The Case for Comprehensive Tax Reform

Shires Financial - The Case for Comprehensive Tax Reform

Please contact mary‐beth.fisher at with any questions, comments or corrections.

Worth Noting

  • 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.

Gross Income

“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
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.

Payroll Taxes

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:

Research Disclaimers:

IMPORTANT DISCLOSURES: Please see important disclosures in the text of this report.

Some sections of this report have been written by our strategy teams. These sections are clearly labelled and do not purport to be an exhaustive analysis, and may be subject to conflicts of interest resulting from their interaction with sales and trading which could affect the objectivity of this report. (Please see further important disclosures in the text of this report). These sections are a marketing communication. They are not independent investment research. They have not been prepared in accordance with legal requirements designed to provide the independence of investment research, and are not subject to any prohibition on dealing ahead of the dissemination of investment research.

The information and opinions contained in this report have been obtained from, or are based on, public sources believed to be reliable, but no representation or warranty, express or implied, is made that such information is accurate, complete or up to date and it should not be relied upon as such. This report does not constitute an offer or solicitation to buy or sell any securities or other investment. Information and opinions contained in the report are published for the assistance of recipients, but are not to be relied upon as authoritative or taken in substitution for the exercise of judgement by any recipient, are subject to change without notice and not intended to provide the sole basis of any evaluation of the instruments discussed herein. Any reference to past performance should not be taken as an indication of future performance. To the fullest extent permitted by law, no BNP Paribas group company accepts any liability whatsoever (including in negligence) for any direct or consequential loss arising from any use of or reliance on material contained in this report. All estimates and opinions included in this report are made as of the date of this report. Unless otherwise indicated in this report there is no intention to update this report. BNP Paribas SA and its affiliates (collectively “BNP Paribas”) may make a market in, or may, as principal or agent, buy or sell securities of any issuer or person mentioned in this report or derivatives thereon. BNP Paribas may have a financial interest in any issuer or person mentioned in this report, including a long or short position in their securities and/or options, futures or other derivative instruments based thereon, or vice versa. BNP Paribas, including its officers and employees may serve or have served as an officer, director or in an advisory capacity for any person mentioned in this report. BNP Paribas may, from time to time, solicit, perform or have performed investment banking, underwriting or other services (including acting as adviser, manager, underwriter or lender) within the last 12 months for any person referred to in this report. BNP Paribas may be a party to an agreement with any person relating to the production of this report. BNP Paribas, may to the extent permitted by law, have acted upon or used the information contained herein, or the research or analysis on which it was based, before its publication. BNP Paribas may receive or intend to seek compensation for investment banking services in the next three months from or in relation to any person mentioned in this report. Any person mentioned in this report may have been provided with sections of this report prior to its publication in order to verify its factual accuracy.

BNP Paribas is incorporated in France with limited liability. Registered Office 16 Boulevard des Italiens, 75009 Paris. This report was produced by a BNP Paribas group company. This report is for the use of intended recipients and may not be reproduced (in whole or in part) or delivered or transmitted to any other person without the prior written consent of BNP Paribas. By accepting this document you agree to be bound by the foregoing limitations.

Certain countries within the European Economic Area:

This report is solely prepared for professional clients. It is not intended for retail clients and should not be passed on to any such persons.

This report has been approved for publication in the United Kingdom by BNP Paribas London Branch. BNP Paribas London Branch is authorised and supervised by the Autorité de Contrôle Prudentiel and authorised and subject to limited regulation by the Financial Services Authority. Details of the extent of our authorisation and regulation by the Financial Services Authority are available from us on request.

This report has been approved for publication in France by BNP Paribas, a credit institution licensed as an investment services provider by the Autorité de Contrôle Prudentiel whose head office is 16, Boulevard des Italiens 75009 Paris, France.

This report is being distributed in Germany either by BNP Paribas London Branch or by BNP Paribas Niederlassung Frankfurt am Main, regulated by the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin).

United States: This report is being distributed to US persons by BNP Paribas Securities Corp., or by a subsidiary or affiliate of BNP Paribas that is not registered as a US broker-dealer to US major institutional investors only. BNP Paribas Securities Corp., a subsidiary of BNP Paribas, is a broker-dealer registered with the Securities and Exchange Commission and a member of the National Association of Securities Dealers, the New York Stock Exchange and other principal exchanges. BNP Paribas Securities Corp. accepts responsibility for the content of a report prepared by another non-US affiliate only when distributed to US persons by BNP Paribas Securities Corp.

Japan: This report is being distributed to Japanese based firms by BNP Paribas Securities (Japan) Limited or by a subsidiary or affiliate of BNP Paribas not registered as a financial instruments firm in Japan, to certain financial institutions defined by article 17-3, item 1 of the Financial Instruments and Exchange Law Enforcement Order. BNP Paribas Securities (Japan) Limited is a financial instruments firm registered according to the Financial Instruments and Exchange Law of Japan and a member of the Japan Securities Dealers Association and the Financial Futures Association of Japan. BNP Paribas Securities (Japan) Limited accepts responsibility for the content of a report prepared by another non-Japan affiliate only when distributed to Japanese based firms by BNP Paribas Securities (Japan) Limited. Some of the foreign securities stated on this report are not disclosed according to the Financial Instruments and Exchange Law of Japan.

Hong Kong: This report is being distributed in Hong Kong by BNP Paribas Hong Kong Branch, a branch of BNP Paribas whose head office is in Paris, France. BNP Paribas Hong Kong Branch is regulated as a Registered Institution by Hong Kong Monetary Authority for the conduct of Advising on Securities [Regulated Activity Type 4] under the Securities and Futures Ordinance.

© BNP Paribas (2011). All rights reserved.

Scott Shires

Click Here to Leave a Comment Below

Leave a Comment: