Wednesday, January 5, 2011

Do we really have a Progressive Tax System (No).

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 -
  2001  2002  2003 -
  2011 -
15% 15%15%10%10%Same
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.