The Case for Comprehensive Tax Reform
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- The highest average tax rate of 23.3% is paid by the top 1% of earners. This group accounts for 38% of all income taxes paid. And no, they do not earn 38% of the income, but proportionally the much smaller 20% of AGI.
- The top 5% of earners (minimum AGI of $159,619) take home 34.7% of total AGI and pay 58.7% of all income taxes. The average tax rate for this group is 20.7%.
- The bottom half of earners in the country (AGI < $33,048) take home 12.8% of total AGI but pay only 2.7%of the total income taxes collected, as their average income tax rate is 2.6%. A popular justification for this is that the payroll tax (FICA taxes for Social Security and Medicare) are effectively “flat taxes” and have a greater impact on their total federal tax burden. That’s accurate, but the bottom 50% of earners, generally speaking, recover more in benefits than they pay into these systems, resulting in a further net transfer of wealth.
- The average income tax rate is 12.2% for all taxpayers. This would roughly be the equivalent “flat tax” rate paidby all taxpayers on each dollar of adjusted gross income if there were no exemptions, deductions, etc allowed.
But the Top (Bottom) Tax Rate is 35% (10%). How Can These Rich (Poor) People Be Paying So Little (Much)?
The tax code has arguably become a morass of subsidies and give‐aways for various special interest groups and protected classes. Tax policy has become an instrument of social policy and ‐ in the case of earned income tax credits, which allow low income taxpayers to be refunded more money than they pay into the system, resulting in a net negative tax burden ‐ another form of welfare distribution. Before discussing what is “fair” for any particular group to pay, it is worth considering the baseline differences in gross, adjusted gross and taxable income used in current tax policy.
“All income from whatever source derived,” and is not limited to cash received. Gross income includes wages, salary, bonuses, interest, dividends, rents, royalties, business income, alimony, pensions and annuities, share of income from partnerships and S corps, and income tax refunds. Gross income includes net gains for disposal of assets and capital gains and losses.
Adjusted Gross Income (AGI)
AGI = Gross Income ‐ Allowed Adjustments
Gross income can be reduced by specific adjustments spelled out in the tax code to arrive at AGI. The most common adjustments include:
‐‐ Allowable contributions to certain retirement accounts (most IRAs, 401(k)s, other qualified plans)
‐‐ Alimony paid
‐‐ Health savings account deductions
‐‐ Certain limited business expenses, moving expenses, half of self‐employment tax
‐‐ College tuition, fees and student loan interest (up to $4,000, with income limitations and exceptions, scheduled to be phased out in 2011)
Taxable income = AGI ‐ ( personal exemptions + standard or itemized deductions )
Individuals may deduct a personal allowance and certain personal expenses. Each taxpayer is allowed a personal exemption ($3,700 in 2011, indexed annually for inflation) for themselves and one for each person they support. Additionally, individuals get a deduction from taxable income for certain personal expenses. An individual may claim the standard deduction ($5,800 for singles, $11,600 for a married couple in 2011) or choose to itemize deductions. Common deductions for taxpayers that itemize deductions include:
‐‐ Mortgage interest and property taxes paid on principal and second homes
‐‐ Local and state income taxes, or state and local sales tax
‐‐ Charitable contributions (limited to 50% of gross income)
‐‐ Medical expenses in excess of 7.5% of AGI
‐‐ Uninsured casualty losses
Allowance for most itemized deductions are typically phased out at higher income levels.
Marginal Income Tax Rates for Taxable Income, 2011
Note that these rates apply to taxable income, not total income. A family of five’s taxable income is significantly lower than its total income, because it gets a standard deduction of $11,600 as well as five personal exemptions worth a total of $18,500. It has no taxable income until its total income exceeds $30,100. Therefore, a family of five whose adjusted gross income was $100,000 in 2008, putting them in between the top 25% and top 10% of earners, might have the following effective rate:
$13,600 / $100,000 = 13.6%; % of AGI paid in income taxes*
*Note that in our simplified example above this is still considerably higher than the actual average income tax rate paid for the top 25% to top 10% of earners, which was 9.3% in 2008. If we assume the taxpayer(s) own a home, the deductions for mortgage interest and property taxes paid could substantially reduce taxable income, resulting in a lower overall tax burden.
In addition to income taxes, which are assessed at progressively higher marginal rates of income, wage earners also pay federal payroll taxes. Payroll taxes are often referred to as “regressive” taxes, because the amount subject to Social Security tax is capped (at $106,800 since 2009). Therefore people whose incomes are above the cap pay a reduced tax rate as their incomes rise.
In 2008, individual income taxes contributed 45% of the revenue collected by the federal government. Payroll taxes made up 36% of total revenue. Payroll taxes have gradually swelled since the creation of Medicare in 1965.
The Federal Insurance Contributions Act (FICA) tax is a Unites States payroll (or employment) tax imposed by the federal government on both employees and employers to fund Social Security and Medicare ‐ federal programs that provide benefits for retirees, the disabled and children of deceased workers.
‐‐ Social Security’s Old‐Age, Survivors and Disability Insurance (OASDI) program
‐‐ Medicare’s Hospital Insurance (HI) program
For 2009 and 2010 the FICA rate is 15.3% of which employees pay 7.65% and employers pay 7.65%. We focus on the employee side only. This is made up of the social security tax rate of 6.2% and the medicare tax rate of 1.45%. For 2011 the employees share of the social security tax has been reduced to 4.2% for all employees. There is discussion of extending this payroll tax “holiday” into 2012, but perhaps not for high income earners.
FICA is a flat tax. It applies to every dollar in gross wages you make up to the Social Security Wage Base for Social Security taxes. There is no standard deduction or personal exemption. There is no limit to the amount of wages subject to the Medicare tax.
– – Social Security Wage Base: $106,800 since 2009
The Social Security wage base rises each year based on average national wages and, in general, at a faster rate than the Consumer Price Index.
Example of FICA tax burden:
For 2011, the OASDI tax rate is reduced by 2 percentage points for employees, resulting in a 4.2 percent effective tax rate. The reductions in 2010 and 2011 tax revenue due to lower tax rates will be made up by transfers from the general fund of the Treasury to the OASI and DI trust funds. Beginning in 2013, an additional HI tax of 0.9 percent is assessed on earned income exceeding $200,000 for individuals and $250,000 for married couples filing jointly.
Sources of Federal Government Revenue:
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