With tax deadlines fresh in our minds, it is a good time to reflect on how our income tax returns lend insights on policy questions.
Start by calculating your own average tax rate. Then compare it to your marginal rate. This is especially important if you don’t understand the distinction between average and marginal. The average rate is the overall proportion of your total income that you pay in income tax — total tax paid divided by total income. The marginal rate is the fraction you pay out of the last dollar earned. The two are not the same.
Americans commonly talk about being in certain “tax brackets.” If you are in a 28 percent bracket, you pay 28 cents out of every dollar earned within that bracket. But you don’t pay that rate on money you earned that falls into lower brackets or that you spent on allowable deductions like mortgage interest or charitable contributions.
The difference is often striking. My wife and I are in the 25 percent bracket. If we earn an extra $100 we must send $25 to the IRS. But our average rate comes to only 7.7 percent.
Keep your current average tax rate in mind when evaluating seductive flat-tax proposals that would eliminate all itemized deductions or income adjustments. When people are told they would pay only 17 percent of their income under a flat tax, many focus on the marginal bracket they are in and assume they would be better off with the flat tax. The average tax paid, however, is the relevant figure. With a 17 percent flat tax rate, for example, my overall tax bill would at least double.
Many flat-tax gurus advocate a wide zero-bracket amount on which no tax would be due. This would exempt poorer households from any tax. But the wider this exempt band, the higher the remaining flat rate must be for everyone else.
A second insight comes from comparing what you paid in federal income tax to what you paid into Social Security and Medicare. They are essentially equal in my household.
Half of all U.S. households now pay more in Social Security taxes than in income taxes. During the eight years Ronald Reagan was president, the top marginal income tax rate was cut from 70 percent to 28 percent. But the FICA rates for employers and employees increased 2 percentage points. Moreover, the earnings ceiling increased from $29,700 to $48,000. The maximum amount anyone could owe increased a whopping 260 percent.
Consider also that the FICA rate was 2 percent when Social Security was introduced in 1937, it increased gradually to 6 percent by 1960 and then hit 15.3 percent in 1989.
Conservative tax reformers argue that taxing interest and dividend income slows investment and thus economic growth. But high Social Security taxes on the very first dollars earned serve as a disincentive to working, which also harms growth.
Look at your income taxes. Think about what they might be with a flat tax. And be aware that the effects of Social Security and Medicare taxes are nearly as important as those of the income tax.
© 2006 Edward Lotterman
Chanarambie Consulting, Inc.