I'm working on a series of posts on taxes and this is the first installment. I'll begin by using my own taxes as an example and explain a few points I frequently make elsewhere about taxes and tax rates because I think a lot of people do not understand some of the basice "features" of our tax system.
I recently finished calculating and filing for my family's federal taxes, which I accomplish myself using Turbotax. I've used Turbotax (and it's predecessors) for well over a decade and, given the frustrating complexity of the tax code, it's a necessity for me even though my returns are pretty basic. This is a consequence of the overly-complex nature of our tax system which is now so complex and opaque that substantial reform is needed. Ideally, I would like to see a system that doesn't require the use of specialized expertise or software, especially considering the potentially severe consequences of tax mistakes (ie. IRS penalties and fines). Wishful thinking, I know, but more on that later....
To begin with, here are my specific tax figures rounded to the nearest 100 dollars:
|Final Tax Liability||$2,900.00|
|Effective Tax Rate:||3.41%|
|Total Fed. Tax Liability||$9,800.00|
|Total Fed. Effect Tax Rate:||11.53%|
As tax filers, my wife and I file jointly and have three young children. Our gross income in 2010 was about $85k. We do not itemize deductions, so we take the standard deduction plus exemptions for all the family members which reduces our taxable income from $85k to $55k ($11.4k for the standard deduction plus an additional $18.2k for 5 exemptions). This alone drops our top marginal bracket from 25% to 15%. More on that in a future installment.
The income tax owed for $55k of taxable income is $7400. That's not what we actually pay though, because now come tax credits which directly reduce the amount of tax owed, unlike deductions and exemptions which reduce taxable income. Since we have three children we get $3,000 cut off the tax bill right there ($1k per child, called the child tax credit). We received another ~$750 in credits for money we spent on child care as well as education expenses for my graduate school studies. Altogether, those cut the tax bill almost exactly in half - from $7400 to $3700. Finally, we also received the "making work pay" credit of $800 which was the result of President Obama's Stimulus package passed in 2009. This is a temporary credit that won't be around next year unless Congress extends it. Also, for some reason this "credit" isn't in the "credit" section of the 1040, but is considered a "payment" and so is added to the tax we paid through withholding. Technically it doesn't count as a credit even though it has the same effect which is strange. Anyway, after all the credits and deductions, the final amount we owe the federal government is $2900 which makes our effective tax rate 3.41%. To get a more accurate picture, we can add in FICA taxes, which totaled $6900. Unlike income taxes, FICA taxes are very simple. There are no deductions, expemptions or credits. Adding FICA bumps our total tax liability to $9800 or 11.53% of total income. If I wanted to get really technical, I could add in the employer-contributed portion of FICA, which is another $6900, but I'm going to leave that out for a few reasons which I won't belabor here.
So what does all this mean for my family? $85k in income is doing pretty well, what I would regard as solidly upper-middle class. In terms of income distribution $85k puts us in the middle of the 4th income quintile (the 4th quintile contains incomes between roughly $62k and $100k). In percentage terms, we're above the 90th percentile which means we make more than 90% of Americans over the age of 15 who earned income in 2009 (Yes, I'm comparing my 2010 income to 2009 statistics - sorry, it's the best I can do, but good enough to illustrate my points).
So, do I consider myself overtaxed? No - I think that claim would be difficult to make considering my effective tax rate is below 4% (or 12% if one include's FICA). Taxes are pretty low in the US, much lower than marginal tax rates would suggest thanks to all the deductions, credits, etc. in the tax code. At income levels more modest than mine, the tax burden goes down even further - all the way to zero. At poverty levels for many people, the rate goes negative - meaning their "refund" each year is more than they paid in taxes - the child tax credit is a big factor driving that. In the end, with the Bush tax cuts, about 1/2 of income earners in the US are effectively paying no income tax at all (they are, however, paying FICA). I think this narrowing of the tax base through income-tax reductions is a problem for several reasons which I'll discuss in a future installment.
The next installment will discuss marginal vs effective tax rates in a bit more detail.