Tax Brackets 101, Ctd

Apr 11 2011 @ 3:02pm

2010FedTaxRates_2

A reader writes:

I made this graph to illustrate what happens to your effective federal income tax rates as your AGI increases. (I included several extra data points for the curve, but only showed the bracket points as marked data points.) I think people are thinking about effective tax rate when they're trying to understand marginal tax rates. This graph shows that effective tax rates increase relatively smoothly as you go up the income ladder. You don't see punctuated changes at the bracket points.

The implication is that it doesn't make much sense to significantly modify your income-earning behavior in order to stay within a tax bracket. The more you earn the higher the tax rate, true, but this increase is relatively monotonic by design.

Another writes:

Everything your reader writes about tax rates is correct, but he’s leaving two major pieces of the picture. For example, “Bill Gates pays the same taxes on the first $10K that he makes as does the Safeway clerk on the first $10K that she makes.” That’s theoretically true, but the practical truth is very different, due to the effect of deductions and the taxation of capital gains and dividends, and the effect of payroll taxes.

So let’s focus on Bill Gates.

Back when he was CEO, his salary and bonus for was just under a million dollars a year. However, he also owns 580 million shares of Microsoft. Microsoft pays an annual dividend of 64 cents a share, so he has about $370 million a year in dividend income. In the past year he has sold about 80 million of his shares, at the current price that would mean a hair over $2 billion in capital gains.  In the US, capital gains are taxed at a maximum tax rate of 15%. Dividends are taxed at the same rate.

So let’s look at Gates’ income summary (in millions):
Income taxed as income:                                             1
Income taxed at a maximum rate of 15%:             2,371

Well at least he’s paying at a higher rate on that $1 million right? Probably not. While I’m not privy to his 1040, almost certainly he has deductions that completely cancel it out. His primary residence is reportedly valued at over $50 million. There’s a good chance that just the property taxes on that eliminate any income tax liability. If they don’t, surely he can spend $2 billion in a way to generate a million of deductions.

Finally, your reader overlooked a tax that is important to low-income earners – payroll tax. Payroll tax is 7.65% of income. The hypothetical $10,000 earner doesn’t pay just $1,082 in income tax, but also $765 in payroll tax.  That’s a big bite. Now, the Bill Gateses of the world do have to pay payroll tax, and it's on every dollar of income, so there are no deductions – but it’s capped at $106,800 of income, or $8,170.  That’s the most Bill Gates would pay on his $2 billion-plus income.

The hypothetical worker with $10,000 in income pays $1,847 in total federal tax, or 18.47%.  It’s inconceivable that Bill Gates pays a rate over 15% and it’s likely substantially less.

Another:

Your reader leaves out a really important point (as I'm sure he/she knows, but didn't want to confuse folks).  The reader writes: "An individual's marginal income tax bracket depends upon his or her income and tax-filing classification."

Not true.  It should be edited to say "depends upon his or her TAXABLE income."  For instance, I dug out my two most recent tax returns. I'm married, 2 kids, have a mortgage, but make no special effort to avoid taxes at all.

2008 Income: $90K, Taxable Income: $56K, Tax: $5K Total tax rate is <6%
2009 Income: $114K, Taxable Income: $81K, Tax: $12K Total tax rate is 10%
In 2010 I will take the tax-loss from the business I started in 2009 and probably pay almost no tax at all.

Not even counted in the income above is money I made from investments in a SEP-IRA (which will be taxable income when I withdraw it) and ROTH-IRAs (which will never count as income).  So if you look at nominal income and the tax brackets you would think I pay 25% when in fact I pay about 4%-8%.  That's a big difference.

Of course there is also property tax, state and local tax, sales tax.  But taken all together and given all the services and opportunity I receive  from living in the USA,  I'm seriously under taxed.  If letting my effective federal tax rate rise from 4%-8% to 15% would help balance the budget, I'm all for it.

Our complicated tax system seems designed to make taxes seem high, while actually being very low.