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 Uses a $250,000 figure that is two decades out of date.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.

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?

Inequality grows - The middle shrinks

The election season is over, and we're well into the holiday gift buying frenzy. But here's a little food for thought while you're out there going further into debt to purchase landfill fodder for your loved ones.

Courtesy of Mother Jones magazine and the MoJo blog, a few statistics:

• In 2005, there were 9 million American millionaires, a 62% increase since 2002.
  
  
• Since 2000, the number of Americans living below the poverty line at any one time has steadily risen. Now 13% of all Americans—37 million—are officially poor.
  
  
• Only 3% of students at the top 146 colleges come from families in the bottom income quartile; only 10% come from the bottom half.
  
  
• Since 1983, college tuition has risen 115%. The maximum Pell Grant for low- and moderate-income college students has risen only 19%.
  
  
• Bush's tax cuts give a 2-child family earning $1 million an extra $86,722—or Harvard tuition, room, board, and an iMac G5 for both kids.
  
  
• Bush’s tax cuts (extended until 2010) save those earning between $20,000 and $30,000 an average of $10 a year, while those earning $1 million are saved $42,700.
  
  
• 63% of federal housing subsidies go to households earning more than $77,000. 18% go to households earning less than $16,500.
  
  
• Inner-city grocery stores sell milk for 43% more than suburban supermarkets.
  
  
• If the $5.15 HOURLY minimum wage had risen at the same rate as CEO compensation since 1990, it would now stand at $23.03.
  
  
• 10 former Enron directors agreed to pay shareholders a $13 million settlement—which is 10% of what they made by dumping stock while lying about the company’s health.
  
  
• Poor Americans spend 1/4 of their income on residential energy costs.

Happy Holidays!

Sources: Income Inequality in the U.S.? Nah., Poor Losers, and A Look at the Numbers: How the Rich Get Richer.