By now most Americans probably know more about Mitt Romney’s tax rate than their own, and that is unfortunate.
Upper middle-income couples in the 25 or 28 percent tax bracket may believe they pay a substantially higher rate on their mostly “earned” income than Mitt and Ann Romney pay on their mostly “unearned” income.
I doubt that.
Before anyone gets worked into too much of a lather about Mitt’s 1040, I suggest taking a hard look at your own.
The headlines are telling you that Mitt and Ann Romney’s effective tax rate was 13.9 percent for 2010 and will likely be 15.4 percent for 2011. What they are probably not telling you is that the effective tax rate on all returns filed in 2009 was about 11 percent. Betsy and I paid an effective tax rate of 14.8 percent in 2009 and 15.6 percent in 2010. I have not crunched the numbers yet for 2011 but I expect that our effective tax rate will be lower than the Romneys’ for the 2011 tax year.
Many of the news reports today are making the apples and oranges comparison of Mitt’s effective tax rate and the marginal tax rates that are found in the IRS tax brackets. This is grossly unfair to Romney because nobody – and I do mean nobody – pays the marginal rates.
To calculate your own effective tax rate divide the total federal income taxes paid/owed (line 60 on Form 1040) by your adjusted gross income (line 27). That is your effective tax rate and it will allow you to make an apples-to-apples comparison with the effective tax rate paid by the Romneys.
If you are really interested in being honest with yourself about your income tax rate divide the tax on line 60 by the total income you reported on line 22. I like to call this the “real” tax rate because it compares the raw, gross income that you have earned (and/or “unearned) with the tax that you pay.
The adjusted gross income (AGI) on line 27 is sometimes the same as the total income on line 22 but for many people AGI is lower because of tax breaks they get for contributing to IRAs, for moving expenses, for paying out of pocket for self-employment health insurance, etc.
If you are really, really interested in being honest with yourself about your income tax rate add to the number on line 22 the amount that your employer paid for your healthcare insurance. I don’t want to get bogged down on this right now but I think it is important to point out that tax-free healthcare benefits are a HUGE tax break for those that are lucky enough to have them. Here us a factoid to chew on; if healthcare benefits were subject to the income tax it would generate $41 billion in additional tax revenue by 2015 and resolve nearly 12 percent of the projected deficit in 2030.
OK, back to comparing your tax rate with Romney’s. There are several reasons why your effective tax rate is much, much lower than the marginal tax rates that so many people mistakenly think they pay.
These are the marginal tax rate brackets for a married-filing-jointly couple in 2010:
· 10% on the income between $0 and $16,750
· 15% on the income between $16,750 and $68,000
· 25% on the income between $68,000 and $137,300
· 28% on the income between $137,300 and $209,250
· 33% on the income between $209,250 and $373,650
· 35% on the income over $373,650
The “income” that is referred to in these tables is not your total income from line 22 nor is it your adjusted gross income from line 27. It’s your taxable income, which is on line 43. This distinction makes a HUGE difference, especially for lower income taxpayers and for any taxpayer that, like the Romneys, gives away huge sums of money to non-profit organizations (e.g. The Church of Jesus Christ of Latter-Day Saints), thus lowering their taxable income which, in turn, reduces their tax bill.
Another reason that effective tax rates are much lower than marginal rates is that EVERY married-filing-jointly- taxpayer pays 10 percent on their first $16,750 of taxable income, and then 15% on the next $51,250. And so on and so forth for all of the other categories of taxpayer and all of the other tax brackets.
Let’s be very clear about this; nobody pays a tax rate that is as high as the rate in their tax bracket. In most cases it is far, far less. Thus, if you really want to honestly understand how much tax you pay compared to someone else, forget about the tax brackets and the marginal tax rates and focus on the effective tax rate.
If you divide line 60 by line 43 (taxable income) the number will likely be several percentage points higher than either your effective tax rate or your “real” tax rate. Let’s call this your “faux” tax rate.
The spread between the real tax rate and the faux tax rate tends to be larger for those who top out in the 10, 15 and 25 percent brackets; and for the very rich.
While the nuanced reasons for this can be mind-bogglingly complex, the primary reasons are simple. For those topping out in the lower income brackets exemptions and the standard deduction have a huge impact on their tax bill (line 60) because they dramatically lower the percentage of taxable income (line 43) compared to total income (line 22).
That is the primary reason that so many people pay little or no Federal income tax; their meager incomes are dwarfed (percentage-wise) by the fixed-amount tax deductions and exemptions that all taxpayers receive.
To demonstrate how this works I used my TurboTax program to create a 2011 Federal tax return for John and Jane Doe. The mythical Does have two children, Jimmy and Jenny (precious little children I’m sure). Jane does not work outside the home and John works for the ABC Company where he earned $45,000 in 2011. The ABC Company did not withhold any Federal income taxes from John’s wages but he did pay $2,790 in Social Security taxes and $652.50 in Medicare taxes (that's another topic for another day).
Even though the Does had earned income of $45,000 and paid zero in Federal taxes TurboTax tells me that they are due a refund of $56.
How can this be?
With four mouths to feed John was not able to contribute to an IRA and he and Jane did not have moving expenses or expenses as an educator or any of the other types of expenses that could have made his adjusted gross income less than his total income. Thus, the AGI for the Does is $45,000, exactly the same as their total income.
Like the Romneys, the Does are devout Mormons and they tithed, donating 10 percent of their income, $4,500, to their church.
However, because the Does live in an apartment they don’t have deductible interest and they pay property taxes only indirectly, through rent payments. Thus the only deduction the Does could list on Schedule A was their $4,500 donation to the church. Because the standard deduction in 2011 for a married couple filing jointly is $11,600 the donation the Does made to their church was meaningless from a tax perspective. They would have received the same $11,600 standard deduction even if they had given nothing to the church and they could not have gotten a larger deduction, even if they tithed 20 percent.
If it is not already obvious, the point I’m making here is that the Romneys got a tax break for tithing and the Does did not.
Regardless of that inequity, the standard deduction is a huge benefit for the Does, knocking their taxable income down to $33,600.
Their taxable income is then further reduced, by $14,800, by exemptions of $3,700 for each member of the family.
That knocks the Does taxable income down to $18,600 and their income tax, calculated using the 2011 marginal tax brackets (which are slightly different than the 2010 brackets listed earlier), is $1,944.
It is very important to understand that, so far, the Does have not received any special breaks. They are taking the same standard deduction and getting the same exemptions that every married couple with two kids gets.
However, the Does are able to avoid paying any income tax at all because they are eligible for something called the Child Tax Credit.
Married-filing-jointly couples with an AGI of $110,000 or less (the Does AGI, remember, is $45,000) are eligible for a credit of $1,000 per child. Thus, thanks to Jimmy and Jenny, the Does will get a tax credit of $2,000. Thus, their $1,944 tax liability is turned into a credit of $56.
If John Doe had earned $50,000 last year instead of $45,000 he and Jane would have had a tax liability of $2,694 while receiving the same $2,000 Child Tax Credit, thus owing $694 in income tax.
In an article published last June in the New York Times Bruce Bartlett, who held senior policy roles in the Reagan and George H.W. Bush administrations and served on the staffs of Representatives Jack Kemp and Ron Paul, explained some of the reasons that the number of filers paying no income tax has increased from less than 20 percent in the mid-70s to nearly 47 percent today.
Bartlett says the Child Tax Credit, a seldom-discussed part of the Bush tax cuts, is a major reason for the increase. He says the Child Tax Credit caused the percentage of filers with no income tax liability to spike by more than 11 percentage points when it took effect in 2008.
On the other end of the spectrum, personal exemptions and the standard deduction (in the unlikely event that it is used) are all but meaningless for the very rich; and the rich are not even close to being eligible for the Child Tax Credit, which is capped at $110,000 of taxable income for couples filing jointly.
However, unlike most of the rest of us, the very rich have so much money that they are less compelled to try to spend it all. While it is often true that the rich use loopholes in the tax code to shelter their income and widen the gap between line 22 and line 43 it is also true that many of them – like the Romneys – give away a lot of their money to non-profit organizations.
In the Times article Bartlett wrote the following:
There are 78,000 tax filers with incomes of $211,000 to $533,000 who will pay no federal income taxes this year (2011). Even more amazingly, there are 24,000 households with incomes of $533,000 to $2.2 million with zero income tax liability, and 3,000 tax filers with incomes above $2.2 million with the same federal income tax liability as most of those with incomes barely above the poverty level.
It is not because of the earned-income tax credit or the child credit that the ultra-wealthy are paying no federal income taxes.
One reason, undoubtedly, is that capital gains are a huge percentage of their income and they may have losses from previous years to offset any realized gains this year. Perhaps some chose to invest all their wealth in tax-free municipal bonds.
And, of course, a large industry of tax lawyers make their living advising the wealthy on how to minimize their tax liability by exploiting existing provisions of the tax law.
These data look only at legal tax avoidance; they do not account for illegal tax evasion, which is quite extensive, especially at the top and the bottom of the income distribution. Those in the middle class who have only wage income are much more limited in their opportunities for evasion.
The phenomenon of large numbers of non-federal income tax payers has long been a subject of debate. Those on the left emphasize that other taxes, such as payroll taxes, are paid by those with no income tax liability, a point I discussed last week.
Those on the right often complain that it is fundamentally undemocratic for such a large percentage of the population to pay nothing to offset the federal government’s general operations. After all, everyone benefits from national military spending and other federal programs.
Perhaps the right and left can at least agree that it is unseemly for those in the top 1 percent of income distribution, with incomes at least 10 times the median income, to pay no federal income taxes. It’s not socialism to ask them to pay something.
OK folks, that’s enough for today. I’m sure I will come back to this topic again in future posts.
For now I simply encourage you to pull out your last tax return and make a fair, honest comparison between yourself and the Romneys before you criticize them too harshly for paying income taxes at about the same rate as you and me.
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