Thursday, April 15, 2010

Preparing for April 15th: Four Myths about Income Taxes

My annual April 15th essay on taxes-- versions of which appeared in various papers around Indiana this week...

Preparing for April 15th: Four Myths about Income Taxes

“I get to deduct the interest on my home mortgage.” Often false; always exaggerated. For a married couple, the “standard deduction” is $11,400. You can “itemize” deductions if you have deductions which exceed that amount.

For most people, the key deductions are home mortgage interest, charitable contributions, and other taxes (state and local income, property, personal property), If the sum of those deductions is below $11,400, you do not receive any subsidy for your home mortgage interest.

If the sum of those deductions is $12,000, then you really only benefit from the last $600! In any case, why are you all that excited to pay the bank a lot of money in interest—to receive a little bit back from the government as a subsidy?

“Those in the 35% tax bracket pay 35% of their income in taxes.” False; not even close. Of course, everyone has access to income deductions and exemptions which reduce the amount of money subject to income taxes.

But a larger issue is the common misunderstanding about “marginal” tax rates and “average” tax rates. Only the dollars earned above a certain threshold are taxed at the 35% marginal tax rate. Dollars earned below that threshold are taxed at lower marginal tax rates—from 0-33%. Thus, the resulting average or overall tax rates are far lower than 35%.

For example, a married couple with two children and an income of $100,000 has deductions and exemptions of $18,700, resulting in a taxable income of $81,300. They are “in the 25% tax bracket”, but only have $13,400 exposed to the 25% marginal tax rate. Overall, they pay $10,694 in income taxes and thus, face a 10.7% average tax rate.

“Half of the population does not pay income taxes.” Technically true, but truly false. The claim refers to income taxes of the April 15th/Form 1040 sort and is true because of income deductions, exemptions, and tax credits. But everyone with reported income is subject to the 15.3% payroll (or FICA) tax on every dollar of income they earn (up to a cap of $106,800).

As a result, more than 80% of wage-earners are hit harder by “payroll taxes” on income than “income taxes” on income. Most troubling, even the working poor—those earning incomes at (or below) the poverty line—lose thousands of dollars from the payroll tax. And someone earning $40,000 forfeits more than $6,000 per year to the overlooked but staggering payroll tax.

“Democrats are defenders of the working poor and middle class.” Often false; always exaggerated. If this were true, you’d hear Democrats talking at length about payroll taxes, right?

Here’s another tax factoid: 16 states impose income taxes on the earnings of those at (or below) the poverty line. (For two-parent families of four in 2008, Indiana was 5th highest at $263.) And in many of these states, the legislatures and governor’s seat are dominated by Democrats.

If you want to be considered a defender of the working poor, how about bringing up these issues? And if you want to be the friend of the working poor, how about you quit taking their money?


At April 15, 2010 at 10:23 PM , Blogger William Lang said...

Would you know how the relative tax burden of upper-income people has changed compared to that of lower-income people in the last several decades?

At April 15, 2010 at 10:52 PM , Blogger Jenna said...

Very interesting. especially the income tax/payroll semantics and burden on the working poor.
You don't have to wonder long what's wrong with the system -- if you Work -they TAKE; if you sit on the couch and eat chips all day - they GIVE.

THEY are the problem.

At April 16, 2010 at 12:56 AM , Blogger Eric Schansberg said...

I'm almost certain that income taxes have shifted toward the upper-half. I also know that tax revenues as a proportion of GDP have been relatively constant. Reagan and the Dems worked to take a bunch of lower-halfs off the tax rolls. Bush continued that with the one decent tax cut he had. So, I'm not sure, but I'd figure they pay a significantly higher burden of what's paid.

Then again, you might be asking about the burden borne by the average upper-income person-- their average tax rate. That's probably mixed: although they're paying more, they've been earning more too.

And all of this ignores the far more painful role of the oppressive payroll tax. Reagan and the Dems increased this substantially to help SS remain solvent (and added the EITC to offset half of its burden on the lower-halfs). Why Dems ignore that is one of my biggest pet peeves. They care about the working poor? Please...

At April 16, 2010 at 8:21 AM , Blogger William Lang said...

The problem with SS is that the public does not like welfare, so SS had to be presented as not being welfare. So working people are told that they are putting in money towards their own retirement through SS.

I had the opposite impression about the burden of taxes paid by upper-income people: In Health Bill, Obama Attacks Wealth Inequality (David Leonhardt, New York Times, March 23, 2010).

At April 16, 2010 at 10:31 PM , Blogger Eric Schansberg said...

The NYT piece is sloppy, seeming to shift back and forth between wealth and income inequality-- and between marginal and average income tax rates. It also seems to conflate various sorts of taxation.

It also talks about the "inequality of the Reagan era" when the underlying causes of the growing inequality are largely independent of the policies which are usually blamed. To note, such inequality began a bit before Reagan and certainly continued at length after Reagan.

The academic article is far more helpful and detailed. Notice that income taxes are lower for almost all income categories-- especially for those in lower-income groups. But there have been far more noticeable changes in other taxes that seem to have disproportionately benefited the rich.


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