Be forewarned. This entire post is just a rant. It even delves into politics a bit. You probably won't learn anything that helps your personal finances or investments here.
I'm getting sick of hearing stupid comments from people who have no idea how the tax code works. Now I'm no CPA, but I have a reasonable understanding of our system, so hear me out.
Exhibit A: People complaining Mitt Romney doesn't pay enough taxes.
The man paid $3.2 million in federal income taxes last year on an adjusted gross income of $20.9 Million, an effective tax rate of 15.3%. $3.2 Million! I paid $18K on what is a pretty average doctor salary. Mitt Romney paid as much in taxes as 178 doctors! Yet he is getting a lot of flak for his “low” tax rate, despite the fact that no one even remotely suggests he is cheating on his taxes. He is just following the rules.
The comments I hear and read about this are idiotic. One commenter on the website of a well-known business magazine says it's unfair that Mitt pays only 15.3% while “Joe American pays 45% of his income in taxes.” Joe American, if you consider him a married father of two taking the standard deduction and earning the average American salary, doesn't pay federal taxes at all. Zero. Zip. Nada. Mitt Romney's effective tax rate is 15.3% higher than Joe American. Not to mention his actual tax bill is $3.2 Million higher. You think Mitt is getting $3.2 Million worth out of our military, roads, welfare programs, and national parks? Hardly. He's paying his own share, and the share of thousands of Joe Americans to boot. How about a little gratitude people? And we haven't even gotten to his charitable contributions yet.
Others suggest it is unfair that Mitt pays at the lower capital gains tax rates. They point to the fact that Barack Obama in 2010 paid $454K on $1.73 Million income (26% effective rate) and New Gingrich paid $995K on $3.1 Million in income (32% effective rate). There's a few things to remember before we criticize.
First, as the IRS looks at it, Mitt is retired and living off his retirement savings. He doesn't have much earned income. Obama and Gingrich are both still working. (Incidentally, Mitt has been retired for some time. He didn't even take his salary as governor of Massachussetts. He's pretty much decided he's going to spend his retirement in politics instead of on a beach somewhere.)
Second, remember the reason capital gains tax rates are lower than earned income tax rates. A good portion of capital gains is simply inflation. If you buy a stock in 1990 and sell it in 2010 for twice the price, you have to pay tax on the entire increase, even though half of it is from inflation. It doesn't make sense to pay a higher earned income tax rate on it.
Third, low capital gains rates encourage investing. We keep the rate low to encourage people to invest their money, building our economy and our nation. The higher that rate, the more likely someone is to spend their money instead of investing it, or at least not invest it in the most economically efficient way.
Fourth, what's your effective tax rate? We already saw Joe American has an effective tax rate of 0%. Mine was 8.3% this year, and none of that income was from capital gains. I'm not in “the 1%” but I am in “the 5%.” Mitt is paying at a rate twice as high as my rate (and far higher than most Americans.)
Now, don't get me wrong. I don't think it's fair for hedge fund managers to be able to take their earned income as capital gains. And I wouldn't even mind seeing capital gains rates go up (most Americans wouldn't pay them anyway since most of their investments are inside retirement accounts.) But pretending Romney is paying at a lower rate than most Americans is just ridiculous. Marginal tax rates are not effective tax rates.
Exhibit B: The Average American Pays a Higher Effective Tax Rate than ExxonMobil!
This one comes from an article on Think Progress. They suggest the average American has an effective tax rate of 20%, while Exxon is only paying 18%. This fact, while probably true, is incredibly misleading. As we saw above, if a doctor has an effective tax rate of 8%, most Americans are paying much less. How can the average possibly be 20%? It's because of the 1% of Americans such as Barack Obama and Newt Gingrich who are paying 26% or 32% on their income. If they would have been transparent with their readers, they would have used the median effective tax rate, which is around 4% (down from 12% in 1980, by the way.)
Also consider that corporations aren't people. The money earned by a corporation goes to its shareholder after taxes are paid at the corporate level. So if the corporation pays tax at 18%, then gives the money to the shareholder as a dividend or a capital gain, the shareholder then pays another 15% on it. 33% seems like plenty of tax to pay on that income to me.
Exhibit C: The “Temporary” Payroll Tax Cut
Last year Congress cut the employee portion of the payroll tax by 2% and now our elected representatives are spending way too much time arguing about whether to extend it or not. This tax break effectively cut employed Americans' Social Security tax by 1/3. They wanted us to spend more to stimulate the economy, and figured this was a good way to do it. Democrats are trying to make political hay by painting Republicans as wanting to now “raise taxes on the little guy” (who never asked for this “temporary” tax break in the first place, since he prefers a robust Social Security program to an extra $35 in his paycheck every 2 weeks.)
But remember that this tax is supposed to pay for social security benefits for the elderly, so grandma doesn't have to eat Alpo. We're supposedly very worried that this money is going to run out because people live too long thanks to safer cars, better nutrition, and improved medical care. So what do we do? We cut the tax that pays for it?! We should be raising the tax (or at least decreasing the benefit), not cutting it if we want to save this justifiably popular program. This is what happens when Democrats (who want to help the little guy) and Republicans (who want to cut any and all taxes) get together. They cut one of our most sensible taxes and endanger one of our best-run government programs. Idiots!
The Conclusion
I'm no extremist. Our tax code is ridiculously complicated. We need to make it fairer by eliminating many questionable deductions and irregularities. We probably also need to raise taxes (on all of us, from the poor right on through to the 1%) since we've apparently decided we want to spend more money on public “goods” such as military invasions, increased welfare benefits, and interest on the public debt (although some believe we can eliminate the deficit and the debt just through spending cuts.) What I'm positive we don't need, however, is the class warfare and politicizing of our tax system caused by ignorance, deliberately misleading statements, and idiotic Congressional actions.
Great piece and I agree pretty much everything here. Something important is missing from the Mitt story: he donated $3 million ($1.5 to the mormon church). He gave 16.4% of his AGI away.
Mitt’s effective 15.3% rate probably was not all that tax efficient when you consider his hefty donations.
Source: http://www.businessweek.com/news/2012-02-01/romney-tax-returns-show-7-million-in-donations-over-2-years.html
“doesn’t pay federal taxes at all.”
He doesn’t pay federal INCOME taxes at all – he still pays federal payroll taxes. In all fairness.
“You think Mitt is getting $3.2 Million worth out of our military, roads, welfare programs, and national parks?”
No, of course not. But I think he’s getting a lot more than $3.2 Million’s worth out of the infrastructure and a government that allows him to earn, you know, $20.9M per year.
As for the thought that 3.2M is a lot in an absolute sense…sure, but 20.9M is even more. Then there’s the whole idea behind our tax bracket system, and that $1000 means a hell of a lot more to a family of four earning 25k/year than $100,000 means to Mittens.
Great article.
Also, I think that you should link to some modern books that are about tax reform. I haven’t read any yet, but I think that this book has been getting a lot of good press:
http://www.amazon.com/The-Benefit-Burden-Reform-Why-Need/dp/1451646194
You could even become an amazon affiliate and make money if someone buys it after reading your article.
@Anon-
You are aware I’m an Amazon affiliate and have an Amazon aStore which includes at least one book on tax reform, right?
I like “Taxing Ourselves” if you’re looking for something pretty non-partisan discussing various reform proposals.
@Sam-
You may disagree, but I look at payroll taxes as pre-paying for a benefit. Sure, those of us who make more are paying a little more for our benefit, but eventually just about everyone is going to use Social Security and Medicare benefits. I think of it more as forced retirement savings than a tax. SS is even a regressive tax, although the benefits are highly progressive. In fact, for a low earner, SS is a fantastic investment. Sure, Mitt doesn’t have to pay SS tax on his last $20 million or so, but he also gets no more benefit out of SS than a typical doc.
@AW-
I suspect we just have different political beliefs and will have to just agree to disagree. That’s just fine. I don’t expect everyone to agree with me, especially on political subjects. But if you carry out the concept that “$1000 means more to me than to Mitt” to its logical conclusion, it isn’t a pretty place. Should there be some redistribution of income? I think most would agree there should. We just disagree about how much. “Fair” is in the eye of the beholder. But you surely agree that at a certain level of redistribution, the economy will shrink, hurting the very ones that the redistribution was supposed to help.
@White Coat Investor:
As much as people like to point at the Laffer Curve, here it is in practice:
http://i254.photobucket.com/albums/hh113/Rusty_griff/400px-Neo-Laffer_curve_svg.png
As for the economy shrinking above a certain level of redistribution, I’ll grant you that may be the case. But to think that we’re anywhere close to that level is to ignore history. The top marginal tax rate right now is at 35%. The top tax rate during the 50s/60s, that time we like to think of as the glory days of American manufacturing, Apple Pie, and job creation? 90%. Nine-zero.
It’s not about the top tax rate. Almost no one paid at that 90% rate. It’s all about the rate at which the job creators are paying. Think about a primary care doc in private practice. If he gets his income up to the point where he’s paying 75% of his marginal dollar in taxes, do you really think he’ll keep doing those 12 hour days? So what does he do? He works 8 hour days and cuts his staff. Jobs lost. Now, everyone is a little different. Some might knock off at 50%, some at 60%, some at 75%. But everyone’s got a point where it just isn’t worth it. Are we at that point now? I hope not. Because we are going to need higher taxes to dig out of the hole we’re in. I wish our politicians would have made that grand bargain last year where they cut $3 in spending for every $1 in tax increases.
Marginal rates right now approach 45% for a lot of doctors under amt phaseout range, and their wives can be well over 50% with soc sec if you count that. Is that enough? Add in the fact there are no where near the deductions and loopholes of the 50s and 60s many job creators cace already historically hefty rates. My wife quit work, why work 50 hours per week to make $20000 gross a year more after taxes?
My husband and I both work at Fortune 100 companies (not as docs) and we have 1 kid. We paid 22% Federal income tax, $85K on $354K of income. State income taxes took another 4.2% or $15K. That’s $100K which I think is a lot of money. All that income was “earned / ordinary” since most of our investments are in IRAs/401Ks and we didn’t sell to trigger any capital gains; dividends are not significant. Our marginal tax rate is 40%. I think marginal tax rates are high enough. Do we take the marginal rate into consideration when making decisions — absolutely. Would I start up a business and employ some people? No way — too much risk and effort when I would end up paying so much of it in taxes. Ditto for free-lancing or consulting on the side. Raise the marginal rates to 50 or 60% and I’ll quit my six figure job as soon as we pay the last college tuition for the kid (6 years from now). By raising marginal rates on “the rich” I think it will have the effect of saying — don’t make more than $X (250K?) or we’ll just take it from you.
Don’t get me started on $11K property tax (not a big house but schools are excellent), ~$15K sales tax, etc that also hits us.
I agree with WCI that taxing capital gains and dividends at higher rates would be unfair. Also that reducing the payroll tax was not a good idea. I think other than the lowest 25%, everyone else should be paying something — at least 5%.
@WCI: Agreed, very few people actually paid that marginal tax rate, but the fact remains that tax brackets were more equitable in the past when we had tax brackets that actually accounted for incomes over 2.5M, as opposed to now where they cap out at a bit over 300k. The argument that us “job creators” will stop working if we go back to the tax rates of the Clinton era is hilarious, and even those tax rates were much lower than when our country experienced the rapid growth of the 50s/60s.
So I have one major issue with this whole discussion. How are the 1% not paying their fair share when ~ 50% of americans do not pay federal income tax? Yes, these same people do pay the payroll tax, but this is not a tax. It is a forced retirement program and a health insurance program for the elderly and poor (most of which goes to the same people). Yes, I get it, $1000 is more important to low income families. But how is our tax system disproportionately hurting low income families when a high percentage of them already pay $0 in income tax. They can not pay less. This whole discussion that obama is creating about paying your fair share, in my opinion, is feeding into a sense of entitlement that our society has.
Mitt Romney isn’t “just following the rules”, him and his friends made the rules. They rigged the rules. Remember in the 1960’s, America’s golden age, world’s highest standard of living, the 91% tax rate on income over 400,000. How has that rate dropped to such relative lows? Could it be cronyism? Could it be legalized tax evasion? Could it be big business owning the state? Or just all three? In addition, Mitt Romney does nothing for society. The elusive obvious. He exploits money and the cracks the monetary system has in order to make his money. Typical financier, produce/contribute nothing get everything. Mitt Romney isn’t a doctor, an engineer, inventor, craftsman, or even regular laborer. He does no work. He is a socially accepted conman. He literally just exploits businesses in his venture capitol job and exploits money.
The effective corporate tax rate is around 13%-15%, way to low.
The reason that 2% reduction was implemented into Social Security was to act as a slow poison to dismantle/ privatize social security. That 2% reduction is going to be made permanent. Creating a huge budget hole shortfall for SS program, causing politicians to complain that it does not work, when in reality SS is a extremely effective, extremely popular program that costs nothing ( admin. cost to run SS are razor thin negligible.) You pay into social security you get your money back later. In reality, you pay into social security, the funds get used for wars, to funnel money to business criminals, then politicians who robbed you complain that SS is a “entitlement”. Yes if I paid you money I’m entitled to that money back.
I suppose you don’t think banks are useful to society in any way? They contribute nothing. Except allowing other businesses to get the capital they need to succeed.
How many people work at Sports Authority, Domino’s Pizza, Staples and other firms Bain Capital helped to succeed? That’s “doing nothing?” I’m sorry, I don’t agree.
Interesting theory about the 2% SS tax reduction. Not sure I agree that the 60s was some kind of a golden age either. I’m pretty sure there was a whole lot more tax evasion going on when 91% of income was being confiscated.
DerekD – I agree that you have a point that people with money get more say in the rules. But again, 50% of the american population do not pay federal income tax. ZERO DOLLARS. So how can we help them any further? Should our society just pay them? You are also right in that social security is not an entitlement and saying it is wrong. It is a forced retirement system. What the government has done as far as taking money from it is just criminal. But that does not make the income tax system bad. Medicare and Medicaid are more of an entitlement, however everyone with an income pays for these and I have no issue with them. Federal income tax supports many programs that are what I would call entitlements. I would be very interested as to what all the american citizens that pay zero federal income tax have done for our society that is better than Romney. You may think Romney does nothing for society, but the fact is that he paid ~ 3 million in federal income tax and donated another ~ 3 million to charity (you may not choose the same charity, but it is still a charity). That is ~ 30% of his income and 6 MILLION DOLLARS. So your argument that he does nothing for society is just wrong.
The often cited 50% figure is misleading. Moving beyond the fact that we’re currently in the middle of a recession (and the number is inflated, doubly so for 2009 because of the passage of the “Making Work Pay” tax credit), it’s overlooking the fact that these people are paying other federal taxes, one of the most significant being the federal payroll tax (others being excise, gasoline, etc). If you just take the excise tax into account, the 2009 number drops to 17%.
Secondly, as much as you guys want it to be not true, the majority of people not paying federal income tax are the elderly, disabled, or students.
All of this culminates into this: if you take into account federal, state, and local taxes, the bottom 5th of households pay 16% of their income in taxes.
But that’s much less interesting than saying 50% of households pay no taxes.
A more detailed analysis can be found here: http://www.cbpp.org/cms/index.cfm?fa=view&id=3505
The figure isn’t misleading insofar as we’re discussing federal income taxes. Yes, the poor pay other taxes. State income taxes (my state has a flat 5% tax after deductions and exemptions), local income taxes, property taxes, sales taxes, gasoline taxes, and even payroll taxes (which I see more as a mandatory pension program.)
But that’s a lousy counterpoint to the point that 50% of Americans don’t pay federal income taxes at all. That’s far more households than students, the elderly, and the disabled. I don’t think expecting someone making $10K a year to chip in $100 into the federal coffers is asking too much, even for someone living below the poverty line. The biggest reason those 50% don’t pay is that we’ve blended our welfare system into our tax code. I don’t mind a welfare system. But let’s call it what it is. It’s apparently far more palatable to our society to call it an earned income credit or a child tax credit than to call it welfare. I also think a welfare system would be better run by the states. We would still have quite a progressive tax system without blending in credits for the poor, deductions for the middle class, and phaseouts for higher earners. I dunno, maybe I’m wrong. Maybe it is better to wrap it in with the federal tax system. But I doubt it.
Bravo. The original article, and all your responses to those left-of-center arguments are spot on.