Taxes are complicated, but that’s no excuse to be ignorant about them. With the November election approaching, now is a good time to evaluate the candidates’ positions on taxes.
Regressive Taxes Versus Progressive Taxes
A large percentage of the populace does not pay any federal income tax. However, you might correctly observe that many of these folks are still “taxpayers” because they pay other types of taxes, some of which are “regressive.” A regressive tax is one that takes a higher percentage of income from those with modest earnings than from those who make more. However, the oft-expressed notion that regressive taxes are automatically “unfair” to those with modest incomes isn’t correct.
For example, all wage earners and self-employed individuals pay Social Security and Medicare taxes (more about them later). Both taxes are regressive, but they pay for programs that deliver major benefits to people with modest incomes. So they are not unfair to those people. Federal and state gasoline taxes may be regressive, but they are only paid by people who use the roads the taxes are intended to pay for. So they are not unfair either.
In contrast, our federal income tax system is very “progressive” because, overall, higher-income folks pay much higher percentages of their income than the rest of us. In fact, lots of lower-income and middle-income individuals pay little or nothing even though they too benefit from what the federal government does. Higher-income folks face a maximum federal income-tax rate of 39.6%. So really, if anyone has reason to complain about the federal income tax system being unfair, it’s higher-income people.
Bottom line: Whenever you hear the word “taxpayer” being thrown around in conjunction with the words “fair” or “unfair,” make sure you understand what kinds of taxes are being talked about. Regressive taxes are not necessarily unfair, progressive taxes are not necessarily fair, and emoting about taxes while refusing to deal with specifics is downright uncool.
Marginal Tax Rates Versus Average Tax Rates
Your marginal income-tax rate is the percentage of your last dollar of income that gets eaten up by taxes. If you live in a state with a personal income tax, you should include it in the calculation.
Figuring your marginal federal income-tax rate is a tricky business. As your income goes up, the marginal rate can oscillate unexpectedly because various tax breaks are reduced or eliminated over various ranges of income. For example, say you’re a married joint filer with $170,000 of taxable income after subtracting allowable deductions. Your advertised marginal federal income-tax rate is “only” 28%. However, if you have two college kids whose education tax credits are being phased out, your actual marginal federal rate could be 53%, because the phaseout rule adds 25% to your effective marginal rare. So if you can somehow earn an extra $10,000, you might lose over half of it to the IRS. Ouch! But once your income exceeds the level where the education tax credits have been completely phased out, your marginal tax rate might drop back to the advertised 28%.
Confused? Don’t blame the IRS. The fault lies with your beloved members of Congress who have created a tax system so complicated that nobody fully understands it. Even me, and I’ve been dealing with this stuff for decades.
Your average income-tax rate equals your income tax bill divided by your total (gross) income. Your tax bill is based on taxable income after subtracting allowable deductions. Then the bill is reduced dollar for dollar by allowable credits. Therefore, your average rate is much lower and usually much more conducive to good humor than your marginal rate. For example, the average federal income-tax rate for a married joint-filing couple with taxable income of $170,000 will usually be in the 18% to 20% range, while the same couple’s marginal federal rate might range from 28% to over 50%. If your state has a personal income tax, both rates will be higher.
Social Security And Medicare Taxes
If you have wages or self-employment income, you must pay Social Security and Medicare taxes. Although you don’t usually give them much thought, they can take big bites out of your wallet.
- On 2016 wages up to $118,500, 6.2% is withheld for Social Security tax. On wages up to infinity, another 1.45% is withheld for Medicare, with the rate increasing to 2.35% at higher income levels. Your employer must pay matching amounts, which also come out of your wallet (albeit indirectly).
- On 2016 self-employment income up to $118,500, you must write checks to pay 12.4% for Social Security via the self-employment tax. For Medicare, you must pay another 2.9% on self-employment income up to infinity, with the rate increasing to 3.8% at higher income levels.