Tuesday, February 1, 2011

Taxes, But No Death [Updated Once]

As Ben Franklin supposedly said, "Our new Constitution is now established, and has an appearance that promises permanency; but in this world nothing can be said to be certain, except death and taxes." I'm much too afraid of death to post about that.

There are a few things everyone must understand when thinking about the issue of taxation:

1. There are numerous kinds of taxes. Numerous levels of government have the power to tax. The city, county, state, and Federal governments all can levy taxes. So when you hear something like "50% of people pay no taxes," you will realize this is ignorant. Of course they pay taxes. Every time they fill up, they pay the gas tax. Every time they shop (rules vary from state-to-state), they pay taxes. Now, it is true that about 47% of households paid no Federal income tax in 2009. This is not the same thing as paying "no" tax. [UPDATE: Median household income in 2009 was $49,777. This means most, if not all of those households who paid no Federal Income Tax in 2009 made less than this.] 

2. Federal income tax is marginal. This means that the nominal rate (see #3 below) applies to the dollars in each bracket. As an example, an individual who makes $400,000 in taxable income (see #4 below) would pay:
  • 10% on income between $0 and $8,350
  • 15% on the income between $8,350 and $33,950; plus $835
  • 25% on the income between $33,950 and $82,250; plus $4,675
  • 28% on the income between $82,250 and $171,550; plus $16,750
  • 33% on the income between $171,550 and $372,950; plus $41,754
  • 35% on the income over $372,950; plus $108,216
They would NOT pay 35% of everything. Their aggregate rate is actually 29.4%. So, if you hear the argument that "if Obama raises my taxes, I just won't work as much," you know that person is ignorant, if not stupid. If the top marginal rate goes up 4% to 39%, that means they earn 4 cents per dollar less, assuming they actually pay the full 39% on that money, which they probably won't. Even if they do, are people really going to just stop working and throw away 61 cents on the dollar (a difference of 4 cents, folks)? If so, they are stupid. Incidentally, in terms of what tax rates do to productivity, please note this. I am not going to advocate a return to 92% top rate, or anything close to that. My point is, from 1946 to 1963, our national economy did just fine with a top rate of 82-92%. Heck, it was 50% in 1986! Whatever level of taxation is best, I can say with a measure of confidence that a 4% increase to 39% is NOT going to kill us. Of course, this is now moot, because Obama gave in to the Republicans and kept the Bush tax cuts for the top earners.

3. There is a difference between nominal and effective tax rates.The nominal rate of Federal income tax is listed above. Nominal means the stated rate. Effective tax rates are the actual percentage of money you pay, based on your Adjusted Gross Income (AGI).  AGI is income minus deductions. There are many common deductions in personal taxes, at least as of 2008 (source):
First up, some common federal tax deductions that you can take whether or not you itemize (these are technically ‘adjustments‘ as opposed to deductions):
  1. Retirement contributions (Traditional or SEP-IRA, 401(k), etc.)
  2. Student loan interest (up to $2,500/year on qualified student loans)
  3. Capital losses (realized losses can offset unlimited capital gains or $3,000 in income)
  4. Business expenses (business owners and employees with certain un-reimbursed expenses)
Next, some common deductions that you can take if you itemize:
  1. Home mortgage deduction (deduct interest paid during the year)
  2. Home equity loan deduction (deduct interest paid during the year)
  3. State and local taxes (or sales tax if that works out better for you)
  4. Charitable contributions (cash and property donated to a qualified organization)
  5. Medical expenses (deduct those in excess of (7.5% of your AGI)
  6. Personal casualty and theft losses (deduct your loss minus insurance payments)
The point here is to get you think about the difference in what people might say taxes are, and what people actually pay in the real world. According to this, the top 1% in 2008, who have AGIs (remember, this is income MINUS deductions) of $380,354 and up paid an effective rate of 23.27% on their Federal tax. The overall rate, depending on a number of variables, including state of residence, is higher, due to the other forms of tax I discussed in #1 above.

4. Gross income and taxable income are different things. Gross income is the amount of money your paychecks add up to (this is a simplification). Taxable income (AGI) is that amount less any deductions. If someone makes $400,000 a year gross, you can be pretty sure they have deductions, such as the mortgage interest deduction. Thus, if they have $50,000 in deductions, their taxable income is $350,000. So, when you hear that Obama wants to raise taxes on people making over $250,000, you understand that means a person (or couple) who has $250,000 or more in income AFTER deductions. I submit there is a meaningful difference between a gross of $250,000 and a net of $250,000, given the value of deductions.

Hopefully this will provide a few basic analytical tools for you to use in evaluating claims about taxes. I'll probably post elsewhere about tax policy, and issues of "fairness."

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