Our Regressive Income Tax

For three quarters of a century, the American electorate has taken the existence of a progressive income tax for granted. The rich, so the underlying reasoning for such a tax goes, can afford to pay not only more taxes than the less fortunate, but also a higher percentage of their incomes. This principle has been implemented through the use of “tax brackets” that impose a higher percentual income tax on additional dollars earned as total income increases.

As late as 1979, the top “marginal tax rate”—the tax on these additional dollars—was as high as 70%. Today, thanks to reforms instituted by the Reagan and the two Bush administrations, the maximum rate stands at half that: 35%. A married couple earning less than $16,900 annually pays no income tax at all. From there, with increasing income, taxpayers pass through the 10%, 15%, 28%, and 33% brackets until, at $336,550 taxable income, they top out at the 35% maximum.

On the surface, this arrangement appears reasonable. Voices of protest against it have been few. Calls for greater progressiveness have been limited to the extreme left; the philosophy of “soak the rich,” highly popular during the 1930s, is so out of vogue that it appears almost quaint. On the right, rumblings in favor of a non-progressive or “flat” tax are occasionally heard—multimillionaire presidential hopeful Steve Forbes campaigned on a flat tax platform in 1996 and 2000—but have never made it to the floor of Congress. Most Americans, it appears, are comfortable with a scale starting at zero and ending at 35%.

Numbers can lie

The widespread assumption that the tax brackets described above represent a system of progressive taxation is, however, false. In reality, the current U.S. taxation system is highly regressive: as incomes increase, the tax burden on additional dollars received generally decreases—especially, as one moves out of the middle class into the upper class, and from there to the stratosphere of wealth, the richest 1/10 of 1% of Americans. How is this possible? In short, it’s because most of the money received by wealthy and very wealthy Americans is not subject to the tax brackets described above.

To test your knowledge of the U.S. tax code—its fundamental precepts, not its arcane loopholes—read the following five scenarios. In each case, I’ve created a hypothetical situation in which you are about to receive an additional $10,000 over what you’re already earning. Try to guess what the marginal tax rate will be—in other words, try to guess how much you will not get to keep. For example, if you get to keep $7,000, then $3,000 is going to Uncle Sam, and the marginal tax rate is $3,000/$10,000, or 30%. In each case, I’m assuming you’re married, but similar results would be obtained if I used the tax tables for single persons instead.

Case #1: You work as an assistant store manager at a mall and earn $30,000 annually. Your wife feels it’s best if she stays at home with the kids, but wants to bring in extra income, so she’s started a home business on eBay. She works very hard, and has managed to earn $10,000. How much tax will be paid on her earnings?

Case #2: You’re a white-collar cubicle-dweller like Dilbert and make $80,000 annually. This year, you’ve done a tremendous job, so your boss has decided to set aside $10,000 to be paid to you as a bonus. What’s the tax?

Case #3: You’re a junior partner in a law firm and make $250,000 annually. You also own some income properties. One of these you’ve had for three years. You bought it for $400,000 and hoped it would rise rapidly in value, but it’s only gone up to $410,000, so you’ve decided to sell. What will you pay on the gain?

Case #4: You’re an investment tycoon earning $2,000,000 annually from various stocks and bonds. One of the stocks you earn has increased its annual dividend to you from $100,000 to $110,000. How much of the windfall will the government take?

Case #5: You inherited an enormous fortune from your grandparents and receive $20,000,000 each year from your vast holdings, most of which you know little about because your accountant manages them for you. Five months ago, your dear Uncle Thurston died and left you tens of millions of dollars in additional wealth that you haven’t even sorted out. Your accountant, however, is looking out for you, and notices a stock that old Thurston had bought in 1950 for $1,000. It was worth $15,000 when he died, and has since dropped back to $11,000. Your accountant is weeding out such small holdings, and doesn’t like the recent drop in price, so he’s sold it for you. The proceeds represent a $10,000 gain over what Thurston paid for it. How much of this gain will be consumed by taxes?

Have you made your guesses and written them down? Then let’s proceed to the answers.

Case #1: Because your wife is running a business, she must pay self-employment tax, which is equal to 15.3% of earnings. (This percentage drops to 2.9% around $100,000 of income, but she’s nowhere near that!) Half of the self-employment tax is tax-deductible, so she must pay income tax on $10,000 less $765, or $9,235. Your combined earnings put you in the 15% bracket, and 15% of $9,235 is $1,385 (rounded). To this must be added the self-employment tax of 15.3% of $9,235, or $1,413. Add this amount to the $1,385, and you get $2,798. Your true tax rate is 28%.

Case #2: You may be thinking that the self-employment tax was created to tax self-employed people (who are often wealthier than in my example) more heavily than the average working stiff. Actually, it doesn’t work that way, as we’re about to see. Your employer has earmarked $10,000 for you—but you won’t see an additional $10,000 on your pay stub. Why? Because if your employer declares it as “gross,” he’ll have to pay an additional 7.65%, or $765 in employer payroll taxes. If you do the math, you’ll find that if your employer is willing to expend $10,000 and no more, he’ll have to list the gross amount will be $9,289, and forward the remaining $711 to the IRS. That’s money you’ll never see, but it’s part of the equation nonetheless.

So on your pay stub, you’ll see a gross of $9,289, from which $711 will be deducted in the form of “employee payroll tax contributions,” sometimes known as FICA. Because you earn $80,000 per year, you’re in the 25% tax bracket, so you’ll pay 25% of the $9,289 gross, or $2,322 in federal income tax. Add this to the $711 your employer paid and the $711 you paid, and Uncle Sam’s total ‘take’ is $3,744, or 37%. As you move up through the ranks of the middle class, the income tax progression indeed starts to bite!

Case #3: At $250,000 per year, you’re in the 33% bracket. But fortunately for you, that doesn’t matter when it comes to so-called “capital gains,” i.e. money you make by selling something for more than you paid for it. The tax rate for property held for more than one year is 15%, ($1,500), so 15% is the effective tax rate.

Case #4: You’ve probably guessed that by the time you achieve this lofty status, tax brackets become virtually meaningless, and you’re right. It’s true that if you worked for a living, you’d be in the 35% bracket… but from a tax perspective, you’ll do better sitting in your easy chair and collecting dividends. Since you’ve made this very wise choice, your tax rate is 15% regardless of income. So pony up $1,500, keep the $8,500 remaining, and complain about the 15% if you’re so inclined.

Case #5: Because the $10,000 we’re talking about here result neither from work, trading, nor investing, but from the most tax-favored of all activities, inheriting, you’ve hit the jackpot!

Indeed, you are in the fortunate position of being able to take advantage of what is arguably the biggest “loophole” of all in the U.S. tax code—namely, the stipulation that potential capital gains liabilities are wiped away at the moment an asset passes into an inheritance. In practical terms, what this means for you is that any tax liability on dear Uncle Thurston’s lifetime gains expired the moment the old fellow did the same. You therefore owe 0%. Zero, nada, zip. It can’t get any better than this, can it?

As a matter of fact, it can. You see, by the time your uncle died, the stock had increased in value from $1,000 to $15,000. (In the past, an inheritance tax might have been owed, but President Bush II did away with that.) Although no taxes were due, the so-called “tax basis” of the stock was bumped up to $15,000.

You are now selling the stock for $11,000, or $4,000 less than it was worth when it fell into your lap. If you’re in the habit of considering the IRS stingy, think again: the IRS will never tax Thurston’s very real gain, but it will compensate you for your paper “loss.”

Come next April 15th, your accountant can list the $4,000 as a “short term capital loss” on your tax return, where it can be used to offset any short term capital gains you may have. Since you have a huge portfolio that your accountant is rejiggering, there are bound to be some gains of this nature. To folk like you, these are taxable at 35%. Multiply that by the $4,000 paper loss, and you are entitled to a $1,400 reduction in what you’ll owe the IRS.

So to summarize all this, you not only get to keep Uncle Thurston’s original investment of $1,000 plus the $10,000 in appreciation in full without paying a penny in taxes. Your other generous uncle, Uncle Sam, has an additional $1,400 tax credit waiting for you that will go toward the short term capital gains taxes you would otherwise have had to pay with real dollars. For you, the effective tax rate on the net appreciation of an inherited asset is negative 14%!

Come on, you’ve got to be kidding!

Many readers will doubtlessly be incredulous at calculations showing that the marginal tax rate on the lower-middle class is around 29%, goes up into the high 30s for the middle-middle and upper-middle, and drops to zero, and even into negative territory, as one goes from rich to super-rich. Surely, either the math is wrong, or the examples are contrived.

On the first count, I can safely state that the math is indeed correct. I even had my examples checked by a CPA.

As for the second, while it’s true that the examples are “made up,” they have not been manipulated to remove them from what happens in the real world; rather, great care was taken to reflect how the taxation system is practically applied in everyday life.

As a general rule, as people get wealthier, the percentage of their income derived from wages and salaries decreases, while the percentage of tax-favored income like capital gains, dividends, and inheritances increases. This is due to several factors. First, with increasing income, people are generally able to save an ever-higher percentage of their incomes: the poor save negatively, going into debt; the middle class struggles to make ends meet; the rich invest. Second, the ability to preserve and increase wealth over generations belongs almost exclusively to the very rich: fortunes in the millions often grow over many decades and even centuries, while modest ones will be consumed when only one generation falls on hard times. Finally, while the middle and lower classes have little opportunity to structure their incomes to fit the tax code: they have their wages and salaries, very modest interest and dividend income, and nothing more. The wealthy, by contrast, often own multiple corporations, trusts, and other business entities, and can structure the profits to take advantage of the tax code—for example, paying themselves modest salaries but generous dividends from their businesses, and the like.

In fact, for simplicity’s sake, I have only included the most basic regressive aspects of the tax code in the above examples. In reality, the system is even more sharply regressive than I have indicated because there is a plethora of tax loopholes benefiting either exclusively, or primarily the very rich, such as various forms of trusts, the use of lightly-taxed stock options as a substitute for normally taxed salaries, tax-free municipal bond investments, and so on.

Regressiveness didn’t “just happen” by mistake

It hasn’t always been this way. In the early 1970s, for example, the highest marginal tax rate was a whopping 70%—which was actually down from a maximum of 91% in 1954. This rate, however, was applicable only to so-called “unearned income,” i.e. dividends, interest, and the like. The maximum tax on “earned income”—wages and salaries—was 50%.

The tax codes during the Golden Age of the middle class, the 1950s and 1960s, differentiated between money earned through work and money generated by investments, and favored the former. Today’s tax codes do the exact opposite, giving tax breaks to dividends and capital gains. (Earned income, incidentally, bears the full brunt of income taxation plus a surtax in the form of payroll taxes, which are highly regressive: they start at a flat 15.3% of income, and drop to 2.9% when earnings exceed $94,200. Needless to say, unearned income is entirely exempt from this tax.)

Tax law is famously complex; the entire IRS code fills several volumes. Not one sentence in these volumes, however, “just happened.” Every nuance of the tax law sparks heated debate among legislators. The regressiveness built into the tax code, therefore, must be seen as intentional: a deliberate means of relieving the very rich of the burden of taxation, and shifting that burden squarely onto the shoulders of the middle class.

Selling regressive taxation to the unwary

Middle class Americans, struggling to get by, justifiably resent the large bite that taxes take out of their paychecks. Like everyone else, they would like to see the bite reduced.

President Bush and his cronies skillfully exploited this wish when they engineered the last tax “reform,” the real purpose of which was to slash the share of taxes being paid by the ultra-rich. By coupling an enormous gift from the U.S. Treasury to the very wealthy with a miniscule reduction in middle-class taxes, Bush successfully hoodwinked average Americans into thinking that his plan was designed to benefit them.

Nothing could be further from the truth. Bush’s gift to the rich was entirely paid for by gargantuan Federal deficits—deficits that more than doubled the national debt during his administration. To put what this means into perspective: the amount of money the government was forced to borrow in order to finance Bush’s tax cuts (and his Iraq adventure) is greater than the total of all borrowing, plus accumulated interest, racked up by all presidents before him—greater than the cost of two world wars, the cold war, the space race, and the Vietnam war combined!

The entire U.S. population will labor under this debt load for generations to come. Future conservatives will be limited in their ability to cut taxes, and future liberals will be limited in their ability to institute new social programs, as the cost of servicing the Bush debt gobbles up an ever increasing portion of government revenue. Who will receive all of this interest money? At least a part of it will go to ultra-rich Americans who invested the gifts they received from President Bush in government bonds.

The road back to fairness and sanity

The tax relief that the middle class so richly deserves has been rendered impossible by the huge deficits of the last eight years. In other words, a fairer tax system cannot be created by cutting taxes on the middle class, but only by requiring that the very rich pay their fair share of the cost of restoring our nation’s fiscal health.

But getting the top 1/10 of 1% of Americans to give back any of the tax gifts given to them by President Bush isn’t going to be easy. Regardless of who wins the Presidency in 2008, tax increases will become inevitable as the deficit, and the interest on it, spirals out of control.

If prior experience is any guide, we can expect that our elites will seek to place as much of the burden as possible on the shoulders of the middle class. Income tax percentages will be increased, especially in the upper brackets, which will be accompanied by much rhetoric about how the tax hike is primarily aimed at “the wealthy.” The new, higher brackets, however, will kick in well inside the range of middle class income—say, at $70,000 or $80,000 per year. In this way, wage earners in the upper middle class will bear the full brunt of the higher tax rates. The truly wealthy, however, whose incomes consist principally of dividends, interest, and capital gains, will walk away largely unscathed. The middle class will be duped and betrayed once again.

If this scenario is to be prevented, we as middle class Americans must learn to ignore the rhetoric, and instead to examine in detail the structure of any proposed changes to the tax code. Specifically, we will need to look beyond the tax brackets, and to focus on how income from various sources is taxed. Some important steps toward tax fairness could be:

  • Repealing tax preferences for dividend income
  • Increasing taxes on capital gains (other than sale of personal residences)
  • Closing tax loopholes involving stock options and other forms of compensation typically paid only to the very rich
  • Restoring inheritance taxes (which, contrary to the noise often made about “death taxes” that purportedly endanger “family farms,” were paid only by the very wealthy when receiving large inheritances)

Once we understand the true middle class impact of any proposed tax code changes, we must make our voice heard, both by communicating our wishes to our elected representatives, and by voting only for those who listen to us, regardless of party.

If enough average Americans are willing to take the time and effort to educate and inform themselves, and to engage in the political process, then, perhaps, we can take he first steps on the long road back to tax sanity—and to repair of the damage that President Bush’s policies have wreaked on the tax system, the Federal budget, and the nation.

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