"To increase taxes on the rich, or to decrease deductions available to the rich, that is the question."--- I TRY to answer here...

The "game" of doing your taxes is to minimize the income that is subject to taxation.  People at all income levels do this.  What I would like to do with this post is to do a basic explanation of how taxes work within the framework of potential policy changes coming down the pike---changes in Marginal Tax Rates and/or deductions you can take to reduce your tax liability.  I tried to make this as simple as possible  and dont pretend to know all the issues.  Let me know where I am going wrong.

Marginal Tax Rates are the tax rates, expressed as a percent, assessed on "each additional dollar" of taxable income (wages and/or other sources of taxable income, i.e. interest on savings accounts).  In the US we have what is called a "Progressive Marginal Tax Rate System"--the more you earn, the more you pay in Federal Income Taxes.

It looks like this:

Confusing, isn't it.  Let's keep it simple and look at a Single Person who earns $600,000 per year (a bonified 1%-er) with all sources of taxable income accounted for.  Assume this person has qualified deductions equal to the average of those in his/her income range. This (2009) table shows those average deductions in the major categories that people typically take deductions. This is  the latest data I could find. Wont be completely accurate but we will get the message.

So, if this person was representative of the average in their income bracket, their qualified deductions would total ($38,149 + $48,317 + $25,527 + $18,488) $130,481.

 

Instead of having a taxable income of $600,000, they would have a taxable income of $469,515. See the difference?

 

If you look at the first table with the ascending Marginal Tax Rates (10%, 15%, 25%, 28%, 33%, 35%) you will see that our person earns more than $338,351 so this puts them in the 35% tax bracket, so all $469,515 is taxed at 35%, right? right?...Well, no. 

 

That is their Marginal Tax bracket, meaning ANY income OVER $388,351 is taxed at 35%,  The taxable income earned prior to $338,351 is taxed at (1) different marginal tax rates and (2) on different benchmarks of taxable income. 

 

Here is the math:

 

The first $8,700 of this persons taxable income is taxed at 10% ($8,700 minus 0 = $8,700 X 10% = $870).

 

The taxable income between $8,701 and $35,350 is taxed at 15% ($35,350 minus $8,701 = $26,649 X 15% = $3,997)

 

The taxable income between $35,351 and $85,650 is taxed at 20% ($85,650 minus $35,351 = $50,299 X 25% = $12,575)

 

The taxable income between $85,651 and $178,650 is taxed at 28% ($178,650 minus $85,651 = $92,999 X 28% = $26,040)

 

The taxable income between $178,651 and $388,350 is taxed at 33% ($388,350 minus $178,651 = $209,699 X 33% = $69,201) 

 

Any taxable income OVER $388,515 is taxed at 35% ($469,515 minus $388,515 = $81,000 X 35% = $28,350).

 

 If we add up all the numbers in bold we will get the TOTAL Federal taxes this person owes--$141,033.  (Assuming they had NO with holding throughout the year, this is the amount they would write a check for). Remember, this total was the result of taxing different levels of income at different marginal tax rates).

 

If we want to find the Average Tax Rate on our taxable income we would divide $141,033 by $469,515 = 30.03%. 

 

While this person is in the 35% marginal tax bracket, he effectively pays 30% of his taxable income in Federal taxes. The average is lower than the marginal because large chunks of his income is taxed at lower rates.

 

Now that we understand that, let's look at how a policy change on this taxpayer will effect him/her.

 

I believe it is likely, as a result of compromise, the Marginal Tax Rate for the 35% taxpayer will increase to 39.% ("Clinton era" marginal tax rate on the highest level of taxable income).  You can think of this as a 4.6 percentage point increase OR a 13% increase in the rate (39.6%-35% = 4.6%/35% = 13%).

 

Assume all the other Marginal Tax Rates stay the same (there is talk of moving the 33% rate to 36% too, but we will ignore that here).  The only new calculation will be on the income OVER $388,515, which was $81,000.  $81,000 X 39.6% = $32,076.  Before the increase it was $28,350, a difference of +$3,726 additional Federal Taxes due  and a new total of taxes due of  $144,759 ($141,033 + $3,726 = $144,759)

 

Now, our Average Tax Rate will be $144,759/$469,515 = 30.08%.  We raised the marginal tax rate on this person by 4.6% percentage points (or 13%), but increased the average tax rate paid by this person by LESS than 1 percentage point! 

 

What IF instead we implemented a policy that effectively decreased this person DEDUCTIONS by 13%, as opposed to increasing the marginal tax rate by that much. What effect would that have?

 

Refer back to the total deductions this person had---$130,481.  Decrease this by 13%, or $16,963, and our total qualified deductions will be $113,518.

 

Now, his/her taxable income will be $486,482 as opposed to $469,515. 

 

As before, all the numbers below $388,515 will stay the same.  We want to tax the amount OVER $388,515 at 35% ($486,482 minus 388,515 = $97,967 X 35% = $34,288).  Compare this to the change in taxes paid at the higher rate of 39.6%---$32,076. A difference of +$2,212. 

 

Our new Average Tax Rate is $146,971/$486,482 = 30.21%. 

 

If we do nothing and the Top Rate stays at 35%,  the 1%-er would pay $141,033 in Federal taxes (30.03% average tax rate).

 

If the Top Rate goes to 39.6% then he/she would pay $144,759 in Federal taxes (30.08% average tax rate).  An increase of $3,726.

 

If we kept the Top Rate at 35% but decrease (cap?) qualified deductions by 13%, then he/she would pay $146,971 in Federal taxes (30.21% average tax rate). An increase of $5,938.  This is 59.4% MORE in tax revenue than raising the marginal tax rate to 39.6%.

 

Seems to me that too much focus is perhaps put on Marginal Tax Rates, especially at the top.  Seems like it would be productive to address loopholes and deductions.  However, that would mean taking on powerful interest/lobbying groups. 

 

On second thought, never mind...