“In this world nothing can be said to be certain, except
death and taxes.”
– Benjamin Franklin.
Tax day is upon us, so it seems like a good time to begin
what will likely be a multiple part series about various tax issues. There are
quite a few angles to cover, and I try to keep each post reasonably short. As
you may have gathered I am a huge advocate of having a solid understanding of
the facts around an issue before developing your opinion. When congress returns
from their recess it is expected they will try to pass tax legislature, so it
is an especially good time to become familiar with how taxes work.
Just about everyone pays taxes. Back in 2012, presidential
candidate Mitt Romney made a statement claiming that 47% of Americans pay no
federal income tax. To be fair, depending on what year you are looking at, that
is accurate. The implication, however, is that these people are not paying
taxes at all, and that is just not true. There are several different types of
taxes paid by Americans, even those with low incomes. In addition to federal
income tax there are taxes such as property, sales, FICA, state and local, and
disability to name a few. This post is going to focus on the federal taxes that
are withheld from employee’s paychecks.
The first tax I am going to get into is the social security
tax. Somewhat off topic, I’d like to point out that the social security program
has always been almost completely funded by its own special tax. It has
relatively recently begun dipping into its reserves, but budget estimates
predict that the program remains solvent for the next few decades. That means
when politicians talk about cutting social security in order to shore up budget
deficits or to fund general tax cuts, they are talking about taking money from
a tax explicitly put in place to fund a particular program. It doesn’t get any
closer to stealing than that.
The social security tax is a shared tax on both employee and
employer. It is also a regressive tax. That means that the percentage is
reduced as the taxable wage base increases. There are simply two tiers to this
regressive tax. The full rate is collected up to the limit and, after that, the
reduction is zero. Since 1990 the tax rate has been 6.2% for each. The only
exception was 2011 and 2012 when President Obama reduced the employee portion
by 2% to help stimulate the economy. In 2017 the limit is $127,200, up from
$118,500 in 2016.
In practical application, the shared 6.2% tax results in a
12.4% tax on earned income. There is broad agreement among economists that
payroll taxes put downward pressure on wages. Your employer agrees too. They
likely account for these expenses like your wages rather than their taxes. And
for those of you who are self-employed, you simply pay both portions
straight-up. Additionally, this tax does not benefit at all from joint incomes.
If you file your taxes jointly with your spouse and you are both working, you
both are still paying the full tax. This tax falls disproportionately heavy on
the average worker since only exceptionally high earners are exceeding the
limit.
The second tax of the FICA taxes is used to fund Medicare. And
to be fair, unlike Social Security, the Medicare program takes a significant
portion of its funding from the general fund, so we can at least have a
conversation about the Medicare budget without being thieves. Like Social
Security, this tax is also a shared tax on employees and employers with the
same ramifications on the employee’s income. Historically, the Medicare tax was
also regressive with just two tiers; the full rate and zero. The rate has been
1.45% each since 1986. In 1994 the tax changed from being regressive to being
flat with the removal of the taxable limit. That means 1.45% for both employee
and employer for all income. In 2013, a provision in the Affordable Care Act
kicked in making the tax progressive. Individuals earning over $200,000 single
or $250,000 jointly would pay an additional 0.9% tax. What we end up with is a
slightly progressive tax on earned income with two tiers. 2.9% up to $200,000
single or $250,000 joint and 3.8% forever after.
The third tax withheld from your paycheck is the federal
income tax and the one most people are more familiar with. In 2017 this is a
progressive tax with 8 brackets ranging from 0% to 39.6%. It’s important to
remember that you pay tax at each bracket using the rate for that bracket. For
example, you are paying 10% on your income earned in the 10% bracket, and when
you begin earning in the 15% bracket you pay 15% of that income. Your overall tax
rate is called your “effective” tax rate and ends up being a combination of all
the brackets that you earned through. When your employer or payroll provider withholds
federal income tax from your paycheck they estimate your effective tax rate and
withhold at that rate in order to smooth out your per paycheck deductions.
Someone once told me that they got a raise for working hard,
and because of tax brackets they ended up taking home less money than before. I
can’t think of a situation where that is mathematically possible. That person
was either simply confused, confused and their employer used terrible payroll
software, or they were lying to try to prove a point. Earning more money will
always net you more money, but you could end up paying a larger portion of the
new money in taxes.
There are 2 tables used to calculate federal income tax
depending on your filing status: single or married. The rates are consistent on
both tables, but the brackets are extended for married filers. For simplicity,
I’ll be referencing the single table for 2017. At $2,300 tax rates kick in at
10%. They progress pretty quickly up to 25% at $40,250. They progress slower
after that reaching their maximum rate of 39.6% at $420,700. There are two
things I’d like to point out about this progression. First, the progression
completely stops after $420,700, so the tax rate at $500,000 is the same as the
tax rate at $10,000,000. That is an incredible difference in income without any
increase in tax rate. And, second, the regressive payroll taxes make up for
most of the difference in the progressive income taxes. I thought this best
demonstrated with a visual aid, so I made an area graph.
When you consider these taxes together, our total earned
income tax rates are much flatter than some lawmakers would have you believe. These
are almost all higher than unearned income, i.e. capital gains, but I’m not
getting into capital gains at this time. Also, I’d like to acknowledge that
there are tax credits like the EITC and Child Tax Credit that reduce the
taxable income significantly for lower income earners, but I’m also not getting
into those at this time.
Our tax rates were not always this flat. Beginning in the
early 1900’s, when income tax first begun, up until the early 1980’s there were
typically more than 20 brackets that had rates progressing up to and exceeding
90%. During this time the United
States had its economic ups and downs to be
sure, but we also grew to be the world’s largest economy. Our seemingly incredibly high progressive tax rates did not
prevent our economic growth any more that cutting them empowered it.
During the 1980’s President Reagan had our federal income
taxes down to only 2 brackets which maxed out at 28% after only earning
$18,550. In 1993 President Clinton brought us up to 5 brackets and 39.6% after
$250,000. This brought us back to a slightly more progressive scale, but was
still much lower than historical rates. During this time of exceptionally low
tax rates which mostly benefited the wealthiest Americans the economy
continued on status quo. It grew and shrank much like it did before. There
were, however, a few stark differences. First, federal deficits and the national
debt skyrocketed. Second, income inequality, the gap between the rich and poor,
increased significantly, and the middle class began shrinking. And, lastly,
money in politics grew to unprecedented levels. It seems to me that because the
wealthy aristocracy was able to keep so much more of their income they chose to
use that capital to influence politics more than ever.
Tax reform will be coming up in congress shortly. When
republican lawmakers talk about tax reform, the rhetoric is usually about
simplifying the system. They claim that the tax system is too complicated, and
that may be true. Then they claim that to simplify the system we must eliminate
tax brackets, or even shift to a flat tax. It is important to recognize when
politicians propose the idea of a flat tax they are intending to change the
last progressive tax, the federal income tax, to a flat tax, and leave the
regressive taxes alone. The meager progression that we currently have barely
compensates for the payroll taxes, and, without it, the lowest earners will
carry a far greater share of the tax burden. History has shown that this sort
of change does little to stimulate the overall economy. All it does is
encourage generational wealth and an idle aristocracy.
To truly simplify the system we need to reduce the
variety of taxes, credits and deductions. That will require more work. Taxes
fund important social programs like social security and national defense.
Credits and deductions encourage desired behavior like environmental protection
and raising children. So lawmakers will have to work hard and evaluate which
taxes can be merged and which deductions eliminated. The only way we have a
chance to get the sort of tax reform that will improve the system for the
everyday American is if enough of us educate ourselves about the policy issues
and communicate with our representatives in a thoughtful way. I encourage you
all to do just that.
