Marginal Tax Rates 101

With all the current hysterical coverage of the impending "Fiscal Cliff" - or "Obama Tax Storm," depending on who you're listening to - and seeing what certain of my friends and associates are saying or posting online about it, it is unbearably clear that most Americans haven't the faintest idea of how marginal tax rates work.

It's not their fault. Politicians and the media have been talking down to us and "simplifying" the discussion for so long, that they'd have you believe things that simply are not true. For example, you may accept as "fact" that President Obama and Congressional Democrats want to raise the tax rate on those who earn more than $250,000 from 35% to 39.6%.

Using that statement and some basic arithmetic, you would assume that a family with $251,000 in income would see their taxes rise from $87,850 (35% of $251,000) to $99,396 (39.6% of $251,000) - a total tax increase of $11,546. You would also be wrong.

The statement "President Obama and Congressional Democrats want to raise the tax rate on those who earn more than $250,000 from 35% to 39.6%" contains three major "simplifications" that lead to these sloppy (and expensive) calcluations:

1. Uses "earnings" (implying total gross salary) instead of "taxable income" (after all deductions, adjustments, and exemptions).
2. Implies that you pay a single rate on all your earnings, instead of explaining how marginal rates apply.
3. Uses a $250,000 figure that is two decades out of date. That figure for the 2012 tax year is actually $388,350.

Let's take these one at a time...

Earnings versus Taxable Income: Nobody, but Nobody, pays income tax on 100% of their income. Each version of the IRS form 1040, from the one-page EZ to the more complicated versions with dozens of attached schedules and sub-forms allows you to reduce the amount of income on which you owe taxes. Frankly, the more complicated a form you use, the more you are reducing your tax liability.

But even a single guy, just starting out, with no dependents, educational expenses, mortgage, or anything else to deduct, just using little old form 1040EZ, will take a standard deduction of $5,950 for 2012. That means, if he earns $30,000, he'll only pay taxes on $24,050. That tax will come out to $3,173, or about 10.5% of his gross income, or 13.2% of his taxable income, even though he's in the 15% tax bracket.

What's that? You don't get how somebody in the 15% tax bracket only pays 10.5% in taxes? Let's move on to that second "simplification" ...

Marginal Rates apply to earnings above the margin: When politicians talk about raising the rate on "incomes above $250,000" (really: taxable income above $388,350), they only mean the increment, or margin, above that figure. It doesn't change the taxes paid on the first "$250,000" you earn ($388,350 taxable).

To explain, we'll build a more complicated example than our single guy above. Let's assume a couple with a nice home, two kids, and combined total salary income of $450,000. They're going to file jointly, so they'll look at Tax Rate Schedule Y-1. Their taxes will be:

• 10% on taxable income from $0 to $17,400, +
• 15% on income over $17,400 to $70,700, +
• 25% on income over $70,700 to $142,700, +
• 28% on income over $142,700 to $217,450, +
• 33% on income over $217,450 to $388,350, +
• 35% on taxable income over $388,350.

But, before they figure out their taxes, they'll itemize their deductions to reduce their gross actual income and find their net taxable income:

• Mortgage Interest: $16,500
• Two Kids ($3,800 each): $7,600
• Charitable Giving (1.5% of their income): $6,750
• Business Expenses: $7,500
• Miscellaneous: $3,500
• Total Deductions: $41,850

(This is a real simple example with modest deductions - I didn't include any medical expenses, educational expenses, deposits to retirement accounts, etc. - These are just a few of the ways to reduce your tax liability.)

So, using Schedule Y-1 above, here's what their federal income taxes will break down to:
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	Earnings	Tax
Deductions	$41,850	$0
10%	$17,400	$1,740
15%	$53,300	$7,995
25%	$72,000	$18,000
28%	$74,750	$20,930
33%	$170,900	$56,397
35%	$19,800	$6,930
Totals:	$450,000	$111,992

Their bottom line is $111,992, or 24.9% of their total income of $450,000 ... even though they're in the top 35% bracket.

Using the media/political simplification of all things numerical, we would have thought they were paying $157,500 in taxes (35% of $450,000). We would also assume that the Democrats' proposal to let the top rate return to 39.6% would increase their taxes by $20,700 to $178,200 (39.6% of $450,000).

But, now that you know how real math works, you know that raising the top marginal rate on this well-to-do family will bring their total federal income tax burden to $112,903. An increase of only $911 (0.2% of their total income) - quite a bit less than the $20,700 certain politicians and journalists would suggest. Because, now you understand, the rate change from 35 to 39.6% only applies above the margin, to that last $19,800 of their taxable income.

So, where's  $250,000 in all this? When President Clinton's tax increases created the 39.6% rate twenty years ago, it was for taxable income over that figure. And, because politicians and journalists are lazy, they've just continued referring to that number ever since (if you don't like "lazy" please come up with a better explanation that doesn't include "lie"). But the cut-off point for each of the tax brackets actually adjusts each year for inflation.

By 2003, when the Bush tax cuts were going into effect, "$250,000" was $311,950, but we kept saying "$250,000" out of habit. During the 2010 "Fiscal Cliff" discussions, "$250,000" was $373,650. Today, it's $388,350. Is that really so hard for reporters and politicians to understand? Never mind...

But aren't we Taxed Enough Already? The Tea Partiers are both wrong and right on this. Regarding federal income tax rates they are completely wrong. Current federal income tax rates are at their lowest point in over 60 years. And, yes, because the base line for each marginal rate has gone up at least as fast as inflation (why $250,000 is now $388,350), that means this year's tax burden is less than last year's.

But, in part because federal income taxes have been held at historically low levels for a decade, other taxes and fees have gone up. States, not getting as much as they used to from the feds, may have increased their income, property, or sales taxes, as well as made cuts. Counties and cities, not getting what they used to from the states, may have raised local sales taxes or passed "special assessments" added on to property tax bills, and/or made cuts in services. Across the board, fees for everything from parking to getting married etc., may have increased to make up for shortfalls from another area.

Because sales taxes, use fees, etc., are not progressive, like the federal income tax (multi-tiered, the rich pay a higher rate), the burden of these taxes falls more on lower and middle income earners. So, depending on where you live, what you earn, and a few other factors, you may indeed feel as if you're paying more in taxes over-all, even with a smaller annual bill from the IRS.

Bottom Line: You probably know where I stand on this. I don't believe it's asking too much of a family that earns nearly half-a-million dollars annually to kick in another grand in taxes when the country faces a fiscal crisis. To insist on holding even this top rate down will only result in more cuts in services and/or increased taxes and fees elsewhere down the line.

But regardless of whether or not you agree with me on the politics, can we all at least agree to use real numbers and real math?

For more fun with tax brackets, this page on moneychimp.com has an easy, interactive tax calculator that allows you to see how all of this works and check your tax rates across time and space.

California 30-38

No, "California 30-38" is not a sports score, and, no, it's not a highway designation. 30 and 38 are competing propositions in the November 6 election, and Californians are in such agreement about the problem they each seek to address, that we're going to send them each down to defeat. But let me explain what they are first, and then tell you why we're probably screwed.

Here's the basic problem: Our state is broke. Our June 2012 budget gap was about $16.6 billion. The budget deal worked out between Governor Brown and the legislature balanced the budget with about $8.1 billion in spending cuts, $2.5 billion in "transfers," and the last $6 billion in new taxes "pending voter approval."

Prop 30 was placed on the ballot by the Governor as part of that budget deal. The $6 billion hole is filled by increasing the tax on incomes over $250,000 (or $500,000 for couples filing jointly) for a period of seven years, and a 1/4 cent per $1 increase in sales tax for four years. The funds go into an "Education Protection Account" within the state General Fund. Because it's within the General Fund, it increases the Prop 98 guarantees to education (K-12, plus Community Colleges), but also frees up some existing funds for other purposes.

The Prop 30 taxes go into effect immediately to cover the $6 billion gap in the current year's budget. If it fails, the budget deal included "trigger cuts." We will have a balanced budget this year, no matter what. Those $6 billion in automatic cuts include $5.3 billion from public schools for the current school year. Ever wondered what would happen if thousands of teachers got laid off in the middle of the school year? Or if your local school district defaulted on its bond payments? You might just find out if Prop 30 fails to pass.

Prop 38 is an alternative tax plan, not negotiated by the legislature, but put on the ballot by Molly Munger, who has spent about $33 million of her own money to pass it.  (Coincidentally, Molly's brother, Charles Munger Jr., has spent about $22 million of his own to lead the fight against Prop 30). Prop 38 raises income taxes on just about everybody (incomes over $7,000) for twelve years, but leaves sales tax alone. The money goes into an "Education Trust Fund," but this one is outside of the General Fund, so it is in addition to the Prop 98 guaranteed funding from the (diminished) General Fund. Prop 38 does not include Community College funding, but does include early childhood education.

Prop 38 could be an interesting alternative to the Governor's plan, except for one fatal flaw: It takes effect next year, leaving the "trigger cuts" in place for this year. Prop 38 might help in the future, but the chaos the trigger cuts would cause in education this year would do incredible harm to 100% of public school students in the state this generation. But I will vote for it anyway.

Yes, I will vote for 38, AND I will vote for 30. The proponents of each have campaigned as though we have to make a choice, and can only vote for one or the other. That is not true. And this is why I say we are doomed.

California law provides for a way to reconcile two propositions passing which each address the same issue: The one with the most votes prevails. Yes, if you vote for 30 & 38, and they both pass, you don't get two tax increases, you only get the one with the most support.

Prop 30 was headed for victory, until the Mungers, Molly and Charles, put over $55 million of their fortunes into ads against 30 and for 38. Now support for 30 has dipped to 46% approval. Meanwhile, Prop 38 only has 39% of voter approval in current polling. Now, it's been a while since I was in school, but in the old days 46+39 equaled 85% in favor of one or the other. Even if we assume there's some overlap in support, there's clearly a majority in favor of some tax increase.

Despite the fact that the majority of Californians agree that we need to enact one or the other tax increase to save our schools, and our state's competitive edge, both propositions will fail because we're being presented with the election as a "choose one only" option. The majority are for saving the state, but those who would rather destroy California than pay one cent more in taxes win by dividing and conquering the majority. Which, the conspiracy-minded might wonder, may have been what the Mungers had in mind all along.

If you're a Californian voter, I hope that you'll join me in voting for both propositions, 30 & 38, and may the better solution prevail.

Here's my quickie ballot guide to the rest of the California initiatives:

30 - taxes/budget	Yes
31 - budget reform	No
32 - special exemptions	No
33 - auto Insurance	undecided
34 - end death penalty	Yes
35 - human trafficking	Yes
36 - 3 strikes reform	Yes
37 - GMO labeling	Yes
38 - tax rates	Yes
39 - business tax	Yes
40 - redistricting	Yes

Republican Tax Policy Explained and Debunked

Sometime last years I promised that I would write about blog about the Laffer Curve, and how it has determined Republican tax policy for the past 30 years, from Reagan to Romney. Well, it's a little late, and it's in a video rather than a written blog, but here it is.

Sit back and learn about Dr. Arthur Laffer and the little doodle he made on the back of a napkin that ended up changing U.S. economic policy for a generation, and why a vote for Mitt Romney is yet another vote for the Laffer Curve.

Income Tax Blog

It seems apt that the final weekend before 2011 tax returns are due should start with Friday the 13th. I completed our returns and filed electronically last month, although I didn't mail the required checks until this past Monday (no refund here).

Back in January, I wrote about Mitt Romney's 15% effective tax rate. Around the same time, in the Statue of the Union Address, President Obama also talked about how wrong it is that millionaires should pay a lower tax rate than their secretaries, or teachers, policemen, or other middle-income earners. To illustrate the point, Warren Buffett's secretary was sitting with the First Lady in the audience.

"The Buffett Rule" was introduced to correct this, with the simple premise that those with over $1 million in annual income shouldn't pay a lower tax rate than middle-class families. To promote passage of the Buffett Rule, the White House has posted a "Buffett Rule Calculator" - just plug in your income and your taxes, and see how many millionaires pay less than you do!

So, how did I do (actually, for my wife and I, filing jointly)? After deductions, we had an effective tax rate of 17% - higher than 37,600 millionaires. Some of our income is taxed at the 25% bracket, but our over-all effective rate is 17% thanks to some generous deductions, primarily the home mortgage interest deduction.

That deduction alone reduced our income by nearly 14% and had a dollar value greater than a full time job at the federal minimum wage. Think about that for a moment. We are not rich by any stretch, and are frankly going through some lean times. Even so, we write off from our income more than many people earn.

With the rich dodging taxes above, and the working poor struggling with a sub-standard minimum wage below, the gap is getting wider. The Buffett Rule is a small, symbolic step, and I support it, but it's just the tip of the iceberg in getting our economy working for everybody again.

(Tell your Senators to vote for the Buffett Rule by clicking here...)

Why 15% Should Matter to the 99%

This week Mitt Romney let slip the real reason why he's reluctant to divulge his tax returns. It's not how much money he earns that he's hiding - we're all aware that it's a considerable sum - it's the tax rate he pays on that income that is controversial.

Because Mitt's income is mostly from investment earnings, he pays the capital gains rate of 15% on his millions rather than the current top marginal rate for wages of 35%, or even the average middle-class top marginal rate of 25%. This has left his supporters to explain why this very wealthy man should pay a lower tax rate than most middle-class Americans.

Capital gains, we are told, are very special because of the risks involved. Not every investment pays off, after all. Very true. But, of course, that's why losing investments can be written off as business expenses and deducted from one's over-all income, reducing one's taxes. So, why, when an investment is successful should it be taxed differently than regular employment income?

Well, 15% of $1,000,000 is still more than 25% of $75,000! Kinda like how, if you buy in bulk at Costco, you get a lower price on food. That's fair, right? Well, in as far as that analogy does hold water, the tax code already has provisions for the "bulk buyer" (IE: additional children = additional deductions). In my case, my home (modest by CA standards, but expensive by national standards) gives me quite a mortgage interest deduction. Add that to my business and other expenses and I probably deduct as much from my income than a minimum wage worker earns in a year.

But on the taxable portion (after deductions), I gladly pay a rate that's somewhat higher than the minimum wage worker because of my relative success. And somebody who earns 10-20 times what I do should pay a little higher yet. Certainly no less a percentage. So, why so much lower?

Well, they say, the rich need an incentive to invest. Why bother if your earnings after taxes will barely keep up with inflation? When I hear this argument I always have to reply that I don't think the rich are as lazy as you think they are. I have faith in their entrepreneurial drive that they'd still invest, create, and build, even if capital gains were taxed as regular income. As long as the tax rate is below 100% any gains are still better than a mattress full of cash (and, no, I'm not suggesting a 100% tax).

If you buy that "incentive to beat inflation" argument, then people should be turning down C-level jobs that hit the 35% marginal rate, and even middle-management positions in the 25% range, and all the MBAs would be looking to work in mail rooms. It turns out, however, people prefer to have 65% of $500,000 over having 75% of $75,000. So, why does investment income require a tax rate so much lower than income from labor?

Gosh! You're just envious! After all, everybody has the opportunity to invest and get the tax benefits of capital gains! Well, perhaps we do have that opportunity, but not to the same extent. According to the Washington Post, "The 400 richest taxpayers in 2008 counted 60 percent of their income in the form of capital gains and 8 percent from salary and wages. The rest of the country reported 5 percent in capital gains and 72 percent in salary." When you defend 400 out of 312,877,450 with "everybody can do it," it's more than a bit of a stretch.

Here's the thing about all this in relation to Willard Mittens Romney: the millions he makes each year from capital gains are not even from investing his own money. There is no risk involved. Mitt's millions are part of his retirement agreement with Bain Capital. Every year he gets a nice slice of Bain's profits, even though he hasn't worked there in 13 years.

Of course, while most of his income comes from Bain and other capital gains, Mitt does work part-time as a public speaker. He describes his income from speaking fees as "not very much." It's actually $374,000/year. As a point of reference, $380,000 is the cut-off point for being in the top 1% of earners.

Capital gains have not always been taxed as low as 15%. This rate is the result of tax cuts (from both GW Bush and Clinton) that were supposed to inspire and encourage the wealthy to invest more, thus creating new jobs. As you can see, that plan didn't quite work out.

Many Republicans are now pushing for a new rate on capital gains: 0%. Romney, in his defense, is not one of them (although he does have other tax cuts in his plan). But if Newt Gingrich is elected, Mitt's tax bill will fall to nearly nothing.

So, please, remind me again, why are capital gains taxed so much lower than income from actually working for a living?

50 Days In

No, not 50 days since I've posted a blog here (actually, it's been a little longer than that), but 50 days (plus a couple) since Barack Obama was sworn in as President, and I know you're all just dying to find out what I'm thinking. Is the honeymoon over? Do I regret my vote? Am I loving everything he does?

No. No. And No.

The honeymoon is not over, I think he's doing a great job in a very difficult situation. I'm still pleased with my choice, and have no regrets over not sticking with an independent or third party candidate. But, no, I'm not thrilled with everything.

But I'm fine with not being thrilled with everything (and, really, who can be seriously paying attention and agree with any politician all the time?). The point is that even where I've disagreed or had a different opinion on something he's proposed, I can at least understand where he's coming from. It may be a different approach, or a different degree of attack than I would have preferred, but I can agree that it's for reasons that I can at least respect.

I'm still finding this a refreshing change from the previous administration, where it was not simply an honest disagreement with a particular detail of a policy, but where I was constantly being outraged with what I perceived to the wholesale destruction of all of what I believe to be great about this country. But back to Obama...

Example one of my disagreement: Obama's tax plan will cap the tax deduction for charitable contributions at 28 percent (current cap 35%). The positive side: this is to help pay for some rather expensive, but needed, health care proposals. The negative: this could put a damper on on major donor giving at a time when the nonprofit sector is being hit on all sides with reductions in revenue coupled with increased demand for services.

As a guy who lives in the nonprofit sector, this concerns me. But I'm not as panicked about it as some people are. The truth is, we won't really know how much of a hit this will bring to the nonprofit sector until long after it's happened, and it's being done for all the right reasons. Taking a hit to fund health care reform feels a whole lot better to me than taking a hit to give billionaires another tax cut.

Another area of disagreement is in Education. My wife is a teacher, and she and her co-workers are upset about the President's recent speech on the topic of failing schools and education reform. Obama crossed in front of a few sacred cows and promised more of the No Child Left Behind (NCLB) policies that failed so miserably before.

Again, my wife and I (and many others) believe that NCLB was a failed policy from the concept (other than a nifty title), and that the problem was not simply "not doing enough of it." But, as I reminded my wife at dinner tonight, we knew this was coming. Obama, the candidate, was clear about his support for NCLB. This was a trade-off we made back in November so we have no right to start acting surprised or hurt by it today.

So, am I still drinking the KoolAid and thinking that President Obama can do no wrong? Absolutely not. But I'm still willing to give the man a chance. Overall, I'll give the First Fifty a strong 85% approval rating. Will it remain that high for the next four years? I doubt it, but I'm enjoying this moment while I can.