Romney, Buffett and Tax Rates

Mitt Romney pays lower tax rates than a teacher? Warren Buffett pays less than his secretary? Really? It’s not meant to happen that way. Our federal income-tax code is supposed to be “progressive”: those with higher incomes should pay higher rates. How does this work?

 

First, exempted income — through exemptions and the standard deduction — causes average tax rates to rise with income. For example, if the first $20,000 of income is exempt from taxation, then someone with a $100,000 income will have 80 percent of his income taxed, while someone with a $40,000 income will only have 50 percent taxed. Second, federal marginal tax rates (“tax brackets”) increase with income. So, dollars earned in higher income brackets will be exposed to higher rates of taxation.

So, it shouldn’t happen, but it certainly could. When a tax code is loaded with special loopholes — deductions and credits for all sorts of activities — an otherwise progressive system may not yield progressive outcomes.

Rich people can legally avoid (and illegally evade) taxation and pay low tax rates. Variations of this story have been increasingly popular over the last few years. (The President even used a story in his State of the Union address.) Perhaps this shouldn’t be too surprising, given the economic doldrums inspired by the “Financial Crisis” and extended for more than four years now by the policies of Presidents Bush/Obama and their Congresses. Envy and resentment find more fertile ground in tougher times.

With respect to federal income taxes, there are two other factors to consider. First, there are different taxes on capital gains and labor income. But this complicates the calculation considerably — and is different in that capital gains income has already been taxed once.

Second, taxes on income include “payroll taxes.” But these are usually ignored, despite the immense pain they inflict on the working poor and middle-class. The most common comparisons you’ll hear are simple, focusing on federal income taxes only.

Unfortunately, these comparisons usually suffer from ignorance of the tax code and most notably, the difference between average tax rates (ATR) and marginal tax rates (MTR).

ATR is the proportion of one’s income devoted to a tax or taxes in general. For example, if one has an income of $100,000 and has taxes of $12,000, his ATR is 12 percent.

MTR is the proportion of tax paid on the last dollar earned. If one is in the 28 percent tax bracket, then the last dollar earned is taxed at 28 percent. Each dollar earned is taxed in its respective tax bracket. Instead, most people believe that if you’re in the 28 percent tax bracket, then every dollar earned is taxed at 28 percent. Not true.

For example, singles have a standard deduction of $5,800 and exempted income of $3,700. So, the first $9,500 earned is not exposed to any federal income taxes. (They’ve already lost about $1,400 to payroll taxes, but we don’t talk about that very often.) If they earn $10,000, only the last $500 is exposed to the 10 percent MTR in the lowest tax bracket, resulting in taxes of $50 and an ATR of five percent.

In the Occupy Wall Street’s Mitt Romney vs. teacher example (on Facebook), Mr. Romney is said to have a tax rate of 13.9 percent while the teacher has a 25 percent rate. Since there is no 13.9 percent tax bracket, the author must be referring to Mr. Romney’s ATR. But if you do the calculations, a teacher who is single would need to earn at least $232,600 to have a 25 percent ATR. Married with no children would need to earn $367,000; head of household with only one child would need to earn $314,700. (The numbers would be higher if the teacher had itemized deductions. I’m assuming he is neither charitable nor has a mortgage on his home.)

Of course, teachers don’t make this much money. So, those making such comparisons are invoking Mr. Romney’s ATR and the teacher’s MTR, comparing apples and oranges — or really, apples and rocks.

If one is really concerned about the taxes paid by the not-so-wealthy, then one has to address payroll taxes — which result in a loss of about $15 for every $100 earned by the working poor and middle-class. If one is really concerned about the taxes paid by the wealthy, the easiest way to ensure equity is a flat income tax with some exempted income for everyone, but no deductions (except perhaps charity) or tax credits. Can we get there? Only with candid discussion and courageous politicians instead of lame comparisons.