Understanding Income Taxes

"You can't debate tax policy until you first answer the question, 'what is the purpose of taxation: raising revenue or social engineering?'"

For fiscal year 2007, the federal government collected $2.568 trillion dollars. It raised 43% through individual income taxes and 32% through Social Security and Medicare taxes. These latter two categories are usually referred to as "payroll" or FICA taxes but as the revenues are pooled and spent along with the regular "income" tax, they simply constitute a second, parallel, system of taxing income. Our federal tax system is very complex. Income is taxed at different rates according to its source and its amount and deductions show all the convolutions one would expect when politicians manipulate large sums of money on behalf of special interests.

Income Tax Calculation
Income tax is "progressive", which means that it is taxed at a higher rate at higher levels. These are the rates for regular income for 2008:

Adding Social Security and Medicare, Effective Rate
So if a single person had a taxable income after deductions of $28,000 per year, her federal income tax would be 10% of the first $8,025 ($802) and 15% of the next $19,975 ($2996) for a total tax of $3798. Thus, the effective tax rate is 13.6 % while the marginal tax rate, which paid on the last dollar earned, is 15%. Compare this to someone earning $200,000 per year after deductions. She would pay the maximum for each category until the last $35,549 which would be taxed at a marginal rate of 33% for a total tax bill of $51,751 and an effective rate of 26%. Added on to each are a Social Security tax of 6.2% on the first $102,000 per year and a Medicare tax of 1.45% on all of one’s income.

1. $28,000 per year total federal tax: $3798 (income tax)+ 1736 (SS) + 406 (Medicare) = $5940 (21% effective rate) 2. $200,000 per year total federal tax: $35,549 (income tax) + 6324 (SS) + 2900 (Medicare) = $44,733 (22% effective rate) It should be clear that payroll taxes matter much more at lower income levels as they are flat rather than progressive and Social Security is capped at $102,000 /year.

Who Pays Taxes
From the perspective of government income however, only high income earners matter. The top 1% of earners (> $330,000 per year) pay about 38% of all income taxes and the top 5% ( > $137,000 per year) pay 68% of all income taxes, while the bottom 50% pay 3% of income taxes.

Changing the Rates
These high income earners respond very differently to tax rates than the bottom 80% of taxpayers and for very good reasons. To start, they pay the highest marginal tax rate of 35%. Looking at the tax tables, it is clear that those with high taxable income pay taxes in all the other tax brackets. These rates are "inframarginal" and do not affect behavior. If you raise or lower these rates, you will get proportionately more or less tax revenues. In 2005, 99% of all taxpayers were in the 10% bracket, but only 25% had 10% as their marginal rate. Thus a cut in the 10% rate would influence a relatively small proportion of taxpayers who have 10% as their marginal rate, while for the remaining 75%, a tax cut would result in a straight forward, predictable revenue loss for the government. It is that highest bracket, now at 35% and how it affects the behavior of our highest wage earners, that lies at the heart of tax arguments.

Tax Evasion (Legal)
Low income earners have fewer avenues open to them to reduce their tax liabilities. They have no flexibility in changing the form of their income, say from cash to stocks, or the timing of income such as deferring it into future years. They have fewer tools with which to manipulate their tax burden, such as retirement plans (401K, IRA, Keogh plans), itemized deductions, trusts, tax-free bonds, etc. Even the culture around low income earners is less focused on decreasing tax bills. Few avail themselves even of the limited programs they have available.

Many tax avoidance methods require expert advice from accounts, lawyers and compensation specialists. These financial professionals are more cost effective for the rich because the costs are spread over larger sums and the avoidance of taxes is, dollar for dollar, more profitable.

Varying Income
High income earners simply have the ability to widely vary their incomes, and because of this, they can vary their behavior in response to marginal tax rates. This understanding, that it is after-tax income that affects people’s behavior, is called "supply-side" economics.

Popularized by the Reagan administration, it referred to the expectation that decreasing the marginal tax rate on the highest brackets from 70% to 35% would not decrease tax revenue dollar for dollar.



Is this true? There is good data from the Congressional Budget Office on the total taxes paid by the top 1% versus their household income. From these data, we can calculate the effective tax rate for the top 1% of income earners. As the graph shows, it remains constant as Congress changes the tax code and as the economy ranges from strong to weak.

While the effective tax rate of top earners remains stable, the group’s total tax payments vary widely as their income varies. It is paradoxical, but decreasing taxes on the rich increases government revenues
 * In 1980, when the top marginal rate was 70%, the top 1% paid 17.58% of all income taxes;
 * In 2005, with a top marginal rate of 35%, the top 1% paid 39.38% of all income taxes.
 * Relative to the GDP, the taxes of the top 1% rose from 1.59% of the GDP to 2.96% of the GDP.
 * In absolute dollars (constant to 2005), the top 1% paid $94.84 billion dollars in 1980, compared to $368.13 billion in 2005.

During this time, the bottom 75% of taxpayers, the middle and lower income earners, went from paying 27.71% to 14.01% of income taxes. As a share of GDP, this represented a drop from 2.50% of GDP to 1.05% of GDP. This entire group now pays about 1/3 as much in taxes as the top 1%.

If the Democrats take power and raise taxes on upper income earners while lowering taxes on lower income earners, they can expect to see an overall decrease in revenues. Yet Democrats simply will not believe the lessons of history:
 * Revenues increased in the 1920’s under Harding, when the highest marginal rates fell from 78% to 24%.
 * Revenues increased in the 1960’s when the Kennedy tax cuts decreased marginal rates from 91% to 70%.
 * Revenues also predictably increased with the Reagan and Bush cuts.

Other Factors
These income tax data do not address the compounding effects of the total macroeconomic response, or that income tax cuts increase other tax receipts (such as dividend and capital gain taxes). Stronger economies also decrease other government spending with less unemployment and less welfare.

The Real Purpose of Taxes
So how can the Democrats justify policies that will decrease government revenues? Their only honest response would be to admit that they believe the purpose of income taxes is not just to have the money, but also to make the rich less rich, as a form of social engineering. They justify this by arguing that the economy has rewarded the wealthy with disproportionately more of the national income over the past twenty years, Therefore, it is only fair that this be taxed away to keep society within a narrower economic range. They do not explain how one tells this type of "fairness" from envy or why the rich do not deserve their earnings. Nor will the Democrats admit that higher taxes will result in lower government revenues.

Questions

 * 1) The Bush tax cuts are due to expire in 2010. This will constitute the largest increase in taxes in history (nearly $1.9 trillion over 7 years), raising taxes on 115 million taxpayers and returning to the tax rolls 7.8 million low and middle income families who now pay no federal income taxes. Will this put the economy into recession ?
 * 2) The Alternative Minimum Tax (AMT) is a separate tax code that must be calculated after regular taxes are computed. It was implemented in 1966 by Democrats when they discovered that 155 taxpayers, who made more than $200,000, paid no federal taxes. Because it was not indexed for inflation, the AMT will affect 56 million people within ten years if there are no changes. Thus it would be fair to say that between AMT, FICA (payroll taxes) and regular taxes, we have 3 separate income tax systems. Suggest improvements.
 * 3) The Social Security tax, 6.2% from the individual and 6.2% from the employer, is currently capped at $102,000. If the Democrats eliminate the cap so that the tax applies to all income, as they did to Medicare in 1993, would this be the largest tax increase in history?
 * 4) Explain to a Democrat that increasing taxes on the rich decreases government revenue. Ask them to explain the expression "cutting off your nose to spite your face".
 * 5) Discuss a Flat Tax or Fair Tax as alternatives. Other solutions?