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Understanding Tax Rates

Last Updated:2012-May-09
Principal Writer:Barry Shatzman

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Understanding The Issue
Analysis and Perspectives
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Related Bills

American Taxpayer Relief Act

2012 (HR-8)

Tax Relief, Unemployment Insurance

2010 (HR-4853)

Jobs and Growth Tax Relief

2003 (HR-2)

Economic Growth and Tax Relief

2001 (HR-1836)

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The Basics of Taxes as Public Policy

Understanding taxes from a public policy perspective can be reduced to just a few simple questions:

What services should our government be providing, and where should that money come from?

You can find answers to the first question simply by looking around. A national defense, police and fire protection, schools, prisons, roads, libraries, parks, consumer protections, and safety nets for those who are trying to get ahead but find themselves in impossible situations are just some of the things you may want your government to spend money on - because it would be too costly or inefficient to take care of these things on your own. This is what makes us a society.

All of these cost money. And a government has only one source of money - taxes. It might be a tax on income. Or it might be a sales tax on something you buy, a fee for driving on a road, or even a fee a corporation pays to reimburse the government for regulating its industry. Regardless of what you call it - at the end of the day it's simply money given to the government. In other words - a tax. And every dollar of it is meant to be used in the public's best interests. That's why it's also called "public money."

And by the way... if your representatives decide the government needs to spend more than it is taking in from taxes, it must borrow the difference. The government has to pay back the lender. That money (as well as the interest) also must come from taxes.

Perhaps the most important thing you elect representatives to do is determine what programs are needed and how much each of us needs to pay in order to fund them. In the discussion of tax policy, we'll focus on the second question - where should the money come from. We'll address the first question - what should our government be providing - in other sections as time goes on.

What are tax rates? Marginal vs. Effective Rates

Simply put, income tax rates are the amount each person (or corporation) pays on their income. Rather than being just one percentage, they're a combination of several percentages based on someone's level of income. Though our tax system has become impossibly complicated due to exceptions upon exceptions, the basic system is easy to understand.

The terms you'll hear most often in any discussion of income tax rates are marginal tax rate and effective (or average) income tax rate. The difference is important. Here is how it works..

You are not taxed the same on every dollar you earn. For example, everything you earn in a year up to a certain amount will be taxed at one percentage. Everything you earn above that amount - up till another certain amount, will be taxed at a higher percentage. And so on. The rate structure is the same for everybody

The highest tax rate someone pays (i.e. the percentage on the chunk of their income above a certain level) is known as their marginal tax rate. The overall percentage of their income that someone pays in taxes is their effective rate.

This short video will make things clearer...

Again, keep in mind that nobody pays the marginal tax rate on all of their income. So when someone mentions a top (i.e. marginal) tax rate, they're talking about the rate paid only on the top portion of income.

Progressive vs. Regressive Taxes

Marginal tax rates make it so someone who earns more money will pay a higher percentage of their income in taxes. This might seem obvious - after all they earned more. But it isn't always the case. A tax in which someone with a higher income pays a greater percentage (such as income tax) is called a progressive tax.

Some people have argued for a flat income tax, where everybody pays the same percentage of their income regardless of how much they earn. Flat tax proposals typically exempt income up to a certain amount (as do marginal tax structures). Therefore, a flat tax system essentially is a marginal tax system - just with fewer divisions.

There also are taxes in which someone with less money pays a larger percentage of their money than someone who has more. Though it sounds counterintuitive, there are many such regressive taxes. A sales tax is an example of a regressive tax. Take two mothers buying diapers and baby food. If the sales tax comes to $5, the mom with $50 in the bank has just paid ten percent of her savings in taxes. The mom who has $50,000 in savings has paid only one hundredth of a percent of her savings.

What should be considered in a budget? Tax rates or beneficial programs?

There's no absolute way to determine the optimal tax policy - either for taxpayers or the economy as a whole. On the expense side, budgets are inaccurate. Agencies simply try to predict exactly what services they will need to provide and how much they'll cost. On the revenue side, people might earn less, and therefore provide the government with less tax revenue.

But elected representatives still are responsible for establishing a policy that works in the best interests of the overwhelming majority of Americans, while hurting nobody. And that means determining what will be needed for the coming year (including debt repayments). The estimated cost helps determine the percentages at which incomes will be taxed. If those percentages are too low, there won't be enough to pay for everything. Either programs will need to be cut, or the rest will need to be borrowed - increasing the national debt (which will need to be paid off by future taxes).

When you listen to elected officials discuss tax rates, you rarely hear the issue presented as the relationship between the two questions we used to define this issue - what programs are needed and where will the money come from. Instead, you hear about how tax rates might affect broad economic issues such as employment.

A budget that makes the best use of tax dollars is one that is driven by programs that will benefit most Americans and our national health as a whole. That doesn't mean that broad ecomonic factors shouldn't be a consideration in setting tax rates - if they can be shown to have an affect on people's lives.

How do tax rates affect jobs?

There are two competing political arguments regarding the relationship between tax rates and employment...

o Tax companies less, and they'll have extra money to hire people.

o Tax companies less, and instead of using the extra money to hire people, they'll pocket the extra money they get to keep. But increase their marginal tax rate, and they'll choose to invest extra earnings back into the company (including hiring people) rather than paying the money in taxes.

They both make sense. But since they're opposites, they can't both be true. Since we need a public policy that works in the interest of the overwhelming majority of Americans, the people we elect to represent us should not rely on which one they think sounds better. They owe it to their constituents (you and me) to create a policy based on evidence. So let's look at the evidence.

The blue line above shows the average unemployment rate for each year from 1948. The green line shows the marginal tax rate in effect for each of those years. There is no easily determinable relationship between the two. If anything, the trend lines (white line through each set of data) show that unemployment rates have risen since 1948, while marginal tax rates have dropped. In other words, there is no historical evidence that lowering marginal tax rates reduces unemployment.

Does this mean that raising the marginal tax rates (tax on income over a certain amount) to 70 percent, as it was as late as 1980, will reduce unemployment? Not necessarily. It just means that if tax rates are based on national needs and how to fairly distribute the burden, there is no evidence that such a policy would reduce jobs.

To summarize... any fear that imposing higher tax rates on those who can most effortlessly afford them will increase unemployment is not justified by evidence.

Who has the money?

The main reason economic conditions have been bad for a large number of Americans is that they simply don't have enough money. Although it sounds obvious, it raises the question about where all the wealth in the United States is. This chart answers that question...

Of the more than 300 million people people in the United States, about 3 million people (the top 1 percent) own more than a third of all the wealth in the country. That's fewer people than the population of Los Angeles. Take a look at both green slices combined, and you'll see that just 5 percent of the U.S. population owns more than 60 percent of all the wealth.

On the flip side of the coin is the sliver of red at the bottom- showing that one-fifth of a percent of the country's private wealth is all that is owned by 40 percent of the U.S. population. And if you combine the non-green slices, you'll see that 95 percent of the population collectively owns less than 40 percent of the wealth.

Where is the wealth going?

Public policies (including tax policies) affect the way wealth is distributed among the population. If taxes are high enough on those who most easily can afford it, less will be needed from those who must decide between rent, food, medicine, child care, and possibly saving some money for a rainy day. Not to mention a few things that make life enjoyable.

Yet, some argue that increasing taxes on the wealthy only will make things worse, as they'll have less money to hire people.

Once again, we need to use facts and evidence to ensure policies have the best chance of improving the lives of the overwhelming majority of Americans. The following graphic points out how wealth has been redistributed over the past few decades...

It shows that between 1979 and 2005 income grew at a radically greater rate for the richest 1 percent of Americans - such that they ended up with approximately $700 billion that would have gone to the bottom 80 percent had all incomes increased at the same rate as the economy.

How do tax rates affect where the majority of money goes?

There likely is no single cause for the enormous wealth and income disparities that we've seen in recent history. It is worth noting, however, that it was in the early 1980s that marginal tax rates were reduced from 50 percent to less than 30 percent. Today they are fixed at 35 percent.

A September 2012 report by the Congressional Research Service examined the effect of tax rates on various econimic factors. It found a direct relationship between tax rates and the distribution of income, concluding that "as the top tax rates are reduced, the share of income accruing to the top of the income distribution increases - that is, income disparities increase."

Where your income comes from affects your taxes

There are two basic ways to earn money...

o You can perform a service or provide a product to someone

o You can invest money you already have - for example by buying stocks

For money you earn by the first method (i.e. by working), the highest marginal tax rate you'll pay currently is 35 percent.

Money earned by the second method - referred to as capital gains, is taxed at a top rate of just 15 percent.

Why is this the case? The main argument cited for a lower capital gains tax rate is that the low rate encourages investment. Yet there is no evidence to support that argument, as shown in this article in Mother Jones magazine.

The overwhelming majority of Americans earn their money through labor. It typically is only those with extra money to invest in stocks who do so - and if the return is great enough they would do so anyway. That is the evidence presented in the article. So the tax savings simply go to those who need it the least.

The report from the Congressional Research Service was direct in its conclusion regarding how the capital gains tax rates affect most Americans.

"Changes in capital gains and dividends were the largest contributor to the increase in income inequality since the mid-1990s," it stated.

How did we get here? The Bush Tax Cuts

The chart below shows how the highest marginal tax rate changed during the Bill Clinton and George W. Bush administrations....

The "Bush Tax Cuts" were a series of tax changes during the course of the Bush presidency. The laws changed things like deductions (including allowing married couples to deduct the same amount as two single people - thereby eliminating the "marriage penalty"). Changes to tax rates included...

o In 2001, Congress passed a tax cut that would gradually lower the highest marginal tax rate to 35 percent by 2006.

o The 15 percent tax bracket (the lowest bracket) was split - with the tax rate at the bottom of that bracket reduced to 10 percent.

o Estate taxes were reduced in two ways. First, the exemption for estate taxes was set to gradually rise to $3.5 million by 2009. Second, the highest marginal rate on estates and gifts was set to be gradually reduced to 45 percent (from 60 percent) by 2009. The estate tax was completely eliminated in 2010, just for that year.

o In 2003, the gradual provision from the 2001 cuts was accelerated. As you can see in the chart above, the highest marginal rate was immediately reduced to 35 percent.

o The 2003 act also reduced the highest capital gains tax rate to 15 percent (from 20 percent).

The tax cuts were set to expire in 2010.

How did the Bush Tax Cuts affect Americans?

As we previously pointed out, wealth in the United States has dramatically migrated from 80 percent of the population to the richest 1 percent. A 2008 report by the Tax Policy Center shows what would happen if the Bush Tax Cuts are made permanent. A few of the report's findings include...

o Among the poorest fifth of the population, 16 percent would receive some tax reduction. Virtually everybody in the richest fifth would benefit.

o The poorest fifth of Americans would see an increase of 0.3 percent in after-tax income. After-tax income for the top 1 percent would increase by 6.4 percent.

o The total share of the tax burden on the top 1 percent would fall from 73.1 percent to 71.9 percent. That of course means the tax burden of the remaining taxpayers would increase.

This would increase the disparity of wealth between the richest 1 percent and the rest of the population even further.

How the Bush Tax Cuts hurt most Americans

Even more serious harm would result, however, because the above analysis does not account for how the tax reductions would be paid for. There are only a few ways the lower revenue could be reconciled...

o Reduce spending

o Borrow the difference

Reducing the amount spent by our government - and making sure whatever money we spend is spent wisely - definitely is a goal we expect our elected representatives to work toward. Lowering tax rates, however, is not the optimal way to achieve the goal. The common logic has been that if tax rates are lowered, reduced spending will follow. But this "starve the beast" tactic has not worked. Between 2000 and 2006, government spending increased from 18.4 percent to 20.3 percent of the economy.

In addition, there is no reason why lowering taxes necessarily would result in reduced spending. Your elected representatives still would be able to budget more than expected revenue as long as money is available to be borrowed (thus adding to our national debt). On the other hand, they certainly are free to budget less than expected revenue. That, in fact, is the only way the debt can be paid down.

But what if spending really is cut? Much government spending is for programs that benefit low and middle income Americans. We've already shown how the tax cuts have resulted in hundreds of billions of dollars of wealth being redistributed toward the richest 1 percent of Americans. Cutting programs designed to primarily help the remaining 99 percent adds to their costs even further.

The Tax Policy Center report goes on to state "In all hypothetical scenarios, two common conclusions emerge: a majority of households are made worse off by the tax cuts, and the net effect of the tax cuts is a transfer of wealth from lower-income households to wealthier households."

The tax cuts were extended in 2010. What happened?

The Bush Tax Cuts were written to expire (sunset) after 2010, with tax rates returning to pre-2001 levels. After a contentious battle between Republicans and Democrats (as well as President Obama), Congress voted to effectively extend the tax cuts through 2012. Key provisions of the law included...

o Individual and capital gains tax rates were extended at 2010 levels through 2012

o The employee portion of Social Security Old Age, Survivors, and Disability Insurance (OASDI) was reduced to 4.2 percent (from 6.2 percent) for wages up to $106,800. The employer contribution of the tax remained at 6.2 percent. This "payroll tax holiday" expires at the end of 2012.

o The estate tax reduction was extended so that, in 2012, estates valued at less than $5 million are not taxed. Any excess value is taxed at 35 percent. In 2013, that exemption is scheduled to return to pre-2001 levels, with the exemption reduced to $1 million, and any value over $1 million taxed at 55 percent.

What is the so-called Fiscal Cliff?

The 2010 extension of the Bush Tax Cuts was for two years. If Congress does not pass a new tax policy by the end of 2012, the tax cuts would expire and rates would return to pre-2001 levels (just like they would have if the 2010 extension wasn't passed).

In addition, the 2010 "payroll holiday", which gave employees a 2 percent reduction in their employment tax, would expire.

These, as well as a few other provisions set to expire at the end of the year, is what has become labeled the "Fiscal Cliff".

The name, however, is misleading. It's true that tax rates will increase for everyone if nothing is done. However, Congress certainly is free to enact new legislation as early is its first day in session in January.

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