Phony tax arguments

I do my own taxes. They are not that complicated and the tax forms and instructions provided by the IRS are pretty clear and straightforward.

Basically, the system for most individuals is that you add up all your income to get your gross income, then subtract all the allowable deductions (personal and dependent deductions, state and local taxes, home mortgage interest, IRA and charitable contributions, etc.) and you are left with what is known as your taxable income. At the very least, a single person in 2008 would be able to claim the standard deduction of \$5,450 and one personal exemption of \$3,500, meaning that their taxable income would be \$8,950 less than their gross income. If they put away another \$5,000 in an IRA savings account, their taxable income gets further lowered by that amount and they pay even less in taxes.

In 2008, for a single person, the tax is computed as follows (see page 80):

On the amount of your taxable income that is \$8,025 or less, you pay 10% of the amount.
On the amount over \$8,025 and less than or equal to \$32,550, you pay 15%
On the amount over \$32,550 and less than or equal to \$78,850, you pay 25%
On the amount over \$78,850 and less than or equal to \$164,550, you pay 28%
On the amount over \$164,550 and less than or equal to \$357,700, you pay 33%
On the amount over \$357,700, you pay 35%

The size of each income tax bracket is adjusted each year for inflation.

This is what is meant by a progressive tax code, that the percentage of income that is taxed goes up the higher the bracket in which your top income level is. Your marginal tax rate is the percentage that is taxed on that portion of your income in the highest bracket. So the marginal rate for someone earning \$50,000 is 25% (meaning that the portion of income over \$32,550 is taxed at 25%), while for someone earning \$250,000 it is 33%.

Because of this progressive structure, the actual percentage of your gross income that goes as taxes is much less than your marginal rate. For example, a single person who earns a gross income of \$50,000 pays less than 11% of their gross income in taxes, even though their marginal rate is 25%, while a single person who earns a gross income \$100,000 pays only about 18% of their gross income in taxes (assuming they take the standard and personal and IRA deductions) although their marginal rate is 28%. So when people say that they are ‘in the 25% tax bracket’, they are merely talking about their marginal tax rate, not the effective rate at which their entire income is taxed.

This is an important distinction between marginal and effective rates that some anti-tax advocates like to blur, by suggesting that small increases in marginal rates are a disincentive to earning, and that it makes good economic sense to limit your earnings so that you stay at a lower marginal rate. It is never the case that, by raising your taxable income so that you move into the next higher marginal tax rate, you will lower your after-tax income.

If you were earning \$78,850 dollars (and thus your marginal rate was 25%), and by doing a little extra work you earned \$1 more and that pushed you into the 28% marginal rate, only that last dollar would be taxed at the 28% rate, with all the other income unaffected. Your take home income would still increase by 72 cents. If you earn more, you get to keep more.

So-called ‘flat tax’ proposals, in which all income is taxed at the same rate, is regressive. The so-called ‘payroll taxes’ such as Social Security and Medicare are regressive taxes since they are flat taxes of 6.2% and 1.45% respectively on all income. In fact, the former is extremely regressive since that tax is not levied on income over an upper limit that is adjusted for inflation (and is \$102,000 for 2008), which means that the more you earn over that limit, the lower the percentage of your income that you pay as tax.

The reason that a progressive tax structure is fairer is that poorer people pay a far greater proportion of their total income for basic necessities like food, clothing, shelter, and health care while the rich have far more disposable income to spend on luxuries. You do not want to heavily tax that portion of the income that goes to meet basic needs, hence the lower rate on the lower brackets.

When George W. Bush came into office in 2000, there were five income tax brackets:

On the amount of your taxable income that was \$26,250 or less, you paid 15% of the amount.
On the amount over \$26,250 and less than or equal to \$63,550, you paid 28%
On the amount over \$63,550 and less than or equal to \$132,600, you paid 31%
On the amount over \$132,600and less than or equal to \$288,350, you paid 36%
On the amount over \$288,350, you paid 39.6%

Even though these taxes were much lower than most years since 1933 (In 1945, the top marginal rate reached a peak of 94%), Bush and the Republicans pushed relentlessly for even lower tax rates, especially the top marginal rates that affected the very wealthy. By 2003, there were six income tax brackets (as now) but the rates for each bracket were reduced to 10%, 15%, 27%, 30%, 35%, and 38%.

Bush and the Republicans pushed for the even lower rates, which resulted in the current situation. All of these cuts largely benefited the wealthy since it lowered their top rates by more. In other words, they made the tax code more regressive. As a result of these tax cuts, a single person in 2008 earning a gross income of \$50,000 saw a drop in their taxes of about \$1,300 (compared with the 2000 rates) while someone earning \$500,000 saw a drop of about \$21,000. The loss in revenue due to the tax cuts that largely benefited the rich, coupled with the huge costs of the war in Iraq and Afghanistan, has resulted in the budget surpluses of 1998-2001 becoming deficits from 2002 onwards.

These tax cuts were sold as a temporary measure, and to help passage a sunset provision was added that was due to go into effect at the end of 2010, causing the rates to revert to their 2000 values. But it was entirely predictable that when the time came for the sunset provision to kick in, the tax cut zealots would start misleadingly squealing that we were getting a tax hike, rather than the truth that we were ending something that was meant to be a temporary measure. And we see this happening now.

While I expected this kind of opposition to reverting to the 2000 rates, what took me by surprise was the sudden channeling by some people of their inner Ayn Rand and their plan to oppose the sunset provisions using a bizarre strategy based on, of all things, the plot of her novel Atlas Shrugged.

Next: Ayn Rand and ‘going Galt’.

POST SCRIPT: Civil liberties and internet censorship

Chris Hansen, senior national staff counsel for the ACLU, will be speaking at the Case Western Reserve University Law School Moot Court Room on Thursday, March 19th from 4:30-5:30 on the topic of “Civil Liberties and Internet Censorship.”
The event is free and open to the public. Call 216-472-2220 or go here for more details.

1. Paul Jarc says

This is an important distinction between marginal and effective rates that some anti-tax advocates like to blur, by suggesting that small increases in marginal rates are a disincentive to earning, and that it makes good economic sense to limit your earnings so that you stay at a lower marginal rate.

What does make sense sometimes is to increase your contribution to a tax-deferred retirement account (giving you less money available to spend immediately) to stay in a lower tax bracket. This assumes that after retirement, when you withdraw money from the account and it gets taxed at that point, your income will be less than when you were working, and so this money will be taxed at a lower rate after retirement than it would have been while you were working.

So-called ‘flat tax’ proposals, in which all income is taxed at the same rate, is regressive.

Isn’t a flat tax exactly neutral on the regressive-progressive scale? A flat tax is more nearly regressive than what we have now, but to be regressive in an absolute sense, it would have to put a higher tax rate on lower incomes.

2. Jared says

Paul,

You are right to point out that since tax progressiveness is a metric it is better to define different taxes as “more regressive” or “less regressive” than another one.

However, I think you are wrong to suggest that it can be objectively normalized. That is, there is no such a thing as an objective neutral in terms of the regressive-progressive scale. I would (subjectively) suggest that a good neutral point would be a tax that taxes the same percent of a disposable income rather than total income. Under this definition a flat tax is regressive. Perhaps tax experts have a better definition?

Why not define flat taxes as the zero point? Well, I do not study public policy for a living, but I am close to some that do. From what I have learned from them, flat taxes definitely fall on the regressive side of taxes. There are a multitude of reasons why it works out that way. Of course, there are worse examples, most notably “sin” taxes such as cigarette taxes.

Respectfully,
Jared