With Tax Day arriving tomorrow and national elections on the horizon, the controversy over tax rates is again in the news. Last year, the issue was highlighted by Warren Buffett discussing his own rates. Much was made at the time of the non-partisan Tax Policy Center’s research in publishing average effective tax rates for individuals at different income levels.
As a wealth manager who works with affluent clients, the published figures did not align with what my clients are paying — they seemed low. After digging a bit deeper, my suspicions were confirmed. There are two problems with the Tax Policy Center’s method (and that of anyone who follows a similar approach):
1. The more assumptions you add and the longer you have to extrapolate those assumptions, the less reliable the results will be.
2. Since individual returns are so unique, averages distort the results — some groups have effective tax rates well below the average and others are well above. The group that is well above pays a disproportionate share, but gets vilified by the averages.
In order to have an intelligent conversation on taxes, we have to begin with some definitions so we can be sure we’re talking about the same thing. Probably the greatest confusion surrounds the issue of marginal income tax rates and effective income tax rates. The United States has a progressive tax system. As your taxable income rises, the income tax rate also rises. The marginal income tax rate is the rate that each incremental dollar is taxed. Each taxpayer starts at the bottom rate and is taxed at each level of marginal rates until topping out at 35%. Currently there are six marginal tax rates.
To illustrate, here are the tables for Single taxpayers and Married Filing Jointly taxpayers:
|FROM||TO||MARGINAL TAX RATE|
Married Filing Jointly:
|FROM||TO||MARGINAL TAX RATE|
(These tables don’t show the special rate for long-term capital gains and qualified dividends — 15% — and the Alternative Minimum Tax rate — 26% or 28%, depending on one’s income level.)
While the marginal tax rate applies to the last unit of currency in your taxable income, the effective tax rate is the rate that you actually pay per dollar earned after taking into account the progressive tax system. It is the ratio of your income tax liability (numerator) divided by your total gross income (denominator). For example, if your federal income tax liability is $10,000 (numerator) and your gross income is $100,000, then your effective federal income tax rate is 10%.
The effective tax rate is a more important figure than the marginal tax rate, because it tells you the average amount of income taxes you pay for each dollar you earn, after taking into account all deductions. Back when the top marginal income tax rate was in the 90 percent range, there were many more deductions to offset that income. Over the years as the marginal tax rates were cut, so were deductions. As a result, even though marginal income tax rates were declining, effective income tax rates were not. Today, effective tax rates are more affected by the type of income one earns and the state of the economy than the fact that marginal tax rates are lower today than they were in the past.
What people pay in income taxes varies greatly by the type of income a family makes. It also matters if the money is brought in by one or two wage earners. Take two married couples who both earn $213,600 (twice the 2010 social security payroll tax limit) — one couple has a single earning spouse making $213,600, while the other has two who each earn $106,800. The couple with two wage earners pays $6,622 more in taxes than the first couple.
Millionaires and the “Earning Affluent”
This leads us to the problem with the effective income tax rates put out by the Tax Policy Center (and similar groups). Their work was based on data from 2006, and included estimates for people who did not file tax returns, but should have. Once you start modeling data from 2006 with assumptions to 2011, include estimates of tax returns for people who didn’t file, and then average it all together, you’ll certainly end up with something… but I’m not sure it’s something meaningful.
We have two types of taxpayers in this country: those who are retired and those with earned income. It is clear that of the two, earned income is taxed much more heavily. If you are retired and a large part of your income is coming from municipal bond interest, capital gains, and qualified dividends and are not paying payroll taxes anymore, your effective income tax rate will be comparatively low. If a person is retired, they presumably saved enough assets to not have to work anymore, and have paid ordinary income taxes all their lives on earned income. While many of them are millionaires (they have a net worth or assets of over $1 million), including them in the average as if all income is created equally, and then saying the wealthy are not paying their ‘fair share’ is itself unfair.
I call those who make a lot of money but who are not yet wealthy in terms of net worth, the “Earning Affluent.” These are individuals who have large incomes, but are not yet millionaires, because they have not saved enough to qualify. Remember that earnings are not assets. The definition of “millionaire” is based on what you have saved, and not what you earn. This is important as we hear a lot about ‘millionaire taxes’ that would not necessarily tax millionaires.
As an example, here are two tax returns that have the same gross income and deductions, but where the income comes from very different sources:
|SINGLE EMPLOYED||SINGLE RETIRED|
|ALT. MINIMUM TAX||$5,002||$8,440|
|TOTAL INCOME TAXES||$83,371||$49,825|
|EFFECTIVE TAX RATE||32%||17%|
You can clearly see the difference in effective tax rates between the earning affluent and retired individuals. This is the trouble with using average rates to describe our nations’ tax situation. As we have seen, how a family earns its income is critical to determining how much it will pay in taxes. And of course, none of this takes into account the significant cost of living differences between the various parts of the country.
We do not live in a one-size-fits-all society and when we talk about tax rates, we can’t speak in generalities. Sound bites are great for scoring political points, but they don’t help us really understand the problem. We need to be able to speak realistically about when and how to raise taxes in a way that would minimize the impact on the economy. In addition, we need to figure out how our government can continue to pay its bills, uphold its social responsibilities, and still allow its citizens to retire in comfort. There are no easy answers.
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