Revealing the 47 Percent

There is a hint of exaggeration in Mitt Romney’s famous 47 percent commentary because, according to the Tax Policy Center, only 46 percent (76 million) of all income tax filers (known in IRS parlance as “tax units”) did not pay any Federal income tax in 2011. Presumably, it was the later that inspired the former.

The primary purpose of this blog post is to identify these non-paying tax filers are and try to explain why they don’t have any income tax liability.

For starters it will be helpful to recall my last blog post, where I discussed the low wages that are earned by a large number of Americans.

Half of the 46 percent don’t pay income tax because they have very low incomes that are less than or equal to the generous (relative to their incomes) standard deductions and exemptions that all taxpayers receive. For instance, one in four W-2s in 2011 reported earnings of less than $10,000 while, in tax year 2012, single filers with no children can earn $9,750 tax free and joint filers with no children can earn $19,500 without incurring any tax liability.

Most of the other half of the 46 percent (36 million tax units) also get a big boost toward zero tax liability from the combination of low wages, exemptions and deductions; but they have enough income that they need additional help from provisions in the tax code that are targeted to a specific situation they happen to be in to boost them all the way to zero tax liability.

Forty-four percent of this “second half” avoid paying income tax by using provisions in the tax code that favor the elderly and 30 percent get a free ride (or more) by using tax credits for children and a credit for earned income that is designed to encourage people (especially low-income parents with children) to work to feed their kids rather than rely on public assistance.

The remainder (about 7.5 percent of the 76 million that don’t pay any income tax) is accounted for by a wide variety of factors that include education tax credits, Schedule A deductions over and above the standard deduction, investment losses, tax-exempt dividends, etc.

I’m not going to spend a lot of time discussing this diverse 7.5 percent group but, primarily, it consists of people with fairly modest taxable incomes that have their tax liability reduced to zero because of circumstances that are usually transitory and/or intermittent. For example, parents paying tuition for a child in college or someone that incurred large medical bills. While relatively rare, there are also some wealthy people who pursue investment strategies that allow them to avoid paying any income tax. For example; savvy investors that “harvest” enough losses on the sale of stock to offset income and/or capital gains, those that receive all of their income from tax-free municipal bonds, etc.

Less than five percent of non-payers have incomes over $100,000. However, there is still some rich irony in the fact that some of America’s highest wage earners pay no income tax. The Tax Policy Center says there are 78,000 non-paying tax units in the top 95th to 99th income percentile, 24,000 in the top 1 percentile, and 3,000 in the top tenth of the one percentile.

Presumably those aren’t the folks Romney was thinking about when he made his 47 percent comments. With the help of TurboTax, I’ve created some hypothetical examples to help explain how roughly 90 percent of the 46 percent manage to pay no income tax. Presumably, these are the folks Romney was thinking about.

Example 1: Bob and Betty Smith - a married couple, both age 70, with no dependents – each received $25,000 Social Security benefits. That’s doing pretty well because the average annual Social Security benefit is a little under $15,000 and the maximum possible is a little more than $30,000. Betty had a part-time job earning $16,850. So, for the Smith’s, that’s a total income of $66,850. Although all of the income from the part-time job is taxable only $4,925 of the Social Security pension income is taxable. Thus, the Smith’s adjusted gross income is $21,775.

The standard deduction in 2012 for couples filing jointly is $11,900. However, for joint filers over the age of 65 the standard deduction is $14,200. That reduces the Smith’s taxable income to $7,575. Of course they each get the same $3,600 exemption for themselves that all taxpayers receive regardless of income or age. And that’s enough – with $25 to spare – to wipe out the remaining taxable income and reduce their tax liability to zero.

There are several variables in the taxation of Social Security income but the key is that none of the pension is taxable if there is no income from another source and more of the pension is exposed to tax as the percentage of non-Social Security income increases. Even if both Smiths received the maximum possible Social Security pension, they could receive as much as $14,900 of additional taxable income (a part-time job, a company pension, withdrawals from a traditional IRA, etc.) and still pay zero income tax. That would be a total income of $75,212 with no income tax!

That’s a highly unlikely scenario but it demonstrates why Social Security recipients are the core constituents of the 46 percent that don’t pay income tax. One out of every four tax filers that pays no income tax is able to do so primarily because they are over the age of 65 and receive a majority of their income from tax-favored Social Security benefits.

Example 2: John and Jane Doe both have jobs. John worked at the ABC Widget Company making $15,000. That’s not a lot of money but it is more income than was reported on one out of every three W-2s issued in 2011 and it’s more than someone making the minimum hourly wage would earn if they worked 40 hours per week 50 weeks a year. Jane works part-time as a waitress and her W-2 earnings were $4,500, which is more than double the average wages that were reported on one out of every four W-2s in 2011. The couple’s adjusted gross income of $19,500 is completely wiped away by their two exemptions and the standard deduction. Thus they have no taxable income and their income tax is zero.

Example 3: Great news for the Does! They now have two children - twins Jimmy and Kimmy -and John got promoted to a job as a widget welder that (coincidentally) pays him the exact average of all wages reported on all W-2s in 2011 - $41,211. Jane continued to work part-time as a waitress but her tip income increased a bit and her W-2 wages rose to $5,000. That may not seem like a big increase for Jane but her income is now higher than the wages reported on more than 15 percent of all the W-2s issued in 2011.

Without the kids, the Does big jump in wages would have required them to pay income tax of $3,139 on taxable wages of $26,711. However, Jimmy and Kimmy not only gave their parents two additional exemptions worth $3,800 apiece but they also made the Does eligible to receive the crown jewels of government benefits for the poor and lower middle class - the Child Tax Credit and the Earned Income Tax Credit (EITC) – along with the relatively smaller and more universal Credit for Child and Dependent Care Expenses (to help Jane continue working the Does paid $1,500 for child care).

Credits are better for taxpayers than exemptions because exemptions only reduce the amount of taxable income while credits reduce the amount of tax owed.

The Does adjusted gross income of $46,211 was reduced by the exemptions for themselves and the two kids, and the standard deduction. Remember now, these are the same exemptions that all married couples filing jointly with two children receive, regardless of how much income they have. However, when applied to people of modest income, like the Does, these exemptions and deductions have a significant impact on tax liability and they reduced the Does’ taxable income by nearly 60 percent, to $19,111.

The tax on the first $17,400 of that taxable income is 10 percent, or $1,740. In the Does’ case all of the remainder of their taxable income - $1,711- is taxed at 15 percent and TurboTax calculates their total tax liability at $1,999 (doing the math by hand I came up with $1,997, but I’ll defer to TurboTax).

We’re not finished however. The Does don’t owe any tax. In fact, they are going to get a $498 “refund” even though they did not pay a penny in income tax.

This “refund” is possible because the Child Tax Credit of $1,000 per child and the $300 credit for the $1,500 they spent on child care and their $197 EITC are what is known in Federal budget-speak as “refundable credits”.

So, just to be clear, without those three credits the Does would owe $1,999 in income tax; but with the credits they get a “refund” of $498. That may not seem like a lot but it would likely be a huge boost for a family like the Does that are scrambling to pay rent, payroll taxes of $3,535.14, utilities, child care, transportation and feed four people on a modest income.

Instead of having their income reduced by paying an effective tax rate of 4.3 percent their income is instead supplemented by more than one percent. Without the credits their weekly take-home pay would be $782; with the credits it’s $830.

If Jane Doe made $7,000 as a waitress instead of $5,000 then the Doe’s tax liability would have been $2,299 and they would have gone above the income cap for the earned income credit. However, they would still get the $300 credit for child care expenses and the $2,000 child tax credit; just enough to wipe out their entire tax liability and still get a “refund” of $1.

And they would still, just barely, remain among the 46 percent that don’t pay any taxes and – presumably – remain in the 47 percent that Romney says voted for Obama because they want to get “stuff” from the government.

All three of the tax credits the Does received are “means tested” meaning that eligibility for the credit depends on income, or lack thereof. However, the mechanics of each are little different.

Every taxpayer, regardless of income, is eligible for the dependent care credit but the amount of the credit is determined on a sliding scale. All joint filers with adjusted incomes over $43,000 receive a credit worth 20 percent of their dependent care expenses but, if their income is less than $15,000, the credit can be as high as 35 percent.

For example, even if the Doe’s had an adjusted gross income of $200,000 the child care credit for the $1,500 they spent on child care would still have been $300. However, if their AGI had been, say, $34,000, then the child care credit would be $375, which is 25 percent of the $1,500 expense.

The $1,000 per child tax credit begins to phase out with AGIs above $110,000 and disappears at AGI $150,000 and above. Thus, if the Does AGI was $111,000 their child tax credit would be $1,950. If their AGI was $149,000 their child tax credit would be $50. All joint filers with AGIs below $110,000 get the full credit.

The earned income tax credit (EITC) is designed to assist low income families while also providing incentives for them to work rather than relying on public assistance.

The maximum EITC credit that any joint filer can receive in the 2012 tax year is $5,891. To get that a married couple needs to have three qualifying children (that’s the limit, there is no “incentive” for a fourth child) and an income between $12,750 and $21,800. For a couple like the Does with two children the maximum possible credit is $5,236. The maximum for one child is $3,169 and the maximum for a childless couple is $475, but only if their income is between $6,050 and $12,700.

It is important to remember that that there is both an income floor and an income ceiling for the EITC.

That’s because the concept of the EITC is to encourage adults in low-income families to work instead of relying on public assistance.

The EITC is the granddaddy of tax credits and a cornerstone of the social safety net that has been embraced and expanded by both Democrats and Republicans since its inception in 1975.

Presidents Reagan, Bush I & II and Clinton all expanded EITC. The Bush tax cuts of 2001 and 2003 expanded both the child tax credit and the EITC, resulting in a double-digit jump in the percentage of tax filers that pay no income tax. The Bush-Obama Making Work Pay tax credit further increased the number but that credit has now expired.

It is generally believed that, with the expiration of the MWP credit and the improving economy, the number of tax filers that pay no income tax will begin to decline when the results for tax year 2012 are tablulated.

The EITC and Child Tax credit cost the government about $118 billion per year in lost tax revenue and nearly 80 percent of the benefit goes to the poorest 60 percent of taxpayers.

However, don’t feel too sorry for the rich. The vast majority of personal income tax deductions and tax credits favor the wealthy. For instance, favorable treatment of capital gains and dividends costs the treasury $161 billion per year (compared to the tax revenue the treasury would receive if the investment income was treated as regular income) and 75 percent of that benefit goes to the top one percent of all tax filers. Contributions to pensions and 401K plans that are paid by employers (thus excluded from taxation) cost the government $101 billion per year and less than 20 percent of that benefit goes to bottom 60 percent of tax filers.

To summarize; there are three primary reasons why so many tax filers pay no income tax:

• The exemptions and the standard deductions that all taxpayers get are quite large in comparison to the low incomes that are earned by so many.
• The standard deduction for senior citizens is even larger than the standard deduction for non-seniors and all or most of Social Security pension income is excluded from taxation if it is the primary source of income. There’s some irony here because some of Romney’s strongest support came from senior citizens even though that is the same demographic group that provides one out of every four tax filers that pay no income tax.
• With strong, sustained bipartisan support over the last three or four decades the income tax has become a primary vehicle for providing public assistance to low-income families with children; through the EITC and the Child Tax Credit. It is probably accurate to say that the single person most responsible for increasing the number of non-taxpayers over the last decade is George W. Bush.