Thursday, January 19, 2012

Effective tax rates are highly progressive

There's a lot of chatter these days about whether the rich pay a high enough tax rate. Warren Buffett comes to mind, as do the recent attempts to shame Mitt Romney for paying only 15% of his AGI in tax.

Confusion arises only if we look at part of the picture. For example, everyone who is employed pays social security tax and personal income tax. But only those with investment income pay capital gains and dividends tax. And in order for investors to receive capital gains and dividend income, the companies they have invested in—with after-tax dollars—need to pay a corporate income tax. Consider, for example (and I'm simplifying), a worst-case scenario person who is self-employed, whose income puts him in the top Federal and California income tax bracket, and who has substantial income from investments. He pays 35% federal income tax, 9% state income tax, a 15% social security tax, and a 2% medicare tax. Any income he receives from his investments—which were originally made with after-tax dollars—is effectively what the companies he owns have earned after paying a 35% corporate income tax, and on top of that he must pay 15% of what is distributed to him—he might be paying an effective tax on his total investment income of as much as 45%. Depending on how the numbers stack up, this unfortunate person could be paying an enormous effective tax rate—well over 50%—on his total income.

When Warren Buffet says he only pays a 15% effective tax on his income, that's because his income mainly comes from capital gains and dividends, and he is completely ignoring the fact that the companies he owns must pay a corporate income tax of as much as 35% before he can receive those gains and dividends.

Fortunately, we do have access to facts that do not distort or color the picture. The chart below uses the numbers as crunched by the Congressional Budget Office. The effective total tax rate shown is the ratio of total federal taxes (income, social security, corporate, excise) divided by comprehensive household income. As Greg Mankiw notes, our tax system is highly progressive: "the rich face average tax rates more than twice those of the middle class, and about seven times those of the lowest quintile." And these effective tax rates include all the benefits of whatever deductions may have been available to individuals and companies along the way.

Greg Mankiw also has a nice summary of how progressive our tax system actually is:

1. The U.S. personal income tax is generally progressive, and substantially so. Click here to see the numbers. The average tax rate for tax returns with over $1 million in income is 25 percent. The average tax rate for returns with income between $50,000 and $75,000 is 7 percent.
2. It is arguably better to use an average tax rate that is all-inclusive. That is, we should include not only personal income taxes but also payroll and corporate income taxes. CBO analysts regularly do that. They find a substantially progressive tax system, as I have pointed out before.
3. If we added transfer payments (which are essentially negative taxes), we would find an even more progressive fiscal system. Those data are harder to come by, as data on transfers are rarely integrated with data on taxes.
4. It make little sense to aggregate payroll taxes with personal income taxes and ignore corporate income taxes.


John Short ad sinorazum said...

Unfortunately in the ponzi-scheme of the last 30 years this progressiveness hasn't mattered much. The rich made out like a bandit with their inflation-resistent stock and capital investments while the poorest buying power suffered due to this

John said...

I remember a friend of the family standing in our living room around 1964 and telling my dad "this is the greatest country in the world if you're a millionaire." I remember my dad telling him "you can't get rich working for wages."

The Tax Foundation data table in Mankiw's post supports both pronouncements.

The tax code is upside down. We as a society need to value work. Nothing gets done without work. We should tax investments at 35% and tax work at a maximum of 15%.

We need a National Bank like the Bank of North Dakota to generate some revenue and a national energy company along the model of Statoil to generate some revenue from energy profits - not just run the government like a business, let part of the government become a business. Let the government earn its money like everybody else.

We need a new paradigm. The current system works great for the few but fails too many.

Benjamin Cole said...

"As Greg Mankiw notes, our tax system is highly regressive: "the rich face average tax rates more than twice those of the middle class, and about seven times those of the lowest quintile." And these effective tax rates include all the benefits of whatever deductions may have been available to individuals and companies along the way."

I think Grannis inadvertently subbed the word "regressive" for "progressive."

For me, the total tax take of the federal government is what matters; I think we shoot for 18 percent mid-term, and 16 percent long-term. Entitlements need trimming, and agency spending needs major revisions (like cutting some departments in half).

I am less concerned that the wealthy pay "too much" in taxes. Life in the modern USA is better than royalty had only a generation ago. Sheesh, even royalty used to serve in armed forces etc.

America's wealthy are perfecting the art of martyrdom, aided by well-paid minions and mouthpieces. It is getting a little silly.

A serious issue is adequate capital formation (if the wealthy are overtaxed), but we seem to have mountains of capital.

djakel said...

Corporate income taxes are double taxation but they should not be added to the investors' tax rate. They should be added to the consumers' tax rate because he is paying the tax in the price of goods and services with his after-tax dollars. All business taxes, including the employer share of payroll tax, are included in the cost of every product or service purchased by a consumer.

If all those embedded taxes were eliminated from the business and later added to the price as a retail sales tax, the producing business would be forced by competition to lower the selling price by roughly the same amount. The consumer would pay the same after-tax price, the business would make the same after-tax profit, and the investor would pay the same investment tax as before.

So it is the consumer who is taxed twice, not the investor.

A better argument for keeping the capital gains tax rate low or eliminating it is to offset the taxation of the inflation portion of capital gains.

Bob said...


The idea of the government competing in the marketplace along with the private sector is nothing more than socialism.

Go move to Europe.


John said...

Bob: North Dakota has a state-owned bank. ND is a red state run by Republicans.

Bob said...


Republicans don't always do the right thing.

The idea of government is to govern, not compete with the ciizens it represents. There is a logical contradiction with that. Inevitably the bias will be with the government entity as they will right the rules and regulations to favor themselves. Obamacare is a good example of to much government involvement in the private sector.

After a time you have socialism and then communism.

A responsible society would force their government to manage the affairs of state on a percentage of GDP with priorities to defense and infrastructure and a workable safety net for those in society incapable of taking care of themselves. By that I mean the very destitute and infirm.

IMO, most of the problems in the country are do to too much wealth to quickly. All that money has to do something and so the availability of easy credit has been the demise of the middle class. Call it the kid in the candy store effect.

But, like most catastrophes, it has given the socialists another opportunity to ply their insidious beliefs on people who, by nature, are individuals. At the core, the founding of this country has been about the individual and his/her right to act freely and responsibly within society with a minimal amount of government intrusion.

We have lost much of that I'm afraid.


Hans said...

SS tax 12.4%
Medicare 2.9%

The effective taxes are much less than 50%, in most cases, however, taxation remains the second or third largest household item.