How Much Are People Actually Paying in Taxes? Part I: Taxes and Equitability
If you read last week’s post on the Electoral College, skip to the next paragraph (and thank you!). If not, welcome! Not So Small Talk provides summaries and overviews on currently relevant topics in science, economics, entrepreneurship, technology, and politics. Today we’re talking taxes, last week was the Electoral College. If you like what you read, subscribe to receive these in email before they’re posted on Medium.
When people talk about their taxes, they usually mean income taxes, i.e. what’s taken out of their paychecks. But, people pay many other types of taxes as well. Sales taxes are well understood, but corporate taxes, property taxes, payroll taxes, and capital gains / dividend taxes are usually the domain of experts.
There’s a lot to cover, so we’re focusing on what’s likely to be up for debate right now and doing it in two parts. Today we’ll discuss income, payroll, and sales taxes and the equitability of all of them. In Part II we’ll cover corporate tax, the economics of taxes, and Donald Trump’s tax proposals. Part I is a bit long, but we know you can handle it. Let’s dig in!
Almost half of Americans pay little to no federal income tax and wouldn’t benefit from tax cuts on income. Seriously.
In America, there are over 160 million Tax Units — that is, individuals or groups of individuals who file a single tax return. Just under 80 million of those pay $0 in federal income tax. That’s shocking fact number one (congrats if you already knew that).
So how can so many people not owe income taxes? Historically income tax was never meant to be a “broad tax base.” Many people don’t earn or report any income. Also, there are deductions that reduce taxable income and tax credits that reduce tax bills dollar for dollar. Some tax credits are even refundable, which means rather than you paying the IRS, the IRS pays you. Feels like Soviet Russia. The basic formula for income taxes looks like this:
Income — Deductions = Taxable Income
Taxable Income * Tax Rate (%) — Tax Credits = Income Taxes Owed
Here’s a quick example assuming $100 in income, a 30% tax rate, a $20 deduction, and a $25 tax credit:
Notice the power of tax credits in the last column.
There are three common deductions:
- The standard deduction ($6,300 for individuals and $12,600 for married couples), available to everyone who doesn’t itemize, or list out specific deductions.
- The personal/dependent exemption ($4,050 deduction) can be taken for each person “financially dependent” on you and only you (you can count yourself)
- The state and local income taxes paid deduction (only available if you itemize)
The most popular tax credits are for parents. You know what else is for parents? Sleepless nights, lots of germs, a total loss of freedom, and sore nipples. Or so we hear. Let’s look at another example:
Melania married Donald Drumpf, had two little dependents with him, and last year she made $77,200 while Donald raised their kids (AKA a campaign of tyranny). Filing jointly, they have $16,000 in deductions for dependents ($4,000 for each family member) and the $12,600 standard deduction, making their taxable income $48,600. Federal income tax rates increase progressively under brackets for “marginal” dollars earned, so their $48,600 is taxed like this:
- 10% on the first $18,450 or $1,845
- 15% on the next $30,150 or $4,522
That’s a total bill of $6,367. But wait, there’s more! The Drumpfs can claim the Earned Income Tax Credit of $5,548 and a Child Tax Credit of $1,000 per child, for $7,548 in total credits. Tada! A $6,367 tax bill is now a refund of $1,181. Although we’re ignoring some complexity (we’re super good at ignoring complicated stuff), this is generally how it works.
Given the above picture, those worried about high income taxes either earn more than most Americans or don’t realize how little they pay in federal income taxes, if anything. Middle income Americans and even those with somewhat above average salaries won’t benefit from lower income tax rates. Now we know that politicians would never mislead middle income Americans to benefit wealthier Americans, but just in case someone tries to do that, keep this math in mind.
Okay… do the rich pay all of the taxes?
When it comes to income taxes… sort of. Higher income Americans are paying more than their share of income tax if you just compare dollars earned in income vs. dollars paid in income taxes.
That said, marginal tax rates are actually close to historic lows. Moar graphs!!
So where does my income go if not to income taxes?
Welcome to the world of payroll taxes. Everyone who earns an income or pays an income, even one $10,000/year or lower, pays payroll taxes. If you employ yourself, you pay a double payroll tax! Payroll taxes are mostly withheld income tax and the FICA taxes which cover Medicare and Social Security.
Let’s talk through some examples:
Medicare is a 2.9% tax, split 50/50 between the employer and employee. There’s an additional 0.9% on incomes above $200,000 (or $250,000 for a couple). Social Security imposes a 12.4% tax on the first $118,500 of income, with the employer and employee going 50/50. Every dollar of income over $118,500 is untaxed, which more than covers that 0.9% Medicare tax. To see how that plays out, look at the FICA Tax Rate for the various salaried folks.
Self-employed folks pay the full FICA taxes themselves, which you can see by comparing the FICA Tax Rate for the salaried vs. self-employed folks.
Everyone paying or earning any income pays payroll taxes, evening the income picture from before. However, with capital gains, we go back to a more uneven world, this time in the opposite direction.
The devilish details of capital gains taxes and the carried interest exemption
Capital gains are income (or gains) from investments (or capital), e.g. profits from selling stocks or bonds for more than you paid for them (appreciation), or from dividends earned as a shareholder. These gains are subject to income taxes, unless they’re held for a year or more — then they’re taxed at long term capital gains rates, which are 15% to 20% federally versus up to 40% for income taxes. So who earns the most in capital gains?
In the left column above, you can see that top 1% earns over 60% of the capital gains, the top 25% earns over 90% of the capital gains. The skew is similar for itemized deductions and exclusions, but let’s move on to the carried interest controversy.
Investors often agree to share 20% of their profits with their investment managers, those making the investments. This profit-share is called “carry” or a “carried interest.” Carry is arguably income because the investment manager didn’t invest the money that created it. But it’s also arguably a capital gain because someone invested and held the investment for over a year. The difference of more than 20% in the highest income tax rate versus the capital gains tax rate causes a tax savings of almost $20 BILLION each year and is how finance professionals often have lower tax rates than their secretaries.
The rich get richer, and the poor pay sales taxes
The one grand unifier that we all pay is sales tax. Fun trivia fact: five states have no general sales tax (Alaska, Delaware, Montana, New Hampshire, and Oregon) and six have sales tax rates over 7% (California, Indiana, Mississippi, New Jersey, Rhode Island, and Tennessee)
Lower income folks have to spend a larger share of their income on goods/services, which means they end up paying more sales tax as a share of their income. That’s just how it works out. When we combine all sources of income and all types of taxes, we get a picture like this:
This may look fair depending on your philosophy, but it isn’t the full story. The top 0.1% are in a whole different ball game from even the top 1%, as a complex tax code and enough money for armies of lawyers and accountants can open up crazy schemes.
In 1992, the 400 highest-earning Americans paid a federal income tax rate of 27%. Twenty years later that rate was down to 17%, leading to folks like billionaire investor Warren Buffet pointing out that he unfairly pays a lower rate than his secretary, and Donald Trump having potentially not paid any taxes (we still don’t know!).
And that’s where we’ll leave it. In summary:
- About half of all Americans (“tax units”) don’t end up having an income tax bill.
- Capital gains skew heavily in favor of wealthier Americans and sales taxes more heavily impact lower income Americans.
- People’s share of taxes owed ends up correlated with their share of income, except for the top 0.1%.
Next week, we’ll change gears and talk about Artificial Intelligence. But stay tuned for Part II of Taxes the week after where we’ll cover corporate taxes, broader tax policy questions, and proposals President-elect Trump.
Edit: Thanks Javan Behler for catching a miscalculation!