There are few things in this world that I hate. I hate pickles. I hate discrimination. And I hate our tax code.
People are talking about taxes. And specifically talking about Mitt Romney’s tax rate. There’s a lot of misunderstanding and misinformation out there about taxes. Take this graphic for example:
Mitt Romney finally released his tax returns this week, and we found out that he paid an effective tax rate of 13.9%. The Internet and the media have been buzzing. I was watching MSNBC and the anchors were gleefully discussing the unfairness of Romney paying only about 15% of his earnings in taxes. After all, teachers and others in the middle class have to pay more than this!
But do they really?
I did a quick Google and it appears the average teacher’s salary in Kansas is somewhere around $40,000. That does indeed put the teacher in the 25% tax bracket as the image above shows. So the teacher must be paying $10,000 in income taxes! (For the mathematically challenged, that’s 25% of $40,000.)
But no. That’s not how income taxes are computed.
First of all, income tax rates are really marginal tax rates. We currently have six tax brackets (see Wikipedia). Income tax is computed for your income through each tax bracket up to your last dollar earned. It’s confusing. Here’s an example:
For this example, we’re going to assume the teacher is single and without children. Under today’s rates, a tax payer who makes $40,000 pays 10% of their first $8,500 of income (the first bracket), plus 15% of the next $26,000 (the second bracket), and then 25% of the remaining $5,500 (the third bracket). Well that’s still $6,125 in taxes — an effective income tax rate of 15.3%! That’s still higher than what Romney is paying!
Except the teacher isn’t paying $6,125 either. At this income level, the teacher automatically takes a $5,800 “standard deduction” and a $3,700 “personal exemption”. This takes the teacher’s taxable income down to $30,500. Go through the math and the teacher is now paying $4,150 in income taxes — an effective tax rate of 10.375%. That’s assuming no other deductions or credits.
Hhhmm. That’s now lower than Romney’s effective tax rate.
But wait! Great news! The teacher has a baby! Yay! (For my math I’m going to assume the teacher is still single. Don’t judge.)
As the head of the household, the teacher’s “standard deduction” jumps from $5,800 to $8,500. (I think I’m understanding this correctly, but if I’m wrong on the standard deduction, shoot the IRS, not me.) Plus the mom now receives a $1,000 child tax credit. Tax credits are much better than tax deductions. Tax deductions reduce your taxable income. But tax credits actually reduce the total taxes owed.
So the teacher’s taxable income is now $27,800. Do the math and you end up with $3,745 in taxes minus the $1,000 child tax credit equals $2,745 in income taxes — an effective tax rate of 6.8%.
Does the teacher own a home? Deduct the mortgage interest. Make some charitable donations? Deduct that too. And there’s more.
I hope you get my point. When Romney pays a tax rate of 13.9%, he’s paying a higher tax rate than most of us. According to the Tax Policy Center, the average effective income tax rates of U.S. households is 8.2% (as of 2010). Nearly half of all U.S. households pay no income tax at all.
But we do pay taxes. Payroll taxes. Gas taxes. Sin taxes. Property taxes… We can talk about tax burden another time.
But Mitt Pays Less Than Other Rich People!
Yes he does. And there are reasons for this. I’m not defending the tax code, only explaining it.
Capital gains are taxed differently than regular income for several reasons.
Rich people have options for what to do with their money. And what we’ve found is that as we lower the capital gains tax rate, rich people engage in MORE activity that is subject to the capital gains tax. When the capital gains tax rate was lowered (first under Clinton from 28% to 20%, then under Bush from 20% to 15%), it created an increase in activity each time that actually generated MORE tax revenue for the federal government. When the capital gains rate was increased in 1980, tax receipts decreased.
Some people, including President Obama, believe that the capital gains tax rate should be increased to be more fair. But keep in mind, this will decrease tax revenues, and enlarge our deficits. That means less money to spend on education, the environment, shovel-ready jobs, whatever. (I discussed this in a previous post here.) All in the name of the rich paying their fair share.
Much of this income has already been taxed, and many economists believe it shouldn’t be taxed at all. I’m going to borrow this next bit from James Pethokoukis. He explains it well:
The capital gains tax is a double tax. For instance, corporate profits are taxed first as income and then a second time when they are distributed to shareholders as dividends. And capital gains from investments are not inflation adjusted, so taxes are often paid on illusory profits.
We shouldn’t tax what we want more of. And the real problem with the capital gains tax isn’t the rate or how it is structured, but what is taxed: gains on investments, which are savings put to work. Economists of all stripes have been saying Americans have consumed too much and invested too little over the past decade. So why would we want to tax investment even heavier, as the Obamacrats want to do?
Indeed, we shouldn’t want to tax capital at all. As an AEI study on consumption taxes explains: “The income tax’s penalty on saving is an undesirable distortion of consumer choice. It also causes less capital to be accumulated in the United States. The reduction in capital accumulation reduces labor productivity and lowers real wages throughout the economy, depressing the standard of living of future generations. Some studies have found that a switch to consumption taxation would increase the size of the U.S. economy by as much as 9 percent in the long run, although other studies estimate smaller gains.”
So the main reason people want to keep taxing capital—or even tax it more heavily—is one of theology rather than sound economics. As the Concise Encyclopedia of Economics puts it: “Strange as it may sound, most economists would agree that having zero taxes on capital income is theoretically the best thing to do. But many reject putting this theory into practice because they think that too much of the benefit would go to the ‘wrong’ people, namely high-income households and the wealthy.” That’s right, the desire to make sure the wealthy like Romney “pay their fair share” is desired by class warriors even if it make everyone poorer than they otherwise would be.
Take it away, JFK (in his Special Message to the Congress on Tax Reduction and Reform from Jan. 24, 1963): “The tax on capital gains directly affects investment decisions, the mobility and flow of risk capital from static to more dynamic situations, the ease or difficulty experienced by new ventures in obtaining capital, and thereby the strength and potential growth of the economy.”
Bottom line: Americans should pay taxes on their wages only, not on any income from saving. The right capital gains tax rate is zero, for everybody. Might a few rich people like Romney pay less in taxes? Maybe. But the result would be a stronger economy, more jobs, and higher incomes for all Americans.
I’m not advocating lower rates for capital gains. That’s not my point. Just trying to put a little reason behind the madness. A little fact behind the fiction.