How marginal tax rates work
Yesterday I hosted a guest article about the mortagage-interest tax deduction. As part of his argument that this tax break should not be used to justify buying a house, CJ from Wise Money Matters looked at the savings by tax brackets. What CJ did not consider (and what escaped my notice, and even that of my accountant) was the concept of marginal tax rates.
Although I was mortified to have let such a blatant error pass through editing, I decided to turn this mistake into a positive experience. I spent some time reading about marginal tax rates, and today I’m going to share what I learned.
Marginal Tax Rates
Let’s start by looking at the 2009 U.S. federal income tax brackets for ordinary income. (These are the rates we’ll use when filing our tax returns in 2010.) For the sake of simplicity, we’ll only examine the rates for single filers and for those who are married filing jointly. The same principle applies to all filers.
- The first $8,350 of Gillian’s $100,000 income would be taxed at 10%, for a total of $835 in taxes due.
- The next $25,600 of her income would be taxed at 15%, for a total of $3,840.
- The next $48,300 of her income would be taxed at 25%, for a total of $12,075.
- The final $17,750 of her income would be taxed at 28%, for a total of $4,970.
Because Gillian earns $100,000 of taxable income, she is said to be in the 28% tax bracket. That’s the percentage she’s taxed on the last dollar she earns. But most of her dollars are taxed at a lower rate. In fact, as a single filer earning $100,000 in taxable income, she’ll owe $21,720 in taxes for 2009, which means her effective tax rate will be 21.72% — not 28%.
An Easy Mistake to Make
CJ’s article yesterday originally contained a mistaken analysis of the mortgage interest tax deduction. He was applying marginal rates as if they were effective rates. I did not catch it, and neither did my accountant. I’m well aware of marginal rates (and so, obviously, is my accountant), which demonstrates just how confusing this can be — if you don’t pay attention.
Even large media outlets make mistakes with marginal rates. President Obama’s tax proposal would increase taxes on families earning more than $250,000 per year. ABC News ran a story profiling upper-income taxpayers who are looking for ways to sidestep this tax hike. One of them, a 63-year-old attorney from Louisiana, is quoted in the article:
“We are going to try to figure out how to make our income $249,999.00,” she said.
“We have to find a way out there we can make just what we need to just under the line so we can benefit from Obama’s tax plan,” she added. “Why kill yourself working if you’re going to give it all way to people who aren’t working so hard?”
Before ABC News revised the article (just as I revised the error out of yesterday’s story at Get Rich Slowly), its main thrust was grounded firmly on a misunderstanding of marginal and effective tax rates. But this attorney is working from a false premise. If she makes $250,000 per year, she’s only going to pay a few cents more in taxes than if she earns $249,999 per year.
My point here isn’t that the attorney is dumb or that the reporter is dumb or that CJ is dumb or that my accountant is dumb or that I am dumb. My point is that marginal tax rates can be confusing, even for those who know better. When you speak about tax rates and tax brackets, always take a moment to be clear whether you’re speaking about marginal tax rates or effective tax rates.
Then you can avoid posting blog articles (or news stories) that contain embarrassing errors!
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There are 96 comments to "How marginal tax rates work".
Can I add a tax terminology pet peeve of mine?
Don’t say “tax return” when you mean “tax refund.” 🙂
I was always wondering why people got so much up in arms about the proposed tax hike on income over $250k/yr when they made right around that income level. I wonder how many people really don’t understand this concept.
From the quote, it’s clear the Louisiana lawyer is exaggerating for effect. But what he (she?) is saying is perfectly logical: if the marginal tax rate above 250K is high enough, it’s not worth the effort to make the marginal dollar.
So, the real question is whether there is an effect on the substantive conclusions of the article because of the numerical mistake?
“Gillian’s income is actually taxed progressively”
I may have my terminology backwards, but isn’t this type of tax system actually called “regressive,” and not “progressive?”
Thanks for the clarification. This also does put a huge perspective on Obama’s tax changes that he talked about during his election. One of my big problems with it was the idea that he was going to significantly tax people for going up a tax bracket. I honestly don’t have a problem with increasing the higher marginal tax brackets as I feel anyone who makes $250,000 is likely doing just fine and therefore can handle a slightly higher tax on their highest portion of income (as opposed to their total income).
@Eric:
I suspect that lots of people don’t understand this, or at least don’t understand it well enough to realise the implications of changes to tax brackets and rates.
@Kevin:
It’s called progressive taxation when you are taxed at a higher percentage when you make more money. If the tax brackets were reversed (35% on the first $8k, 33% between $8k and $33k, 28% between $33k and $82k etc) then that would be regressive.
Regressive taxation is usually considered unfair, because those on lower incomes can usually least afford to pay more in both $ and % terms.
The marginal tax rate is critically important in helping you make the right decision about investing and taking out a mortgage.
Politically, its also important but from a different perspective. Without question, as marginal rates go up, the incentive to work drops.
I believe that is true – even if the hit is not across the board, its still a disincentive.
I have a few things to point out. First, the increase in marginal rates is not the only issue with Obama’s plan. There are other tax credits, deductions, and the like that will be phased out once your income goes above the threshhold. For example, the mortgage interest deduction and the charitable giving deduction. Second, you are correct that marginal rates are important to consider, but deductions benefit you at your marginal rate. In your example, if Gillian pays $15,000 in mortgage interest and that is her only deduction the benefit to her is a $4,200 reduction in her tax liability (28% of $15k), and her effective rate would be reduced to 17.52%.
To Kevin: JD has it correct, in that when higher incomes are taxed at marginally higher rates then that is a progressive tax system. Alternatively, if the working mother of three with an income of $45,000 paid the same marginal/effective rate (in the case of a flat tax they are the same) that Warren Buffet did, then that would be a regressive tax.
The idea being that because of the diminishing marginal utility of goods (here money), it is appropriate from an economics perspective to tax lower brackets of income at lower marginal rates.
Or in other words, a dollar (or $10,000 for that matter) is going to be worth a lot more to that mom (in terms of utility) than to Warren Buffet because of the percentage of income that dollar represents.
@ Kevin:
Regressive would mean that each tax bracket is taxed a lower percentage than the bracket below it. The goal (in theory) of regressive taxes would be that everyone pays the same amount, rather than the same percentage. The IRS tax code is progressive.
It’s also worth pointing out that the tax brackets apply to what the feds call MAGI – modified adjusted gross income. Basically, your net income minus all your deductions. A person who takes home $100k/yr in net income might have a MAGI of $80k.
You have to remember to take deductions into account when you’re trying to figure what your marginal tax rate is. Everybody gets at least the standard deduction, which I believe is $10,900 for 2009.
Thanks for clarifying. I’d had this explained to me once before, but this explanation makes quite a bit more sense.
Wouldn’t her effective tax rate be lower than 21.75% because of deductions and exemptions? The first $5700 of her income would be tax free if she files with the standard deduction (more if she itemizes). Then another $3600 is tax free for her personal exemption. Right? That should bring her effective tax rate down to about 19%.
Thanks, J.D., for this very informative post…I also wonder how many just don’t understand this rather basic (and important) distinction. So why, then, does practically every person I know, including those who consider themselves extremely financially literate, raise such a stink when you earn a raise or take on a second job and say, “BE CAREFUL…this could send you into the next tax bracket!”???
Calculating taxes and rates will definitely give someones headaches at one moment.
“Alternatively, if the working mother of three with an income of $45,000 paid the same marginal/effective rate (in the case of a flat tax they are the same) that Warren Buffet did, then that would be a regressive tax.”
Sorry, no. You are wrong. If everyone pays the same effective rate that’s a FLAT tax, NOT a regressive tax. A regressive tax is when you pay a HIGHER effective rate on a LOWER income. Sales tax is an example of a regressive tax.
Also, J.D., it’s not really erroneous to assume the mortgage tax deduction applies to your highest marginal rate, since if you deduct $X from your taxes that is X MARGINAL dollars removed from your taxable income, not some random X “overall” dollars.
One of my relatives is still confused about this after I’ve told him a thousand times how taxes work. In fact, they refuse to even keep much money in interest bearing bank accounts because he’s afraid the interest earned will push him into the next tax rate and will suddenly owe a higher tax rate on all income.
Ugh, oh well.
Off topic but there is an AP story today about “extreme frugality”. One of the lines is that the woman’s 2 year old and 3 year old wear hand-me-downs. THIS is what the media think is extreme frugality??? I wear hand-me-downs(from my mom), hand-me-ups(from my grown kids) and hand-me-acrosses(from friends)- and I am 55. And the woman shops with coupons and looks for 70% off sales(heck, wait for the 80% or 90%- and use a coupon).
Let me add a couple things to yesterday’s discussion about the mortgage tax deduction. If it’s wrong to post that here, J.D. can remove it.
I agree with the premise of the article. We’re prepaying our mortgage–aggressively–and the 30 years will be reduced to 10, or hopefully even less. We could reduce it to a 15 year rate, but there’s just not that much of a difference in the interest rates to justify the higher minimum payments (i.e., the lower minimum payments of the 30 year amortization allows me to have a somewhat lower emergency fund) But that’s our only debt, and we also invest aggressively in stocks in the tax shelters of retirement accounts and 529’s. I don’t want to get lost in the weeds arguing about marginal tax rates–suffice to say there is a certain deduction available when your total deductions exceeds what you might otherwise take from the standard deduction. For some this is big, for most it is not. Basically though, as with anything, you shouldn’t buy something you don’t need or really, really want just because you have a coupon; and that’s essentially what this is–a coupon from the government. Unfortunately, that same mentality is what leads many to buy a bigger house than they need or would otherwise want, and they continue servicing debt they could have otherwise dispatched.
A little bit of history…no government policy was ever created inventing the “mortgage interest tax deduction” as a way of encouraging a responsible society of homeowners dilligently mowing their lawns behind white picket fences. Rather, when income taxes were first created in the early 20th century, ALL interest was tax deductible. There wasn’t much distinction between personal income and business income, therefore interest was simply considered a cost of doing business (in your little general store or on your farm), and the government only wanted to tax your net profits. So THAT is why interest was tax deductible. Later by the 1970’s as consumer credit was exploding, folks started to realize that it didn’t make much sense for the government to continue to give folks a tax break on the interest they were paying to MasterCard. So, by about 1987 (I might be off by a year or two here) a big tax reform act took away the blanket tax deduction for interest paid, EXCEPT interest paid on mortgages. By this time, the mortgage interest tax deduction HAD been around long enough to be immortalized as one of the great things about America, right up there with Abe Lincoln and apple pie. And if you ask people about it its origin, most think it has something to do with getting out of the Great Depression and giving a boost to all those returning GI’s moving into Levittown, or something along those lines. And that’s wrong. But then came the worst part in the late 1980’s. What happened as a result of this huge change in the tax code was the banking industry invented a way to essentially blur the line between unsecured consumer debt and secured mortgage debt; and just like that the “Home Equity Line of Credit” was born. That’s the law of unintended consequences. Why pay 13% to MasterCard when you can “tap the equity” that your house has “earned” for you. Roll all those high interest rate debts into one easy monthly payment, AND get a tax deduction. What could be better? As your house goes up in value “take out some of your equity” to redo the kitchen and add a pool. You earned it; and you get a tax deduction. The banks sold this mentality so powerfully for years and very soon middle class America bought it hook, line, and sinker, and now we’re seeing the catastrophic aftermath. (Even someone’s comment talked about their accountant telling them, yes, pay off your mortgage, but then have a HELOC as an emergency fund. More debt is exactly what you don’t want when you need an emergency fund because you’ve lost your job–especially not secured debt that threatens to take away your previously paid off house. In an emergency you need savings, there’s no easy way to get around that fact). But what is the most outrageous irony possible is that now that the bubble has popped, often times when people have this discussion about paying down your mortgage, the same folks who were once convinced to “tap the equity they had earned” will not want to prepay a mortgage because they say “this is not a good time to be putting more money into your house.” Paying off your mortgage is NOT putting more money into your house; it’s paying off debt.
So basically, as with many things we discuss on this blog, you should consider both the hard numbers and also the effects on behavioral economics. You all have more than adequately examined the former, but the latter is important too. Sometimes if you’re extremely focused on a particular financial goal like getting out of debt, (and believe it or not, mortgage is debt; not good debt, not bad debt, just debt) then you’re more likely to allocate more resources to that. It’s not necessarily a case of “I could make more in a broad index fund than I would be paying off my mortgage early” but rather it’s often “Maybe we should buy a used car this time instead of a new one until our mortgage is paid off–then treat ourselves.” (that’s EXACTLY what I’ve been thinking about in the past couple of months) The problem with thinking the mortgage tax deduction is good is it desensitizes you to carrying 30 years of debt as you continue to indulge in other luxuries.
In defense of prepaying a mortgage, you need to realize that it is a form of diversification. It’s pretty unfair to compare it to a stock investment because they have completely different risk/return structures. Nobody in his right mind says “5.0% on a CD is a horrible deal; I could make 10% in stocks.” Prepaying a mortgage is like buying a CD; the rate equals your mortgage rate, and the term equals the remaining time in your accelerated amortization schedule. And I hope this doesn’t get too confusing, but the return you “earn” by paying off your mortgage is tax free, unlike the interest from your bank savings. Some folks say that this tax free return cancels out the mortgage tax deduction, but again, that’s weeds. Some of you wrote in the comments “Even after prepaying, the same payment is due next month.” That’s true, but next month a higher portion of your payment is allocated to principal rather than interest. (How much higher you wonder? Exactly the same amount that you would have earned in interest if you had put that extra payment into a savings account at the same rate for one month) And even better it’s the same every month thereafter for the remainder of your loan. So you’ll either be debt free that much earlier and be a true homeowner sooner, or you will get a bigger check at the closing table when you sell. Either way, the money is there, and it’s not lost just because the same total payment is due the following month.
Finally, if anyone in the future wants to argue with you about prepaying your mortgage, telling you all about the long term benefits of stocks (and remember, I do have plenty of money in stocks and continue to pour more into them) just ask them one very simple question that trumps all this discussion. If it’s so easy to make money in the stock market, and prepaying your mortgage is such a bad idea, then why are all these banks wasting their time and money LOANING us mortgages for a piddly 5%? Why don’t THEY just buy a nice index fund and call it a day? It’s obviously a good deal.
This is one of my pet peeves, “I quit the job because it put us in a higher tax bracket. We would be paying more in tax than I was making.” Um, no.
Basically here the issue is the same, do NOT buy a home for the tax write off, do NOT buy a home until you are financially, emotionally, and physically ready to.
Getting back to the “tax write off” of your mortgage interest, even if you were to get back 50% of your interest it is not a good deal. Better put, give me as much money as you can every day, and I will give you 50 cents of every dollar you give me. Doesn’t make sense does it?
Remember there is alot more to buying a home than the payment. here are some of the “payments” we forget about, real estate taxes, electric bill, water bill, heating costs, who will cut the grass, who will shovel the snow, and don’t forget to include 1-2% of the homes value for maintenance costs because through the years you are going to want to paint, put new flooring, replace plumbing fixtures, cabinets, trim, and if you are there long enough siding and roofing and windows and etc. These are just a few of the things that people forget about in the euphoric rush of buying a home.
That is great. But if you were already more than half way paid off on your original mortgage, then maybe you should have just focued on paying it off within the next few years and savings the money you spend on closing costs.
I read yesterday’s post and skimmed over the tax rate issue without a second thought of its accuracy. Perhaps it’s because my taxes are calculated automatically by software since my 2006 returns were filed and I don’t physically go through each tax level with a calculator anymore. Perhaps that’s why others struggle with understanding marginal vs. effective tax rates. If your accountant hands you a completed tax return that only requires your signature (or not even that if you e-file) do you go back through the tax tables to see how the tax was calculated? Being removed from the actual tax calculation and preparation can cause you to miss out on the details. That’s a big reason why I still choose to suffer through my own tax preparation. It forces me to understand how to figure out my tax bill each year.
Using the marginal tax rate is actually correct when figuring out how much you’ll save from deductions, at least until you’ve got enough deductions to reduce your AGI to the next lower tax rate. Using the effective tax rate would give you an inaccurate assessment.
An example: A married couple together earned $150,000 in 2008. Their income between $131,450 and $150,000 ($18,550) is taxed at 28%. Any deductions to their income up to $18,550 come directly out of the money they’re taxed at the 28% rate. Any deductions beyond $18,550 will come off the money they’re taxed at the 25% rate.
If they had $15,000 in mortgage interest, $5,000 in property taxes and $2,000 in charitable giving for a total of $22,000 in itemized deductions, they’ll reduce their income to $128,000. If they’ve got two kids their personal exemptions are $14,000, further reducing their taxable income to $114,000. The tax will be calculated on this amount, then any tax credits will be applied, further reducing their tax. Only when you’ve got down to the final tax, after all deductions and credits, can you arrive at your effective rate.
So, the short answer is that J.D. was correct in his original theory of starting with the marginal tax rate when making evaluations about how a deduction will affect your tax situation.
@Andrea #19
Haha, I agree with you completely. There was something in the New York Times the other day, a similar type article. It mentioned something about what the Obama girls wore to the Inauguration. It said they wore J.Crew outfits rather than “designer labels.”
I re-read it twice, thinking I missed something. I thought J.Crew was designer. I guess I’m poorer than I thought. haha
Just a note on standard deductions for tax year 2009,
single will be 5700
married will be 11,400
more info at taxes.about.com
One point that I feel is being omitted is that the gain from the sale of a primary residence up to $500,000 for couples (with some conditions, of course.it is the IRS!) is tax free as long as the home was owned and lived in as their primary residence for 2 of the past 5 years prior to the sale. This is important when viewing home ownership from a long term perspective. While it seems right now there will never be gains again in real estate, there will be. Normal will eventually return. As the article points out, there may or may not be a tax advantage from the monthly mortgage interest payments, but at the end of long term ownership, and by making home payments over the years, investors are actually buildng equity in a very important asset; their home. By paying rent, they are helping someone else build equity in a real estate asset. Selling of the home could come at a time when they are empty nesters choosing to downsize, and if the home has been owned long term, there will likely be a sizable gain from the sale….a tax free gain. That equity can then be rolled into another smaller home, and the proceeds invested in an income producing asset if needed for retirement, or another type of asset depending on their goals.
Another scenario is that tax free home sales could occur several times during one’s lifetime, depending on circumstances and the real estate cycle at the time of purchases and sales. This may also be tied to job moves.
We are currently in a real estate market with very low prices and mortgage rates at all time historical lows. How many times during ones’ life does this happen?
Real estate purchased at this time could very likely lead to eventual gains.
From a big picture perspective, and while I, too, like to analyze such scenarios, I wonder if this is more important than the potential monthly tax savings from mortgage interest.
Finally, a home is an asset that demands and deserves an owner’s attention and care, and can provide the owner with comfort and security, when purchased and mortgaged wisely. This cannot truly be said about many assets.
Andrew,
I would agree with you whole heartedly that sales tax is a regressive tax because they are paying a flat tax based on the cost of good, which would then equate to people with lower incomes paying higher effective tax rates. And I would further agree that “A regressive tax is when you pay a HIGHER effective rate on a LOWER income.” Well said.
But my point about a flat income tax being regressive is that asking people with vastly different incomes to pay the same effective rate is not equitable from a utility perspective. Therefore, I would argue (and you are free to disagree) that even a flat tax rate is EFFECTIVELY regressive. Having made my point, I am happy to concede that a flat tax is not by definition a regressive tax, but in my opinion it is effectively regressive.
My apologies for including my opinion into a definitional matter.
Ex.
For a flat tax rate of 18%, someone with MAGI of $45,000 would pay $8,100. For someone with MAGI of $1,000,000 that’s $180,000. Considering diminishing marginal utility, the utility of the first person’s $8,100 is worth more to them because they then only have $36,900 to live off of after taxes. The person with MAGI of $1,000,000 still has $820,000 after taxes.
Is the flat tax then equitable? I submit that it is not, but that is something that certainly can be debated.
Now that you understand marginal tax brackets a bit better, I recommend you take this to the next level and consider tax rules that “phase out.”
The phase out region of any tax rule is an area of even higher marginal rates. From my own taxes for example: my wife receives disability income. Normally our income falls in the 15% marginal bracket because we make between $16050 and $65100 of taxable income.
But because of the way tax is computed on disability income, she doesn’t pay tax on all of her income. In fact, if our AGI is $44000 or below, she only pays tax on half of it. For every dollar of income over $44000, she has to declare an extra $0.85 in income, which is then taxed at 15%.
Effectively, in the region where our AGI is between $44000-50700.48 our Federal marginal tax rate is (15 + 0.85*15)% = 27.75%.
Naturally, some years I contrive (via IRA contributions, etc.) to make our AGI a few dollars less than $44000. In fact, all else being the same, it would be better to alternate between years where I did a lot of Roth contributions and where I did pretax contributions than to always land in the top portion of our high marginal tax region.
I might for example make traditional IRA contributions for 2 years to avoid the high marginal rate, and then convert them all to Roth the third year (and only pay the high rate on half the money or less).
Any tax law that “phases out” will have a region of high marginal tax, just like this. So tax laws that phase out at $250000 do indeed (for some interval) have a higher-than-you-think marginal rate.
I would like to expand on what Joe said. Taxes aren’t as simple as marginal rates. There are magic points along the income scale that phase out deductions and tax credits, increasing your effective tax rate. For example: for every $1000 you make above $110k (MFJ) you lose $50 of one of the child credits. That increases your effective rate on that money by 5%. There are also phase outs of deductability for student loan interest. And then there is the dreaded AMT (Alternative Minimum Tax) that completely changes everything when you cross a magic threshold.
I am working part time this year. Part of the reason is that I don’t take much home of the last dollar I make, so if I don’t need it why should I work for less and less money? The last 4 hours per week are a lot harder than the first 4 and I’m getting a lot less money? No thanks.
Also an aside, I ask my husband every year around this time if I can have a divorce. I do our taxes and I look at how much more we pay because we are married. I could save a few thousand dollars in taxes every year by getting a divorce and just living together (especially now that we have kids and one of us could file as head of household). If the new tax laws get bad enough divorce for me might turn from a joke to a tax shelter.
I still cannot believe your accountant screwed up such an elementary accounting concept. As a fellow accountant, I would be absolutely mortified – it’s like a mathematician not understanding that 7 times 8 is not the same as 7 plus 8.
@ Camille
The 2 of 5 years law is no longer valid. Last September as part of the bailout it was changed to the amount of time used as a residence (though I think it still must be at least 2 years), so if you lived in a house for 2 of 4 years of ownership, 50% would be tax free and the rest would be subject to capital gains.
The idea of not wanting to make $250,000 if you have the opportunity to make slightly less, is that some tax hikes take the form of taking away tax benefits that those under $250,000 would enjoy. An example would not deal with the ordinary tax rates, but the capital rates. Those with higher income have more discretion regarding their capital gain rates. Something that is in the works under the Obama administration is to have a set of capital gains rates that differs depending on your AGI. So, if you can get below the $250,000 level then your capitam gains tax rates will not be as high. This is big because of the amount of capital gains income that the affluent have. Another example of this is if you own a company and decide to sell it. The gain on the sale is a capital gain. Currently, if it is a long tern gain, it will be taxed at 15%. When Obama is able to increase the rates though, it will like go to between 28% and 36%. So, if I sell a company to start my retirement for say $1,000,000. I could pay only $150,000 in taxes or if I wait a year or two to sell, I might pay between $280,000 to $360,000. This will seriously effect my ability to sell and retire. So, I will move up the sell.
@Jimbo (#32)
My accountant didn’t actually screw this up. He just didn’t look at it. I didn’t ask him to. I asked him to address the concept in the article, which he did. This is my fault, and not his. He’s not happy to be involved with this mess that I’ve created, and I don’t blame him. He sent me a detailed analysis of the whole scenario this morning that took into account everything — including marginal rates. 🙂
Here’s an analogy. Imagine you come to me with a story and ask me to comment on the plot. I comment on the plot, but I don’t correct your grammar errors. This doesn’t mean that I don’t notice the grammar errors; it just means you asked me to comment on the story. Same deal here.
My accountant is highly skilled and highly competent, and I trust him completely.
J.D.,
You could teach. You have a gift of taking the difficult and breaking it down to digestable parts. Here is my question………….Who has an excel spreadsheet that will allow you to plug in a salary and it will automatically adjust for marginal rates and give the effective rate as a total? I am tempted to make one, but I’m sure someone out there already has one better than I could make. Anyone????
In order to be accurate, I think what you’re really asking for here is the latest edition of TurboTax.
Of course you could make the basic spreadsheet, but since so much changes each year it becomes so complex that Intuit can justify the $50 or so for the software package each year.
As an aside, I’m absolutely fascinated by the level and insight of all these comments. It’s definitely true how TurboTax or any tax preparation service ultimately seems to cause more and more misconceptions about even the basics of tax law. They prepare a correct return (not refund, haha, will never make that mistake again) and most people are pleasantly surprised to get something back. But when Congress debates the merits of this or that change, then the voters are effectively less and less educated about what the heck they’re talking about. Of course, the politicians themselves are actually less and less educated too, because wasn’t it the current Treasury Secretary who had to pay 30k in back taxes who said “I used TurboTax, I don’t know what happened.”
i feel bad for those poor people making over $250k a year. I hope after Obama’s tax increase they’ll still be able to put the caviar on the table and send their kids to their private catholic schools!
@dave
This is my fourth draft at this post in an effort to not be exceedingly rude:
I know people who make $250k per year (and no, I don’t make near that). They don’t dine on caviar. They work hard and invest heavily in themselves, either via extreme levels of education or their businesses. Many of them do jobs and work hours that I would never choose to do, and have for years. I know PhDs who lived on ramen for years, MDs who slept only a handful of hours while as residents, engineers who worked in some of the harshest conditions, and small business owners who worked out of their cars hauling other people’s poop (clogged sewer lines are a bitch, but someone has to clear them).
I’m not sure where your apparent hostility to achievers is, but it bothers me that you are reading a blog titled “get rich slowly” but have a problem with people who work at doing just that.
@ Massey and Andrew
I was just debating the flat tax at dinner last night.
Massey said it better than I did but I completely agree with her that it isn’t technically a regressive tax, it has a similar effect.
Curious about any good debates/info on the flat tax concept.
Eric (#2), Wise Money Matters (#6), and Dave (#38) all seem to express the same (seemingly popular) sentiment that people who make a lot of money can afford the taxes so they should stop complaining about it.
I don’t make $250,000 a year, but I do make just a bit over half of that, which is still a fairly high salary, and I’d like to give my perspective as to why someone with a six figure salary doesn’t want to pay taxes any more than someone making $40,000 a year.
Last year I made $142,000. I paid $42,000 in taxes, and that’s even after things like 401k contributions and pre-tax health insurance deductions (and doesn’t include sales tax, or vehicle registration, or anything not taken out of my paycheck directly).
Here’s an anecdote: I live in California, which is part of the reason I make such a high salary in the first place, but due to housing prices still being astronomical, I cannot afford to buy a home. I’d have to stretch myself to the limit to afford a house, and that’s not something I’m willing to do. But I *do* pay $3500/month in taxes. If I didn’t have to pay that, it would cover the *entire mortgage* on a half-million dollar home.
That’s how much I’m paying in taxes — enough to buy a $500,000 house. That’s why we get upset about taxes. Someone making $250,000 a year would be paying twice as much in taxes — enough to buy a million dollar home.
We’d probably feel better about it all if we could look at the government and think, “well, at least we’ll get our money back in the forms of roads and police service and parks and all the things our taxes pay for”. But we know that we won’t. I don’t get any more out of our highway system than someone who paid $5000 in taxes last year, assuming we both drive the same amount. The police won’t respond to a robbery at my apartment any faster than at anyone else’s home. Parks are open equally to me and anyone else. People with higher salaries all pay more for the same government services that people with low salaries pay less for.
With the amount of services the government provides, we couldn’t afford to charge everyone equally, so that they all pay, say, $500/year towards their local police department, and $300/year toward highway repairs, etc. The portion of the country that makes above average salaries funds a *lot* more of these things than the portion of the country that makes below average salaries. This is accepted, it’s the way it works now, and I’m pretty ok with it. But when people start saying that even though I’m paying two or three times my fair share already, that I should still be paying *more*, and they shouldn’t, and then makes jokes about all the caviar I’m eating, it’s a bit aggravating.
I have to add that depending on where you live in the country, $250,000 is not as high as you may think. If you are living in Hawaii, California, NYC, Washington, DC, or Chicago on that salary, you would be doing just fine. But all three of your children would not necessarily be going to private school and you would not be dining on caviar each night. For some perspective, I live outside of DC in a 1950’s 1,800 square foot ranch house with 3 bedrooms. My house is worth about $550,000 – today after the big housing bubble. Put that same house in Kansas City and it’s probably worth $150,000. So keep in mind that $250,000 goes a lot further some places than others.
Under Obama’s tax plan a person making $250,000 would pay another $46 of tax maximum for every $1,000 extra they made. I computed this by taking the highest current tax rate for 2008 = 35% and comparing it to what Obama would raise it to = 39.6%.
I don’t know about any of you, but I’d gladly take an extra $1,000 by agreeing to pay an extra $46 (total of $396) in tax. The argument that making additional money because it’s just going to be paid in taxes is ridiculous.
The woman claiming to be trying to reduce her income below $250,000 wasn’t entirely wrong. Part of Pres. Obama’s plan was to reduce the percentage applied to deductions on couples making more than $250,000. Thus, if I make $250,001 with $40,000 in deductions (charitable contributions, mortgage interest, student loan interest, etc.) under current law I would be able to deduct all of that at 33%, saving me $13,200 in taxes. Under Obama’s plan I would only be able to deduct that at 28%, saving $11,200 in taxes. However, if I made $249,999 I would still be able to deduct all of my expenses at 33%. Thus, Pres. Obama’s plan would cost me $2,000 just for $2 worth of income. That was my reading of the plan anyway.
Kevin’s comment about the US tax system being REGRESSIVE is correct. But don’t feel bad, the terms have been manipulated to confuse.
The problem is the comparison you are making. To truly determine if a tax is regressive, progressive or neutral, you need to compare it to discretionary income.
High earners have significantly higher discretionary income. Therefore, the taxes they pay are significantly smaller as a % of their discretionary income, than low earners.
It is why, reducing taxes on the poor has so much more impact on the economy. The trickle down theories were always non-sense, rich people getting more money have little extra to consume. They are much more likely to buy tax-free bonds or low taxed dividend yielding stocks. Poor people on the other hand will buy stuff right away, because they need it.
I have to point out that there is more to taxation than your tax rate. Many tax “rebates” are phased out once you hit a certain income. So for the article to have stated that someone is going to try to make $249,999 is absolutely a good strategy given that they may be unable now to subtract certain deductions.
I know because we were phased out of our child credits. Instead of getting $1K per child, we only got $200. How’s that for a slap in the face? And it starts to phase out once you have over $110k in taxable income. So for every $1k over $110K, they reduce your deduction x amount. And now with talk about capping charitable deductions for “high income” workers, it makes even more sense to try to stay below a magic phase out number.
I assume the AMT works similarly, but thankfully we’ve been spared so far from paying that.
rugman11 #44, your example is perfect.
You know, just a crazy thought here, who decided that the government, the seat of all wisdom, knowledge and competence, should be the ones to set rules to make things “fair”?
I’m not one of these “high income earners”. I work an office job in a retail store. My AGI is consistently under 25 grand.
You know what, I understand that basically, I don’t have any damn money to pay for the cops, army, etc. and that the government’s going to take it from people richer than I am. Okay fine, whatever.
But even at my income/tax level, I see, consistently, that other people who are less responsible get, through the provisions in the Code, things I don’t get for being more responsible.
As an example of what I’m talking about, I don’t have children. I cannot afford them on my own pay.
But the people I work with who make the same amount of money do have children. They cannot afford them either. They get lots of free services from the government, like free food for the children, free health insurance for the children, etc. And on top of all that, they get exclusions, tax credits, Earned Income Credit, and stuff like that on their income taxes that I don’t get!
In fact, most of these people do not pay income taxes at all. They actually rejoice when tax time comes around because they get thousands of dollars above what they theoretically were obligated to pay before all those credits and such.
And to be honest, that pisses me off. We shouldn’t be rewarding people who earn what I do who buy into lifestyles they can’t afford, especially not when it punishes people like me who don’t do those things that cost thousands of taxpayer dollars every year.
And the thing is, those people who make all that money, are paying it. And the people who are getting all those tax breaks vote constantly to take more money from other people for their pockets via more free government services and tax incentives.
You create a huge underclass of people whose best opportunities in life are to siphon from what other people have earned, with no incentive to try harder to produce more value in society.
I very much favor a flat tax with no floor or income related credits if we simply must have an income tax. That’s the only way that rich people pay more, poor people pay less, and no one gets anything they really shouldn’t. Is it completely fair? Perhaps not, but this ridiculous system we have now is even less fair.
I see where the people in the higher tax brackets are coming from. I pay into the system while watching others, who really shouldn’t, benefit from it. I don’t think it’s wholly unreasonable to expect top earners to pay for the basic government we need, but when you’re supplementing lifestyles for people who couldn’t afford them on their own, you start to get, well, pissed off.
@snowballer
This is ironic for me to argue against what you wrote, but I want to defend your coworkers a little. Just because they don’t pay taxes (after all the credits and deductions, etc.) doesn’t mean that they don’t add value to society. They get up most days, go to Wal-Mart, or wherever, and mop the floors and stock the shelves and work the registers of the store that lets people like me, who earn 10 times their income, keep more of my money by providing me with inexpensive labor/inexpensive products.
There is still an incentive in this society for them to move up. In general if they make more money, they’ll start paying a little bit of taxes, but they’ll still have more money at the end of the day. That’s the crux of welfare reform and the “make work pay” tax credit. You’ve got to make it more beneficial for them to work instead of collecting welfare, even if that means that they pay no taxes, or pay negative taxes. Remember, all hard work is honorable.
And, despite the fact that I’m normally a cold hearted Republican, I want their children to have health insurance; and food if necessary through WIC, etc.. We can afford it.
@ Scott NJ DAD
WHAT taxes are reduced on the poor? The 40% bottom earners don’t pay income tax. There are other taxes, but those are usually flat (sales, property, etc.) so reducing them effects everyone, not just the poor. The only *tax* that hits poor higher than rich is lottery ticket sales.
I am not sure about your logic that rich people don’t have much more to consume. Isn’t one of the issues discussed here recently about lifestyle inflation and the fact that 1)As you earn more your expenses inflate and 2)Even high earners can overspend their income?
Isn’t the fact that the economy is *collapsing* partially because people aren’t spending (and therefore generating demand for products and therefore jobs for people to produce/transport/sell them) kinda support the fact that spending money “trickles” through the economy?
Well although philosophically I feel that the children of these lower income people should find relief through private charity and not governmental handouts, I could probably live with the fact that people get free stuff for their kids if they weren’t also getting a $4000 annual boost in their income. If you make $24000 a year, an extra four grand is almost a 17% raise.
The problem is that people like us stuck in these type jobs can’t really get a 17% raise through conventional means of working harder at that same job, so instead these people focus their efforts on using the tax system to siphon more money off people who earn more.
I just think we’re better off leaving people in my spot better incentives to learn things that pay more, which creates more value in society. Say one day I accomplish my goal of becoming a CPA and move out of this low end bracket. Everyone wins: there’s now a valuable CPA and the cost of those services goes down, I make more money, and the wages of the people who can’t leave these retail jobs goes up as there’s now fewer available workers.
Granted a CPA entry level job starts at about 40k a year so maybe that was a bad example, someone else stuck in this situation may only be capable of doing something that pays another 4 thousand a year or so. But why try any harder when the government just gives you more and more of a backdoor welfare payment via income tax every year?
And no, my coworker aren’t bad or dumb or evil, but I feel this whole scheme does them a disservice.
To me letting them solve their own problems, well that’s better than giving them other people’s money.
Wouldnt a flat tax make life so much easier? The cons I heard was that it is a regressive tax.
It seems that all media sources who talk about personal finance, blogs included, should educate themselves about concepts like marginal tax rates before giving advice on things like investing, saving, or spending. Don’t you agree?
“The only *tax* that hits poor higher than rich is lottery ticket sales.”
That statement is false. Plus it seems a bit demeaning.
Social Security tax hits poor harder than rich. A person making $40,000 a year will pay 6.2% of their income into social security while someone making $250k a year only pays about 2.6% of their income to SS.
Sales taxes generally hit the poor harder than rich.
Gasoline taxes take a much higher % of the income of poor people compared to rich. A typical American drives 15k miles a year and buys 750 gallons of gasoline. Federal gas tax is 18.4¢ per gallon so a typical driver pays about $138 in gas taxes to the US govt. $138 of $40,000 income is a much higher percent than $138 of $250k income. Please don’t argue that driving is proportional to income.
Jim
Jim said exactly what I was going to. Don’t forget all the “other” taxes we have to pay in addition to income tax.
It’s not fair, but no system is.
Snowballer – good luck on your goal of becoming a CPA. I’ve been one for 5 years and it’s a good field to be in.
Your post inspires me to ask for your comments about how Joe taxpayer can use the tax code to maximize their financial position. The tax consequence of decisions, like considering the marginal tax rate, is an important factor to making good choices. I am glad you choose this topic as I often see confusion over what the marginal tax rate is. Let’s kick it up a notch. In my view, the tax code is written to encourage investment. Pure and simple. Investment income is exempt from FICA tax. I’m talking about income from dividends, interest, rents and the like. Understanding marginal tax rates is an important step toward understanding that we can’t retire until we have invested our earnings and created sources of income to replace our wages. Keep up the good work!
rugman11 (comment #44) – as I understand the proposal, it would cap those deductions at 28% for earners currently in any bracket above 28%. That means going from 249,999 to 250,000 in income would make no difference in how much of a deduction you would get for charitable donations.
Thanks a whole lot. I always used turbo tax. I knew that it went up progressively, but wasn’t sure how. I knew that I was paying a fairly normal rate (25%) but also knew that deducting more seemed to give me back more than 25%. Now I know where the cutoffs are and that this really just looks like a graph that changes slopes on these certain marks. Making more than 82,250 isn’t near as scary anymore. I also am not as worried about making side money, knowing now I can see directly how that will effect my taxes.
Jim,
The SS security tax I agree is regressive in the fact that the amount of income taxed is limited. There is the tier that pays the tax and the tier that doesn’t, though I doubt that will be the case for long.
Other than that it seemed to me that determining a progressive vs regressive tax by how much discretionary or total income one has is dishonest. Words mean things and regressive means percentage of that marginal dollar goes down as total goes up. That’s the definition used by economists and tax professionals as far as I know.
As far as my lottery *tax* comment, I consider it a tax because the government collects the money and it goes to pay for things that taxes might otherwise pay for, and it is a fact that poor people buy more lottery tickets than rich people. They pay not only a higher percentage of their income, but also the total collected. It fits the definition of a regressive tax (though it is a voluntary tax). Lottery tickets are a bad math tax, and poor people are more likely to have bad math skills.
As far as sales tax, I never said it wasn’t a bigger burden for poor people. If a low income person and a high income person both spent the same amount it would be a regressive tax, but as a general rule that isn’t the case. And that is the argument for why basic needs (like food) aren’t typically subject to sales tax. It may be slightly regressive, but you can’t spend money you don’t have (at least not for long). And I was questioning the statement that high income people don’t spend if they have more money. That argument doesn’t hold water at all with the observed tendency of most of us to lifestyle inflation.
Finally regarding the gas tax: If a low income person doesn’t have the money they shouldn’t have a car. Though it limits ones options in life there are plenty of people who forgo the expense, or who get by with a single vehicle for their household. However I considered it a flat tax like the sales tax for the same reason: If you don’t have money you are more likely to drive an economical car that uses less fuel for the same number of miles, hence keeping spending in line with your income.
Generally as your income goes up your consumption goes up. And I know there are special cases. There are people who have to drive long miles and burn ridiculous amounts of fuel though they are poor. I am speaking in generalities as tax law based on special cases doesn’t make for very good law. There are people who read this site who live as though they have significantly lower income than they do and therefore pay a much lower percentage of their income in consumption taxes, just as their are low income people who spend more than they make and pay a very high percentage in consumption tax.
But my original point and questions still stand. What taxes have been reduced on the poor in the 20th century that resulted in a boom in the economy (because they typically have very low tax burden so a reduction in tax doesn’t mean a whole lot more money being spent)? And isn’t the call to spend money to circulate through and provide jobs and the trickle down effect pretty much the same thing?
I appreciated this post and Eric’s comment (#12).
Very helpful.
The simplest thing to do is figure out how much tax will be saved from your mortgage interest (easiest if you aren’t borderline between two tax brackets) subtracting the standard deduction from your annual mortgage interest (which is a shrinking number) and multiplying it by the tax rate of your income bracket. Then divide that savings by your interest total and multiply that by your original APR. This is now your effective mortgage interest rate. Compare that to alternate investments. If you save enough in taxes and have a low interest rate such that you only pay 4% effective mortgage interest and can make more than 4% net profit -after taxes- elsewhere (determining that is a lot harder), don’t pay off your mortgage early. OK that doesn’t sound EASY but it is basic math and if you write it all down and put the numbers in the right place, you can decide what’s best for you.
I never knew this is how it worked! Thanks, JD!
“We are currently in a real estate market with very low prices and mortgage rates at all time historical lows. How many times during ones’ life does this happen?”
Some CA real estate valuations may have fallen 30% or so, but they still are up hugely above the inflation rate since 2000 (+60% ?). There aren’t many places on the coasts where one could reasonably suggest that housing prices are “low” yet, just lower than the former rediculous heights.
Better to wait until interest rates go UP (and downpayments are required). At that point, you will see what “low” housing prices look like, because they will then be firmly tied to incomes, rather than to how much of someone elses money you can convince a shady mortgage broker to lend “justified” by his crooked appraiser.
Principal is “forever” (well, 15 to 30 years at least), while interest rates are cyclic.
CJ was right… I don’t know what you are getting at by explaining effective taxes rates because any additional deductions (from itemizing) would be reducing your highest level of income so the marginal tax rate of your highest dollar is all that matters not your effective rate.
I don’t know why people in the $250k crowd are whining about a couple of percentage points. Historically, they should still be very, very, very happy. Keep in mind that top marginal tax rates were at over 90% during years past and as recently as the 1980s, 50% was the norm. Be thankful that tax rates are historically low and if you’re smart about managing your tax situation, the impact should be minimal. For example, if you get paid $1 million this year and have access to a non-qualified deferred compensation plan, you can defer the last $750,000 of income and still be at the $250k. For business owners, this gets even easier…but I digress. On the historical scale, this tax increase is like going from a 5% mortgage rate to 5.125%. Big deal.
I was wondering about that! I can’t believe I “caught” a mistake you guys didn’t 😛
I’m French, so I didn’t realise it was a mistake, you see, but I was thinking it was a weird system. The French system is very similar to the American one, incidentally, except with different values.
I have always wondered about two things that “save money”: one, when people spend money to pay less taxes. They still end up with less money in the end, so what’s the point? At least money spent in taxes helps schools, hospitals, roads and such. Money spent for something you don’t need to spend less in taxes is money wasted.
The second thing is the obsession that people have, here too, about going down a bracket to “pay less taxes”. You pay less taxes, but you earn less money, and with the way the system works, you have less money in the end. Again, it looks more like “boycotting taxes” than wanting more money.
I’m all for paying only what you need to pay, but some people are excessive in trying to pay less taxes. Sometimes you can pay more taxes and still spend less. Plus, taxes are like a donation to the state, to schools, to hospitals, to roads, to the police… To everything that’s state funded.
@Jim / #54
“Gasoline taxes take a much higher % of the income of poor people compared to rich. Please don’t argue that driving is proportional to income.”
Even though it’s true?
You would prefer we ignore the fact that not only do rich people tend to drive MORE (having jobs to go to and taking vacations – keeping in mind airline fuel is also taxed, and tacked on to your ticket price), they also drive BIGGER vehicles that require more gas? Truly poor people don’t drive at all. They often don’t have jobs. Even if they do, they can’t afford a car, so they walk or take the bus. Thus, they pay no gas tax at all.
So why were we supposed to give you that point for free, without “arguing?”
On the notion of a flat tax. Yes, it would be simpler to implement and calculate. However, it violates two public policy principles that the Federal government has typically upheld.
First, it has been generally agreed that a progressive tax system is more fair (whether or not you agree is another question). However, you could also ask, “Is our tax system with all of the various credits and deductions actually fair?” That’s up for debate.
Second, the Federal government has generally chosen to not only use tax law as way to generate income, but it is also to incentivize certain actions that it wishes to promote such as owning a home, giving to charity, and even having children. In most of the proposals I have seen for a flat tax, deductions and credits would be eliminated to streamline the process.
I have no answers here, but I am enjoying the discussion. Further thoughts on overarching taxation structures?
Thanks for the explanation of this strange issue. While people who aren’t math-challenged may think all this is “simple math,” I sure don’t. It’s inexcusably complicated. How did our tax system get to be so convoluted? And shouldn’t it be simplified, so each person can do his or her own tax return without having to hire a professional to get it right?
Gee, I’m sorry about the poor guy (41) who has to scrape by on $100,000 after taxes. Life is rough, eh? Maybe he’d like to try to get by on my after-tax income of around $34,000, or the $24,000 I will be trying to live on after I retire or get laid off.
I live in a state adjacent to California. While most of our housing prices never bloated as much as they did on the Coast (some did: my housing value tripled during the bubble, and it’s still possible to buy houses in the million-dollar range within walking distance of my very ordinary home), other costs are comparable to California’s. Our sales taxes are almost 10%. Our gas rose to around $4/gallon in the late fuel inflation. Our electricity costs are among the highest in the nation–partly because our rates support a nuclear reactor that supplies power to California. Our water bills would take your breath away. Food is no cheaper here than in California, and we have neither the choice nor the quality that Californians have. Our public schools are laughable — in university classrooms, I’ve heard the products of those schools say that Wisconsin is a Rocky Mountain State, that all black children are by definition “children at risk,” and that World War I was the only thing of note that happened during the 19th century. Please: let me struggle along on a hundred grand in San Francisco or Santa Barbara…somehow I think I could make do.
As for Shara’s remark (59), “If a low income person doesn’t have the money they shouldn’t have a car. Though it limits ones options in life…” In a city that has no viable public transportation — which describes most cities in the United States — one of the options it limits out of existence is the option of going to work at all. I drive 18 miles one-way (36 miles a day) for the privilege of earning enough to fork over $18,806 in taxes. That’s not considered an especially long commute here. To get to work, you have no other reasonable option than to drive. I tried the bus: two hours going and two and a half hours coming back, in a conveyance so rickety it delivered a ride way too rough for commuters to do any work or even to read a book. Do you really think a 4 1/2-hour commute to cover 36 miles makes sense?
Well, among the many things that don’t make sense in our lives, the tax system ranks among the foremost. The whole lash-up needs an overhaul!
“You would prefer we ignore the fact that not only do rich people tend to drive MORE (having jobs to go to and taking vacations – keeping in mind airline fuel is also taxed, and tacked on to your ticket price),”
Rich people do not drive “MORE” proportional to their income. Many of them have no job at all, living off their investments. Its middle class workers who have jobs where they have to go to work. They also fly just as far on vacation, they just don’t fly first class, stay at outrageously expensive hotels and have to go back to work after a week or two. The rich can stay in a fancy hotel for a month without worrying about getting back to work.
The rich who do work, do most of their travel on the company’s dime. They don’t personally pay for first class plane tickets, the expensive hotel rooms, restaurants, resorts etc. either, much less the taxes on them.
I doubt there is anyone who decides whether to work based on a 2%-5% difference in tax rates. In fact, I doubt many people pay any attention to the difference between a marginal rate change from 15% and 25% except to notice their paycheck is not as big as they would like.
More money is more money.
“I know PhDs who lived on ramen for years, MDs who slept only a handful of hours while as residents, engineers who worked in some of the harshest conditions, and small business owners who worked out of their cars hauling other people’s poop (clogged sewer lines are a bitch, but someone has to clear them).”
Spare me. Not one of them would trade places with a farm worker who has worked all their life just as hard and gets paid a lot less. And that farm worker produces a lot more value than most of the investment bankers and mortgage brokers of the world.
The only “fair” tax is if everyone pays the same dollar amount in taxes. That tax at the federal level in 2008 would be about $7,000 for every man, woman AND CHILD. If you have a piddling little family of four, that’s $28,000 just in federal taxes. That’s your FAIR SHARE.
So now hopefully you realize that the virtually all of us are nowhere near paying our fair share and the country is really being propped up on the backs of the very richest. And now we want them to pay even more. Why? Because we can get away with it. You can call it progessive or regressive but please don’t call it fair.
There is a HUGE difference between a “rich” person who doesn’t have to work or is traveling on their company’s dime while screwing over the common workers and a working couple in an area with a high standard of living (such as NYC or other metro areas) who are making $250k combined. Making 6 figures does not make you rich, it makes you middle class in much of the country. Maybe not in the middle of nowhere where you can buy a house for $100g, but in the urban parts where $400g barely gets you a starter home, that extra taxes you pay hurts, especially since you have lost a lot of the tax deductions that lower income people take for granted. The tax hikes hurt people in areas where the cost of the standard of living is high and helps people where the standard of living is cheap.
And anyone can be a farmer. Doctors and lawyers put in the time to learn a skill that the farmer cannot do. Sure, the farmer works hard, but a premium is paid for SKILLS that are needed. If you have no skills, or skills that no one has a use for and therefore aren’t willing to pay for, then do not complain that you are getting a low wage.
And no, I’m not making anywhere near that much money, and I’m not someone with an advanced degree.
No, the attorney’s comment is perfectly valid. It’s not that $250k would subject ALL of their income to the top rate, but why would you even work past $250k when the majority of your income is taken away???
Combine 39.6% (Obama’s new top rate) with 15% self-employment tax, with a 10% state income tax, plus another 10% from the phase-out of deductions, and that attorney will be paying 75% of every dollar past $250k. I WOULD STOP AT $249k TOO!!!
“And anyone can be a farmer.”
Well, no they can’t. As any number of well-educated hobby farmers have discovered. But I was talking about farm workers.
“Sure, the farmer works hard, but a premium is paid for SKILLS that are needed.”
Which has nothing to do with how hard they work or have worked. It mostly has to do with the opportunities they had.
Anyone who is in the United States ought to understand their standard of living is based more on the country they live in than their own skills or effort.
“in the urban parts where $400g barely gets you a starter home, that extra taxes you pay hurts, especially since you have lost a lot of the tax deductions that lower income people take for granted”
What deductions are those? The fact is that most “lower income people” are not eligible for many deductions that wealthy people take for granted. When their retirement accounts went south last fall they had no ability to write off the losses the way those with investments could.
$400,000 is well above the median home price in all but a handful of markets. And where it isn’t, the folks making $250,000 are getting compensated accordingly. That is often not true for the folks with a median income in those same cities.
“So now hopefully you realize that the virtually all of us are nowhere near paying our fair share and the country is really being propped up on the backs of the very richest.”
That simply is not true. You are taking the entire federal budget and pretending the only revenue is from the income tax.
If my wife and I only had to pay $14000 in federal taxes we would be deliriously happy. Just to be clear – that is 25% of $56,000. And social security taxes alone are over 6% – 13% if you include our employer’s portions. Then there is the gas and other excise taxes we pay directly on the products we buy. And there is the corporate income tax and excise taxes that get included in the price of things we buy. Only the income tax collects more from the rich than others and that accounts for less than half of federal revenue.
And when you look at the state level you see an even more pronounced pattern with regressive sales and property taxes as the primary source of revenue.
If you want to argue everyone should pay the same amount, perhaps you can explain why an infant should pay the same share as a wealthy adult. It ought to be clear rich people get more benefits out of government. They benefit more from living in United States. They have a bigger stake in the country. They place a larger burden on government – demanding more services to support their wealth.They ought to pay more, the same way someone with an expensive car or home has to pay higher insurance.
“Combine 39.6% (Obama’s new top rate) with 15% self-employment tax, with a 10% state income tax, plus another 10% from the phase-out of deductions, and that attorney will be paying 75% of every dollar past $250k. I WOULD STOP AT $249k TOO!!!”
And this would be bad because … the problem with the United States is a shortage of math-challenged attorneys? I am not sure we lose anything if our attorney is unwilling to work for “only” $25 per hour net after taxes. That is still well-above the median family income.
I just want to note that the self employment tax is only 2.9% (medicare) after the cap of 94k. Self employment tax like regular social security is capped.
I’m personally less concerned with the tax rates. I generally support what the changes are trying to do. For instance I do not believe mortgage interest should be deductible at all. Why reward people for buying too much house? The bigger problem is the growing complexity of th tax code. The whole thing needs to be torn down and rebuilt.
“Combine 39.6% (Obama’s new top rate) with 15% self-employment tax, with a 10% state income tax, plus another 10% from the phase-out of deductions, and that attorney will be paying 75% of every dollar past $250k. I WOULD STOP AT $249k TOO!!!”
Fortunately, the capitalist system is designed to respond to issues like this. If the attorney decides that the marginal value of each extra hour worked is not high enough for him, he has the choice to not work it, which then means that some other attorney is able to exchange their time for the money that is now available. The second attorney will do this because the net income of an extra hour worked is more valuable to him than the hour. If no attorney will take that hour, the customer will either decide that he didn’t need the work done, or he will increase the price until he finds an attorney.
Of course, I don’t know if we could all live with the tragedy of lawyers choosing to work only 50 hour weeks and live on the resulting penurious 1/4 million salary, but I guess we’ll deal with that when it happens. (And yes, there are lots of other factors like barriers to entry, etc etc).
@Ross Williams
“It ought to be clear rich people get more benefits out of government. They benefit more from living in United States. They have a bigger stake in the country. They place a larger burden on government – demanding more services to support their wealth.”
The rich don’t get “more benefits out of the government” or “place burdens” on it. What you mean is that the rich have “made the most of a capitalist economic system and a republic that values liberty”.
If the government were the source of liberty, I’d agree we should pay it royalties on its patented idea in proportion to how much we benefit. But the government is not the source, it is the guardian.
Mr. Obama was stated that US Constitution is deficient because does not list many things that the government should do, only things that it should not do. He misses the point. The GENIUS of the Constitution is that it IS a list of things the government should not do!
‘What you mean is that the rich have “made the most of a capitalist economic system and a republic that values liberty”.’
No, that isn’t what I meant. What I meant is that without government to protect them and their possessions, the rich would be a world of hurt. For a country that “values liberty”, the United States has an awful lot of people in prison.
“But the government is not the source, it is the guardian. ”
And the rich have a lot more that needs to be guarded and get a lot more benefit from having that guardian.
But it is absurd to suggest that is all government has done for the rich in the United States. They made a lot of their money only because of public investment of tax dollars. Abolish public education, roads, police, fire departments, courts, libraries and thousands of regulations that limit other’s “liberty” and the rich would not be able to maintain their standard of living.
What an interesting discussion. Two points call out for a response:
Don @ 30: Normally our income falls in the 15% marginal bracket because we make between $16050 and $65100 of taxable income.
But because of the way tax is computed on disability income, she doesn’t pay tax on all of her income. In fact, if our AGI is $44000 or below, she only pays tax on half of it. For every dollar of income over $44000, she has to declare an extra $0.85 in income, which is then taxed at 15%.
Effectively, in the region where our AGI is between $44000-50700.48 our Federal marginal tax rate is (15 + 0.85*15)% = 27.75%.
Don, this is a thought-provoking example–specifically because the case you’re talking about is (presumably Social Security) disability income.
You’re basically taking the side of people who don’t want to pay more taxes, even though a substantial portion of your own family’s income derives from the social safety net that is funded from those taxpayer dollars. Interesting.
I would guess that the rationale behind this kind of phased treatement of disability income is because it’s meant to keep people out of dire poverty. And when you’re talking a family that’s at about the median household income for the US (which is in the neighborhood of $45K), that’s not dire poverty.
If you can see the justification for people to want to lower their tax bill by working less, perhaps you can understand why it makes sense for the federal government (i.e., the taxpayers) to recoup some of that disability income when it doesn’t meet the means test.
I am NOT knocking SSI disability, by the way–my mother is supported by it and it is literally a life saver. I’m just sort of bemused that someone who is funded by “the system” is knocking “the system”. It sure seems like cutting off your nose to spite your face.
Secondly, Tyler at 41, your post was quite eloquent and your frustration is evident. But when I was reading it, I was again reminded that people are wired to be much more aware of what they DON’T have than what they DO have.
If you’re making $142K and paying $42K a year–and because you don’t mention spouse or offspring, which significantly impact finances and taxes–I assume that you must be single with no kids. And dude, if you’re a single person clearing $100K a year after taxes, you are truly in the elite of the wealthiest people on earth. I am not making this up. It’s a lot easier to be aware of what you don’t have (a $500K house) than what you do.
My suggestion to you is to travel. Specifically, take some time in some developing countries and get a good sense of exactly what your citizenship in America buys you.
Even spending a little time in places where there is no sewer system or electricity, where little kids beg on the street (think about that–think about all the implications of that, what effects that must have all their lives, no school, probably no literacy), where civil engineering is so far behind that one good rain shower shuts down the main highway for a full day, where health care is rudimentary…it is bound to have a huge impact.
It will put into sharp relief exactly what you’re “buying” with your tax dollars. Maybe you could even take it as far as Warren Buffett does, and realize that it wouldn’t be possible for you to be where you are today without the baseline standard of living (sanitation, education, transportation, etc, etc, etc) that the US has enjoyed for a long time.
Even if you personally have come a long way from an impoverished background, the society around you–that has built the structures that lets you succeed now–rest on the contributions of those who came before.
Would you really have it another way?
Finally: Tyler, if you’re making $142K/year, by traditional lending standards you’d still be able to afford a $500K house, or damn close to it. (A loan 3X income plus a 10 or 20% down payment would get you there.) Last–do you really think that $500K houses would stay at that price point if magically all taxes went away?
Not sure why the attorney in the article has a false premise or why you say he doesn’t understand marginal rates. The 249,999th dollar may have been worth it to earn because maybe he gets to keep 65 cents of it. Maybe he only gets to keep 45 cents of each dollar after that (because of move to next rate and phasing out of deductions/crdits etc.), and 45 cents isn’t worth it were 65 cents was. Sure nobody actually loses money by working more, but doesn’t the return eventually get low enough to make it not worth the effort?
Furthermore, maybe I shouldn’t comment since I can no longer see what CJ said about mortgage interest deductions, but I’ll take a stab at it, why wouldn’t this discussion use marginal rates? If a have a $4000 deduction and I am firmly in the 25% bracket, then the $4K reduction of taxed income is worth $1k to me, because all of this $4K would have been taxed at 25% (this is if I truely am more than $4K into the 25% bracket. I agree you could cross brackets if you are not that far into that bracket, but then you’d just look at the next marginal bracket down for calculating your savings, you’d never use your effective tax rate.)
“Sure nobody actually loses money by working more, but doesn’t the return eventually get low enough to make it not worth the effort?”
If $25/hour is not worth the effort then how do you get anyone to work for minimum wage?
“he gets to keep 65 cents of it. Maybe he only gets to keep 45 cents of each dollar after that”
Maybe not. If you look above, the highest bracket is 35%. The next lowest is 33%, so the actual difference is between 67 cents and 65 cents. Or, in the case of our attorney, $67 net versus $65 for a little less than an hour’s work.
I think the idea that tax brackets have any real impact on people’s willingness to work is mostly imaginary. Its based on that common misunderstanding of marginal tax rates.
“If $25/hour is not worth the effort then how do you get anyone to work for minimum wage? ”
You really think someone who makes $100/hr would be enticed to work more for minimum wage? You’re talking about two different people. The little kid across the street will run an errand for $2/hr, does that mean you would to?
“If you look above, the highest bracket is 35%. The next lowest is 33%, so the actual difference is between 67 cents and 65 cents. Or, in the case of our attorney, $67 net versus $65 for a little less than an hour’s work.”
he’d net nowhere near that because of other taxes as well, though your main point is a good one.
“You really think someone who makes $100/hr would be enticed to work more for minimum wage?”
I thought we were talking about someone who was only making $45/hour after taxes. 🙂
And that is not entirely a quip. The reality is that what people get paid anticipates, to some extent, their tax bill. Because they are competing for jobs with people who will be paying the same taxes.
That lawyer sets the number of hours he will work and then bills his clients at the highest rate he can to maximize his income. If his taxes were lower, he might lower his price. He might also choose to work less. It is highly doubtful he would decide to work more.
A great post on a frequently misunderstood subject, J.D. And some excellent conversations that it sparked. Some of my own thoughts:
1) Although the taxes on earned income are progressive (mostly), there are other types of income that aren’t taxed in the same way. Long term capital gains are taxed at no more than 15%, prompting Warren Buffett to quip that he was paying less in taxes (as a portion of his income) than his secretary.
2) As long as the effective marginal tax is below 100% (at which point every additional dollar earned is siphoned off as taxes), there isn’t actually as a disincentive to earning more money, only less incentive. If there is a margin tax rate of more than 100% (as there may be in cases where additional money will force you to be taxed under the alternative minimum tax system), there’s a disincentive toward earning more money. Until you reach that point, however, it’s an individual choice as to whether the increased work is worth the additional money; even with a marginal tax rate of 99%, there might be people who feel earning an extra $100 to keep an extra dollar is worthwhile.
3) Figuring out the ‘fair’ amount of tax each individual owes as measured by how much they benefit from government services would be difficult, if not impossible. Some reasons:
-Many government projects benefit many groups, not necessarily equally. (A road improvement near a Wal*Mart benefits the shoppers, the employers, the owner of that Wal*Mart, and the Wal*Mart shareholders, to say nothing of anyone else who simply drives on that road. How much does each group benefit from this road, and how much should each group be charged for that roadwork?)
-Many of the benefits from government action are intangible and difficult to quantify. (The existence of the FDA cuts down the rate of dangerous products being sold. How much of a benefit this is depends on what you consume, how much you consume, and how FDA regulations alter the availability of alternative products for consumption. Figuring out the costs/benefits of these effects for even one single person would be mind-boggling, let alone for an entire country.)
-Many government services only come into play at particular times and circumstances (Fire departments and police serve as a sort of community insurance policy; you fund them with taxes, so they are available to you in the future. This is one area where the argument that wealthier people derive more benefits from the government come into play; if you have more stuff to insure against fire or theft, you benefit more from stopping or recovering from these events.)
All of these reasons make it nigh impossible to come up with a tax system that pulls from people the same amount of money as they gain in benefits as a result of government action, meaning we have to rely on alternative measures (income, spending, investing) as proxies and tax them accordingly.
“Until you reach that point, however, it’s an individual choice as to whether the increased work is worth the additional money; even with a marginal tax rate of 99%, there might be people who feel earning an extra $100 to keep an extra dollar is worthwhile.”
I think this misses the point to some extent. The question is whether making a $1 is worth the effort. It doesn’t really matter whether you get paid $1 per hour and get to keep 100% of it or get paid $100 per hour and get to keep only 1%.
The only way moving into the top tax bracket would matter is if you think its worth working at $134/hour but not at $130/hour. That being the difference in taxes for someone making $200/hour, which is close to what you have to be making to reach that top bracket.
@Ross Williams:
I admit, I was engaging in some hyperbole with my example. I merely meant that the top marginal tax rate, regardless of what it is, will not necessarily dissuade everyone from doing extra work. If the amount you make after taxes justifies both the quantifiable costs (the gas to get to work, the wear and tear on the car, etc) and the more intangible costs (giving up an hour of time with your family to earn some extra cash), then the logical choice is to work more, regardless of what percentage of the gross you pay out in taxes.
Now, obviously, that calculation is going to change depending on your job, hourly income, and cost of doing business. If you’re making $10 an hour at Wal*Mart, working an extra ten hours to net one dollar probably isn’t a good option, especially if you spend more than a dollar on gas getting to and from work. On the other hand, if you’re an ex-US President and can get $150,000 for making a one hour speech, it’s probably a good deal, even if you get to keep ‘only’ $1,500 after taxes.
For a more realistic example, let’s consider two men named John and Ted. They’re accountants, and as such, are fairly logical guys who love numbers. Both are in a (hypothetical) 40% marginal tax bracket. Being that it’s tax season, they’re approached by their boss to work some overtime, at $30 an hour gross, or $18 an hour net. Their thought process:
-John decides that an hour of his time is worth $20, and thus turns down the overtime and spends the weekend with his family.
-Ted calculates that his time is worth $15 an hour, and leaps at the chance to work the overtime.
Same tax rate, same amount of money earned, different sense of motivation.
“John decides that an hour of his time is worth $20, and thus turns down the overtime and spends the weekend with his family.
-Ted calculates that his time is worth $15 an hour, and leaps at the chance to work the overtime.”
That isn’t the question here. The question is whether that extra $2 would have changed John’s calculation.
The consequences, if that $2 makes a difference, is that there is more work for Ted. Of course, if he really needs John, the employer will simply raise the pay offer by to $34 and John will jump to it because he would be making his $20.
BTW – why does this employer think either one of these guys is going to do extra work for only $30/hour? He must be paying them close to $200/hour for their regular work in order for them to be in the imaginary 40% tax bracket.
The actual top bracket is 35% which means these guys would be taking home $19.50. And if they were in the next lowest bracket it would be 20.10. So the actual difference is $.60 per hour. I think you hit it on the head when you said the cost of gas. That and parking are going to be bigger economic factors than the tax rate.
It’s not so much a question as to who is ‘dumb.’
I strongly believe there is now way to put a price on the feeling of being happy not to have a mortgage. If that describes you, then pay off that mortgage. It will make you happier and you will live with less stress.
How can you place a price on that?
@ Ross: This is the trouble with coming up with examples off the top of my head; I have a tendency to come up numbers that make no sense. I was just using round numbers for the hourly wage and the tax bracket, to make the math simple. You can either tack on an extra zero to that figure (for $300/hour gross) or assume that the example took place in the past, when the tax brackets were much higher and inflation hadn’t bumped up salaries quite so much. (Or the near future, when we might have to raise taxes on everyone (including two pencil-pushers making a fairly low hourly wage) to cut down the deficit and cover other spending.)
You are right, about the effect of the tax rate in discouraging or encouraging work. (I haven’t been disagreeing with you, just trying to clarify my thought process.) The higher the marginal tax rate, the more people (in theory, at least, see below) will decide that it isn’t worth the extra time and effort to make more money. The result will be either more work for those willing to work for the effectively lower wages or great compensation to serve as further inducement.
Of course, we’ve been dancing around the fact that most people usually don’t calculate out the value of their time, or for that matter, consider the effect of taxes on their real wages. Most people, when offered overtime, would think in terms of their gross hourly wage (or 1.5 times their gross hourly wage, as the case may be) without bothering to sit down and figure out how much they’ll actually be taking home after taxes, transportation costs, and any other applicable expenses. Ask someone how much they make, after all, and most like they’ll give you a gross number, either in hourly or yearly terms.
As a result of this, people have a tendency to act in ways that have little to do with the idea of maximizing marginal utility.
I’d wager 50-70% of Americans do not understand effective tax rates, and misunderstand plans like Obama’s for this reason.
Thank you for pointing it out!
Next, you should debunk the logic behind the attitude taken by the quoted Alabama couple, namely “why work harder when that extra money will just be taken away from me?”.
The argument is false, and often used disingenuously for political means.
Perhaps I missed it, but did you define effective tax rates?
I think effective tax rate is a misnomer. People pay SSI tax of 6.5% on income up to $100,000. You have to add that to the real marginal tax rate. So the person making $83,000 has a marginal tax rate of 34.5% while the person making twice that has a marginal tax rate of 28% and even someone making 4 times as much still has a lower marginal rate.
That is a little misleading since there are no deductions on the amount taxed for SSI. That means the person who is at the $83,000 level in taxable income, probably grossed close to that 100,000 limit and won’t have to pay SSI taxes on any additional money.
But if your taxable income is $33,000 per year, your marginal tax rate, including SSI, is almost certainly higher than someone making $172,000 per year. Your effective rate depends on your deductions.
I have a friend who was all upset and HAD to like others make sure he did not go over 250K. He owns his own business now, How can he be so confused? This carries over from the days of being an employee. You work X hours and take home Y in your paycheck. Then you work 1 or 2 hours overtime and X goes up but Y goes down. Most of us know that this is due to moving to a higher withholding bracket and at the end of the year there wasa real benifit to working those overtime hours. This is where the big misconception takes place. Even my own wife saw it this way. Before the election she was (amongst many other reasons) opposed to Obama and the tax increases. One year we did make 400K. I showed her that with the tax increase we only would pay 4K more than we did. I really would not care about paying the extra 4K if I could ever make that much again. I only care about how it is being spent.
wow!!! clearly answered my question l always have. Thanks