiaries the moment it is paid in. And when the Social Security "trust fund" is "in crises" there are two and only two choices - raise the cutoff amount or cut benefits. And over the years, Social Security has been "fixed" by raising the cutoff amount.
The combination of a progressive tax that flattens in terms of rate increase (the first differential of rates, but now I'm going into Calculus, and I'm sure I lost you in the first graph) along with a regressive Social security tax (that cuts off at an arbitrary limit).
Of course, I am not putting in the 1.47% Medicare tax, but that applies to all income at a flat rate, so it does not affect the overall analysis.
Note that I am not also taking into effect a number of deductions which help out the upper middle class more the middle class or the poor. For example, the home mortgage deduction is a boon to someone in upper brackets, but not worth much to the poor - who are far more likely to be renters.
If a poor person buys a $160,000 house, finances $150,000, they might have a monthly payment of $851.68 at 5.5% interest, and $8,199.57 in interest payments for the year. If they make a combined income that keeps them in the 15% bracket, they save about $1229.94 a year on taxes.
A wealthier person, on the other hand, would get $2869.85 knocked off their taxes for the same house because they are in the 35% bracket. And of course, this means that they can afford to buy more house for their dollar, as they save more on taxes.
So, for our example, our poor person pays $851.68 a month for a house, which is a lot for a poor person. With the mortgage interest tax deduction, this costs them $749.19 a month. A rich person, in the 35% bracket, could buy the same house for an effective monthly payment of $612.53 a month - they pay less, even though they can afford more.
Or look at it another way, for the same $749.19 a month the poor person pays to live in a $160,000 house, the rich person would pay the same amount (with the tax deduction) to live in a $215,000 house for the same effective monthly payment. So you can see that "progressive tax rates" combined with tax deductions, result in more savings for the wealthy. And of course, this has the unexpected side-effect of encouraging people to borrow more money for homes to get a deduction.
And of course, I haven't addressed all the nice loopholes the very rich can use to avoid taxes entirely or convert them to capital gains. I made use of this when I had investment Real Estate - converting ordinary income (at the 35% rate) to capital gains (at 15%, and delayed by a number of years) using the perfectly legal mechanism of the depreciation deduction.
Do the rich pay more taxes than the poor? Yes, because they make more money. But as a percentage of income, they pay little more or equal to, what the average middle-class person in America pays, in terms of marginal rates and overall rates (graph to follow!). People blather on about "flat taxes" in America, but in effect, we have a largely flat tax rate as it is.
While many people criticize the "progressive tax system" it should be noted that our system is not really progressive, thanks to both the Bush-era tax cuts and also to the Social Security cutoff. It is regressive in some aspects, and flat in others. It is hardly the 50-75% marginal rates of the Kennedy era.
And since the largest tax rate hike occurs at a very low level, the middle class in America end up paying the lion's share of taxes, in terms of percentage of income and overall contributions.
But hey, that's not as nice and neat as a simple, mindless slogan, like "No new taxes!"
Now about the Gifts and Estate tax - the so-called "death tax" - well, that's a whole another ball game. And once again, people who make very little money and have little chance of ever having to worry about a "death tax" are pushing for repeal. Long story short, if your parent's estate is less than $1.5 million dollars, OR if they are farmers, you won't likely be paying the tax. But that involves more charts and graphs to explain, and the guy holding the Obama-dressed-as-Hitler sign really isn't going to get that, is he?
America! What a country!
The original point of this posting was that if you make less than $34,000 a year, you do pay a lot less taxes - if you can structure your life to live on less than $68,000 a year in combined income, you really come out way ahead. Once you cross over into that black hole between $34,000 and $106,800, you are paying a very high marginal rate! Above that, your taxes level out or decrease. The middle-class gets a real screw-job. Be rich, or be poor, but don't be middle class! That seems to be the lesson, here.
Well, the real lesson here is that our tax system is not all that complicated - but that people are even less complicated and refuse to think about such things or "do the math" as I like to say. It is more comforting to shout a slogan or believe a political ad than to think.
8 comments:
I noticed the drop in marginal as well and it was only after I learned about the social security cutoff that I began to understand it. You did a nice analysis of the phenomenom. I'm pretty sure you could add some more points and do the marginal change graph as well. I've seen some online (that include deductions/credits) that show some very strange areas sub 40k per year that have extraordinary marginal rates in the upwards of 80% for small sub thousand ranges as deductions/credits phase in/out. However, when I look at "marginal tax rate" google pictures, I get a fair number of pictures that I'm skeptical of. So I'm not 100% sure on that previous figure. (Especially the obama tax proposal pictures, I'm betting are outright lies, but don't have time to investigate)
Nevertheless, the tax code is very interesting and sometimes you can make a killing if you get credits in the correct manner. (And you get lucky..)
For instance since I was married this last year I qualified for some education credit's that I wouldn't have (due to single person salary) that granted me almost 4k in credits. Just completely ridiculous.
I think what the flat taxers etc are really interested in is just a simpler tax code. It shouldn't be hard to plot a marginal tax rate as your income increases, but year to year, and unless you work at some tax accounting firm, I bet it would be very challenging to come up with the actual numbers.
The main problem with the flat tax is that it would probably lower taxes for some, and increase taxes for others. Thus, there is a constituency that would constantly vote against it - those who would see their taxes increase. At least in theory, anyway.
But some folks can be persuaded to vote against their own interests, hence you have people making $30,000 a year railing about the "Death Tax" when there is no way in heck they will ever have to pay it, unless their parents win the Powerball, which is not likely.
What I find interesting is that the marginal rate for sub $34,000 income (which is my retirement income) is only 15%. Thus, the tax incentive to have mortgage debt, in my tax bracket, is pretty small. If I make $50,000 however, the marginal rate jumps a huge 10 points to 25%, and suddenly, deduction-chasing becomes a big deal.
Progressive tax rates are an incentive to make less money - which was the original point of my post, before I got off-track.
Back in the day, when I was a big-shot Attorney making six figures, I was getting about 35% of my mortgage payments back, in terms of taxes. There was a lot of incentive to have mortgage debt back then - as well as play other games, like converting ordinary income to capital gains, using rental properties. BTDT!
But frankly, I prefer my life now, where my taxes are simpler to prepare, I pay less, and I can spend more time at the beach. Hmmm...what happens when all the baby boomers retire and make less money? Bad news for the IRS!
Tax credits, as you noted, are a particular bugaboo as they can lop huge chunks off your income taxes. For example, if I bought an electric car this year, my tax bill would go negative! The tax credit is $7500.
One other aspect of the flat-tax movement is that perhaps the government should not be "forcing" us to do certain behaviors by providing deductions and credits which make it lucrative to do certain things - buy a home, contribute to a 401(k), buy an electric car, etc.
Basic economics suggests that when the government provides such incentives, it does not lower prices for the goods or services involved, but rather the market adjusts prices accordingly.
The real effect of tax incentives is to financially punish those people who do not take advantage of them. They become more of a stick than a carrot.
As for the Bush-era tax cuts, I think the general idea of the Obama administration was to let the top TWO brackets expire, and go from 33/36 to 35/39.6, while leaving the bottom four brackets alone.
Bear in mind that you have to be making (and that is NET profit, not GROSS income) $171,000 before those brackets kick in. And again, they've done a good job of convincing people making $30,000 a year that the Obama proposal was a bad idea.
For example, one argument posited was that a businessman would not hire workers because of the tax increase. However, the expense of hiring a worker is a deduction.
But like I said, I probably lost most people with the first graph, because "You don't need math in Real Life!"
What would the flat tax rate need to be for the goverment to receive the same amount of revenue?
How much money would be saved by the taxpayers nation wide if they did not have to pay accountants to process their taxes and attorneys to sort out tax problems?
Can you make a chart that shows why people should believe anything a person who's livelyhood depends on the progressive tax system tells them.
I have heard a lot of numbers bandied about - you may want to try some of those "flat tax" websites for more information and the charts you are looking for. I would not know where to begin to calculate such a chart. Maybe for a future posting...
The problem with a "Flat Tax" of course, is that a lot of people don't understand the difference between GROSS and NET income. The difference, of course, is in the DEDUCTIONS.
So if you charge a flat tax on gross income, for some people they would go bankrupt.
For example, suppose you have a business selling electronics. You buy one million dollars of electronics and sell them at your store for $1.1 Million dollars, making a 10% profit.
If a "flat tax" of 15% were assessed on your gross income of $1.1 Million dollars, you would end up LOSING $50,000 and have to close your doors for good.
But the opposing argument would be that the merchant would just raise his prices by 15% to cover that tax, and thus end up making the same amount of money. And it would be an incentive to the merchant to be as efficient as possible and to cut overhead.
Many businesses are like that - they have huge gross incomes but small net incomes. Traditionally, we have taxed only "net income".
The game, however, is, what is a "business expense?" - a car to drive to work? A uniform to wear at work? Dinner with a client? The rules are quite convoluted, and some people get to deduct their clothing, their car, and even their meals, while others do not.
For example, if you hire a gourmet chef and set up a kitchen in your office and have gourmet luncheon meetings every day, that might be deductible. But if you just eat at a restaurant, maybe not.
So the rules get Byzantine and we need accountants or accounting software to figure it all out, and most of use live with a vague feeling of uneasiness that no matter what we did, we either foolishly paid too much tax (wasting money), or unwisely paid too little (facing an audit).
My friends in the IRS tell me that this FEAR that people have of the IRS is their greatest weapon. Very few people are audited, but when they are, it is such a hassle that it keeps the rest of us in line.
Maybe a flat tax would work. The problem is, politically, so many people have irons in the fire here (including accountants) that it would never fly - I think.
I know this is a year old post and you'll probably not going to update it but for correctness, you really should correct the number for the maximum taxable income for social security to $106,800, not $108,600.
With only a difference of about $1800, I don't think any of your graphs or conclusions would have changed (by much anyway). But it would be nice to have the correct number, nonetheless.
Thanks for the heads up, but as you note, it really it nit-picking. The analysis remains the same, nevertheless, and the actual cutoff number changes over time.
The point is, most folks don't even realize there is a cutoff and how this makes SS a regressive tax.
And unfortunately, in this day and age, most people, when discussing taxes or policies, tend to look for nit-picking things and say "Aha!" and miss the overall, bigger picture.
Conspiracy theories work the same way....
I have long supported progressiveness in the tax system simply because I believe that those who earn the most are also the ones that benefit the most from the government services provided. For example, I worked for a small business for a number of years the owner of which always complained about the 'unfairness' of a progressive tax system because it penalized his 'success'. Yet he depended on the police to protect his store, the courts to enforce his contracts, the highway and airport system to transport the goods he sold and the travel business he ran, the stability of the banking system to support his loans, the public school system to educate his workforce, and so on. In other words, his marginal need for government services was much higher than the minimum wage employees he hired yet he didn't feel he 'owed' anything to the system that ultimately made him successful. I once asked him if he had been born in Borneo if he thought he would have been as successful as he had been growing up in the United States and he agreed that it would have been much harder. The reason a progressive tax system is fair ultimately is that the government provided services it finances make it possible for not only the extraordinarily gifted among us to succeed, but also those who may be merely average. I realize this fly's in the face of the 'he pulled himself up by his own bootstraps' myth that the right uses to appeal to the middle classes and poor, but its a more realistic picture of the reality.
What I have never understood is why a constantly progressive tax system with no deductions is ever discussed. For example, the low end of the income tax would be set at some lower end point above the poverty line, we might say the low end tax would be 5% for any one or family earning 15% above the poverty line and would progress continuously to the highest income earner. If congress set a goal of paying off 6% of the national debt a year plus what ever the estimated costs of government were for the next year, it would set the highest point at that level each year to bring in that amount. Then a line would be drawn between those two endpoints and each income earner would pay a percentage equal to where they fell along that line.
You make a good point. If you tax the poor more, then you have to pay them more, so they have to pay taxes. The net cost, in theory, to the employer, is the same.
And it illustrates why taxes are taken at convenient "points of entry" in the economic system:
1. When you get a paycheck
2. When you buy something
3. When you declare a profit
4. When you sell something
5. When you give something away or will something to someone.
6. When you import something.
It is not that these particular events are viewed as "taxable" for moral reasons, but more that that are convenient points of entry into our economic system, where the tax system can easily collect a tax.
So we collect sales taxes not because of some moral feeling that selling things is a taxable event, but that Counties and Cities can easily collect such taxes from merchants.
Similarly, it is easy to deduct taxes from a paycheck, because you can trace paychecks through employers. In fact, most taxes end up being collected in employment-related endeavors, simply because employers are limited in number and can be more readily audited.
Some tax theorists argue that where you collect the taxes and how much you tax people in various groups is less relevant than the overall tax picture - the total amount of taxes collected versus the gross domestic product.
You tax the gardener more, and he has to raise his rates to the Millionaire who hires him. The Millionaire ends up paying more in costs, even if his taxes are lowered.
That's the theory, anyway. In reality, progressive and regressive taxes do odd things and do redistribute wealth.
And some theorists say we need not collect taxes at all - just print more money and let inflation be the "tax" on all of us. You print more money to pay the government's bills, and the money is worth less and less over time. This ends up dinging everyone proportionally to their income and wealth - and discourages savings over spending. It is an interesting theory, but I think given the experiences of the Wiemar Republic and Argentina, not an experiment I would want to repeat.
The problem is, even if you believe in progressive taxes, many of our taxes in our economy are in fact, regressive. The Social Security tax, as noted in this posting, is regressive.
Sales taxes are regressive, in that the poor pay more of them, in terms of percentage of income, than do the rich. And the rich can play games to avoid paying taxes.
So progressive taxes are fine in theory, but at least in this country, they have trouble being implemented.
When you can convince a $10-an-hour laborer in South Carolina that Republicans "lowered my taxes!" then the deal really comes apart.
The whole idea of progressive taxes, marginal rates, and even basic mathematics is like speaking Esperanto to him (which he will assume is French, and thus suspect).
It doesn't matter that you have actually increased his tax burden. The TeeVee said that Republicans lowered it, and that is all he needs to know.
So good luck selling tax policy ideas to the Average American. They are as dumb as posts.
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