Do the Rich Owe America for Their Fortunes?

In his December 17, 2009 Wall Street Journal blog entry, Robert Frank asks "Do the Rich Owe America for Their Fortunes?":

United For a Fair Economy, the left-leaning policy group, held a press call Tuesday to argue for preserving the estate tax before it temporarily expires in 2010.

During the call, Vanguard-founder Jack Bogle made an interesting argument for why the wealthy should pay the tax. In short, he said the wealthy owe a large part of their fortune to the country and its government.

“I’ve known many people in the financial business, who said I’m really proud because I did it all myself,’” he said. “When someone has the temerity to say that to me, and a lot of people do, the first thing I say is, ‘Isn’t that wonderful. You did it all yourself. I think that’s terrific. I don’t know many people that have done that. But tell me, how did you arrange to be born in the United States of America.’”

He added: “Our birthright has created enormous wealth and stability of property and for us to think that we don’t want to pay our fair share of the costs running this nation when our young citizens, let us not forget, are dying in wars out there trying to protect democracy and the nation we built up, it seems to be quite outrageous.”

Bill Gates Sr., father of the Microsoft founder, made a similar argument. He cited economists who estimate that the nation’s stable market for goods and assets adds 30% to the goods we own.

He said 50% of the annual growth in our economy is a function of new technology — technology often created with government support, since it spends $96 billion a year on research and development.

“The largest and most generous venture capitalist in the universe is Uncle Sam,” he said.
“And it’s clear that those who become wealthy did not do it alone. The people owe something back to society that enables them to create that wealth.”

Do you think the wealthy can truly “make it on their own?” What do they owe the government for their success?

Is Marijuana the Answer to California's Budget Woes?

A July 22, 2009 article by Tom McNichol in TIME magazine asks "Is Marijuana the Answer to California's Budget Woes?":

Proponents of marijuana legalization have advanced plenty of arguments in support of their drug of choice — that marijuana is less dangerous than legal substances like cigarettes and alcohol; that pot has legitimate medical uses; that the money spent prosecuting marijuana offenses would be better used on more pressing public concerns.

While 13 states permit the limited sale of marijuana for medical use, and polls show a steady increase in the number of Americans who favor legalization, federal law still bans the cultivation, sale, or possession of marijuana. In fact, the feds still classify marijuana as a Schedule I drug, one that has no "currently accepted medical use" in the United States.

(See a TIME video on Medical Marijiuana Home Delivery)

But supporters of legalization may have been handed their most convincing argument yet: the bummer economy. Advocates argue that if state or local governments could collect a tax on even a fraction of pot sales, it would help rescue cash-strapped communities. Not surprisingly, the idea is getting traction in California, home to both the nation"s largest supply of domestically grown marijuana (worth a estimated $14 billion a year) and to the country"s biggest state budget deficit (more than $26 billion).

On Monday, Gov. Arnold Schwarzenegger and the California legislative leaders a tentative budget agreement to plug the state's deficit, but it would involve making sweeping cuts in education and health services, as well as taking billions from county governments. Democratic state assemblyman Tom Ammiano has introduced legislation that would let California regulate and tax the sale of marijuana. The state's proposed $50 an ounce pot tax would bring in about $1.3 billion a year in additional revenue. Ammiano's bill was shelved this session but he expects to introduce a revised bill early next year.

(Read "Can Marijuana Help Rescue California's Economy?")

If the state legislature doesn"t act, perhaps California voters will. One group is preparing to place a statewide initiative for the November 2010 ballot that would regulate and tax the sale of marijuana for Californians 21 years of age and older. Tellingly, the group spearheading the measure calls itself TaxCannabis2010.org, stressing the revenue advantages of marijuana legalization. The group hopes to collect the required 650,000 voter signatures by January to place the measure on the November 2010 ballot.

"There"s no doubt that the ground is shifting on marijuana," says Ethan Nadelmann, executive director of the Drug Policy Alliance, which promotes alternatives to the war on drugs. "The discussion about regulating and taxing marijuana now has an air of legitimacy to it that it didn"t quite have before. And the economy has given the issue a real turbo charge."

(Read "Can Marijuana Help Rescue California's Economy?")

The legalization effort is getting serious consideration from surprising quarters. In May, Gov. Arnold Schwarzenegger publicly called for a large-scale study to determine whether to legalize and tax marijuana.

"I think it"s time for a debate," the governor said at a news conference. "I think we ought to study very carefully what other countries are doing that have legalized marijuana and other drugs."

(See a TIME photoessay on Cannabis Culture)

In California, medical marijuana sales are already taxed, and some communities are looking for ways to get a bigger slice of the pot pie. Residents Oakland are currently voting in a mail-in special election that includes a measure which would make the city the first in the country to establish a new tax rate for medical marijuana businesses. If the measure passes, Oakland marijuana dispensaries, which are now charged at the general tax rate of $1.20 per $1,000 in receipts, would see that rate raised to $18 per $1,000.

A Field Poll conducted in California this spring showed 56% of the state"s registered voters in support of legalizing and taxing marijuana as a way of offsetting some of the budget deficit. Several national polls have shown that more than 45% of American adults are open to legalizing pot, about double the support a decade ago.

Even the most ardent marijuana advocates aren"t expecting nationwide legalization anytime soon. Instead, any action is likely to come on the state and local level. For now, all eyes are on cash-strapped California, where high taxes could take on an entirely new meaning.

Interpreting the California Vote

In their May 27, 2009 column in Business Week entitled "The Power of Pushback," Jack and Suzy Welch praise the benefits of divided government. Included in their argument is an interpretation of California voters recently rejecting all of the proposed increases in state revenues in order to fund the government services provided:

Californians voted overwhelmingly to block further tax-and-spend mayhem....Finally, people are saying, "Enough!" to financial irresponsibility. In fact, if the 2-1 margin means anything, it suggests that California residents are shouting to make their voices heard.

The Welches imply the California vote was a mandate for less government. We will see how Californians respond to the upcoming deep spending cuts that will affect education, police, and firefighting services. I think a more reasonable interpretation is that many people are unrealistic, selfish, and short-sighted. They do not want fewer government services, but rather just do not want to pay for them. Others are reluctant to pay for services they do not benefit from directly. Yet, someone benefits from every type of government spending. And it is difficult to reach a consensus on what qualifies as wasteful government spending. This explains why the federal government accumulated about $10 trillion in debt between 1981 and 2009. Politicians are reluctant to reduce government services, because they are widely popular. Yet, tax cuts are popular, too.

Tax Reform

I am willing to consider reforms of the tax system. I have attended rallies for the "flat tax," the "fair tax," and a few others. One thing they have in common is that EVERYONE in attendance (that I talked to) thinks he or she will pay less under the proposed new system, despite claims that the proposals are revenue neutral. The rich, middle-class, and poor all think they will pay less. But they cannot all be right if the new tax will generate the same revenue as the taxes it replaces. So who is being deceived? My bet (and that of most economists) is that the poor and middle-class are being mislead (again). The wealthy and powerful have a potent propaganda machine.

Can we eliminate federal budget deficits by reducing spending and not raising taxes?

Many opponents of tax increases claim we can reduce government budget deficits and pay down the public debt just by cutting government spending. Is this a reasonable assertion?

The federal budget defIcit for the current fiscal year is estimated to be more than $1.8 trillion. I think we would be extremely hard-pressed to find 51 U.S. Senators who would agree to cut federal spending by anything close to that amount. We can try to elect more fiscally responsible leaders. But in the meantime, what do we do? As it stands, we are passing trillions of dollars of debt to future generations. I think that is morally and ethically wrong. So, yes, I do favor raising taxes now (while still trying to reduce government spending). And, yes, I think we should extract most of that from the wealthy. I do not agree with the assertion that if you tax the rich they will just leave. Mississippi has substantially lower taxes than Massachusetts, but I don´t see most of Boston making that move.

Is taxing the rich a misguided policy?

A May 27, 2009 article in the Wall Street Journal entitled "Millionaires Go Missing" decries taxation of the rich:

Here's a two-minute drill in soak-the-rich economics:

Maryland couldn't balance its budget last year, so the state tried to close the shortfall by fleecing the wealthy. Politicians in Annapolis created a millionaire tax bracket, raising the top marginal income-tax rate to 6.25%. And because cities such as Baltimore and Bethesda also impose income taxes, the state-local tax rate can go as high as 9.45%. Governor Martin O'Malley, a dedicated class warrior, declared that these richest 0.3% of filers were "willing and able to pay their fair share." The Baltimore Sun predicted the rich would "grin and bear it."

One year later, nobody's grinning. One-third of the millionaires have disappeared from Maryland tax rolls. In 2008 roughly 3,000 million-dollar income tax returns were filed by the end of April. This year there were 2,000, which the state comptroller's office concedes is a "substantial decline." On those missing returns, the government collects 6.25% of nothing. Instead of the state coffers gaining the extra $106 million the politicians predicted, millionaires paid $100 million less in taxes than they did last year -- even at higher rates.

No doubt the majority of that loss in millionaire filings results from the recession. However, this is one reason that depending on the rich to finance government is so ill-advised: Progressive tax rates create mountains of cash during good times that vanish during recessions. For evidence, consult California, New York and New Jersey (see here).

The Maryland state revenue office says it's "way too early" to tell how many millionaires moved out of the state when the tax rates rose. But no one disputes that some rich filers did leave. It's easier than the redistributionists think. Christopher Summers, president of the Maryland Public Policy Institute, notes: "Marylanders with high incomes typically own second homes in tax friendlier states like Florida, Delaware, South Carolina and Virginia. So it's easy for them to change their residency."

All of this means that the burden of paying for bloated government in Annapolis will fall on the middle class. Thanks to the futility of soaking the rich, these working families will now pay Mr. O'Malley's "fair share."

The article IMPLIES that the increase in Maryland´s taxation of the wealthy caused rich people to move elsewhere and thus dramatically reduced government revenues. One might assume an intended inference is that by reducing taxes on the wealthy, tax revenues would increase. Yet the article admits that the primary cause of the loss of millionaires is the recession. Many people who earned more than $1 million in recent years have less income now. These are not people who moved out of Maryland because of its tax policies. Despite the inferences of this article, it provides conjectures, but no evidence, of a detrimental effect of higher taxes.

Arthur Laffer - Father of Our $11 Trillion Debt

Arthur Laffer, the Ph.D. economist who created the Laffer curve and is sometimes called "the father of supply-side economics", can also take credit as the father of our massive public debt.  The tax cuts (and subsequent revenue reductions) he inspired were not matched by decreases in government spending.  And contrary to the claims of supply-siders, the tax cuts did not result in extraordinary economic growth. (See Table B-4. Percent changes in real gross domestic product from the Economic Report of the President.)

Taxing the Rich—Foods, That Is

Taxing the Rich -- Foods, That Is

Efforts to impose tobacco-style "obesity taxes" on some snacks and drinks have companies scramgling.  Business Week, February 12, 2009.

Fiscal Policy - Taxation and Government Spending

Fiscal Policy – Taxation and Government Spending

Fiscal policy is the use of taxation and government spending to manage the macroeconomy by either increasing or decreasing overall spending on newly produced goods and services (i.e., aggregate demand). 

Aggregate demand (AD) for domestically produced goods and services is comprised of consumption spending (C), investment spending (I), government purchases of newly produced goods and services (G), and exports of domestically produced goods and services to foreign buyers (X) minus the items in consumption (C), investment (I), and government purchases (G) that are imported from foreign producers (M).  Thus,

AD = C + I + G + X – M

Expansionary fiscal policy seeks to increase overall spending (i.e., aggregate demand) by either: (a) increasing government purchases of newly produced goods and services (G), which is a direct effect, or (b) decreasing taxes to encourage more consumption (C) or investment (I) spending, which is an indirect effect because tax cuts might not result in new spending (e.g., if an individual uses the tax benefit to pay down credit card debt).  It is appropriate to use expansionary fiscal policy to reduce unemployment and attempt to slow or reverse economic downturns (recessions and depressions).

Contractionary fiscal policy seeks to decrease overall spending (i.e., aggregate demand) by either: (a) decreasing government purchases of newly produced goods and services (G), which is a direct effect, or (b) increasing taxes to discourage consumption (C) or investment (I) spending, which is an indirect effect because tax increases might not result in less spending (e.g., if an individual uses a credit card to maintain consumption).  It is appropriate to use contractionary fiscal policy to reduce inflation.

Fiscal policy has a political bias.  Citizens like expansionary fiscal policy, but dislike contractionary fiscal policy.  Because of this bias, society tends to rely more on monetary policy to manage the economy.

 

Taxation Principles

Efficiency – How much of a burden is imposed on society by the tax?  Example:  A poll tax (head tax) causes no distortions to behavior.  By contrast, an income tax may reduce the incentive to work.

Equity – How fair is the tax?

 

Who should pay taxes?

Benefits principle – Whoever receives the benefit of the government service should pay the tax to pay for it.  (e.g., fuel taxes to pay for roads and highways)

Ability-to-pay principle – People with a greater ability to pay tax should indeed pay more tax.  (But how much more?)

 

Taxes in Relation to Income

	Income	Tax Paid	% of Income	Tax Paid	% of Income	Tax Paid	% of Income
Lee	$25,000	$5,000	20%	$6,250	25%	$7,500	30%
Sandy	$50,000	$12,500	25%	$12,500	25%	$12,500	25%
Tracy	$100,000	$30,000	30%	$25,000	25%	$20,000	20%
		Progressive – the tax is a higher percentage of income for richer people.  Example:  individual income taxes (usually – but tax reforms, such as the reduction in the capital gains tax, make the tax proportional or regressive for some people).		Proportional – the tax is the same percentage of income for everyone. Example:  property taxes to the extent that assessments reflect differences in income.		Regressive – the tax is a higher percentage of income for poorer people.  Examples:  Social Security taxes, sales taxes, most fee (driver´s license, car registration, park admission fees, sewer and water assessments.)

State & Local Government Taxation

State & Local Government Taxation

The two most important taxes for state and local governments are sales taxes and property taxes. Sales taxes are the primary source of income for state governments. Property taxes are the primary source of income for local governments. State and local governments also receive a significant amount of revenue from the federal government.

U.S. State and Local Government Receipts by Category
(Billions of dollars)
Fiscal Year[2]
Total
General Revenues[3]
Property Taxes
Sales & Gross Receipts Taxes
Individual Income Taxes
Corporation Net Income Taxes
Revenue from the Federal Government
All Other Revenues
2001-2002
1,685
279
324
203
28
361
490
2000-2001
1,647
264
320
226
35
324
478
1999-2000
1,541
249
309
212
36
292
443
1998-1999
1,434
240
291
189
34
271
410
1997-1998
1,366
230
275
176
34
255
396
1996-1997
1,289
219
261
159
34
245
371
1995-1996
1,223
209
249
147
32
235
351
Source: Economic Report of the President, Feb. 2005





When federal, state, and local government taxes are added together, the overall tax structure in the U.S. is almost proportional.

Federal Government Taxation

Federal Government Taxation

The overwhelming majority of the federal government’s revenue is collected as payroll taxes. Payroll taxes, which are collected by employers through deductions from workers’ paychecks, include individual income taxes and social insurance (i.e., Social Security) taxes. The largest source of revenue for the federal government is the individual income tax. Individual income taxes comprise almost half of all revenue for the federal government. Social insurance taxes are more than a third of all revenue for the federal government. Corporate income taxes provide about a tenth of all revenue for the federal government. The “other taxes” category includes excise taxes, tariffs and customs duties, and other fees collected by the federal government.

U.S. Federal Government Revenues by Category
(Billions of dollars)
Fiscal Year
Total Receipts
Individual Income Taxes
Corporation Income Taxes
Social Insurance Receipts
Other Receipts
2006
estimates
2,177.6
966.9
220.3
818.8
171.6
2005
estimates
2,052.8
893.7
226.5
773.7
158.9
2004
1,880.1
809.0
189.4
733.4
148.3
2003
1,782.3
793.7
131.8
713.0
143.9
2002
1,853.2
858.3
148.0
700.8
146.0
2001
1,991.2
994.3
151.1
694.0
151.8
2000
2,025.2
1,004.5
207.3
652.9
160.6
1999
1,827.5
879.5
184.7
611.8
151.5
1998
1,721.8
828.6
188.7
571.8
132.7
1997
1,579.3
737.5
182.3
539.4
120.2
1996
1,453.1
656.4
171.8
509.4
115.4
1995
1,351.8
590.2
157.0
484.5
120.1
Source: Economic Report of the President, Feb. 2005

Central Government Tax Revenue as Percentage of GDP, 1990 and 1997.

To compare the tax burden in various countries, examine the data for Central Government Tax Revenue as Percentage of GDP in 1990 and 1997 from the United Nations Public Administration Network.

Tax Burden in the U.S.

Tax Burden in the U.S.

Although many Americans complain about how much they pay in taxes, the tax burden in the U.S. is low compared to European countries. The U.S. tax burden is high, however, when compared to other areas of the world.

Country
Central Government Tax Revenue as a Percentage of GDP
France
38.8%
United Kingdom
33.7%
Germany
29.4%
Brazil
19.7%
United States
19.3%
Canada
18.5%
Russia
17.4%
Pakistan
15.3%
Indonesia
14.7%
Mexico
12.8%
India
10.3%
Source: World Development Report, 1998/99.





“Taxes are the price we pay for a civilized society.”

– Oliver Wendell Holmes, Jr.
Justice of the U.S. Supreme Court
from 1902 to 1932.

Consumption Taxes

Consumption Taxes

Some people advocate replacing income taxes with taxes on consumption. These might include a national sales tax, additional excise taxes on particular products, a value-added tax (VAT), or customs duties on imports or exports. Proponents of consumption taxes claim income taxes reduce people’s incentive to work, but consumption taxes do not. Instead, consumption taxes discourage consumption and thus encourage saving. Increased savings provide more financial resources that can be used for economic investment by businesses or the government. Increased economic investment generally leads to higher economic growth. Thus, consumption taxes do not distort incentives for the economy to save and invest. This should lead to greater economic growth.

Prior to the creation of the current income tax system in 1913, the U.S. relied heavily on import duties and excise taxes to finance federal government expenditures. Taxation of imports and exports reduces the volume and benefits of trade and may reduce a country’s welfare. Consequently, many consumption tax proponents favor value-added taxes. A value-added tax (VAT) is a type of consumption tax that is based on the additional value of a product added at each stage of the production process. The VAT differs from traditional sales taxes because it is collected from producers rather than retailers. It is collected from the factory that makes the product, not the stores that sell it. And unlike sales taxes, the VAT is included in the prices of products instead of being added onto the sales price at the time of purchase. The U.S. is the only major industrialized country without a value-added tax. A VAT has been proposed numerous times in the U.S. Congress, but has never received any significant support.

A national sales tax is another type of consumption tax. Sales taxes are quite common in the U.S. at the state and local level. Some people advocate creating a national sales tax to replace some or all or the federal income tax. If the U.S. relied on a national sales tax as a primary source of revenue for the federal government, the tax rate might need to be 25%. This means that every time a consumer made a purchase, 25% of the price would be added to support the federal government. Critics of a national sales tax complain about the regressive structure of such a tax. The imposition of a national sales tax would shift much of the tax burden away from the wealthy to middle and low income Americans.

The Flat Tax

The Flat Tax

An alternative to the current individual income tax structure is the flat tax. The flat tax has been proposed since 1983 by various people, including Congressman Richard K. Armey, who was a Republican representative from Texas from 1985 to 2003 and Malcolm S. "Steve" Forbes, Jr., a billionaire candidate for the Republican nomination for the U.S. presidency in 1996 and 2000.

Under most flat tax proposals, the current individual and corporate income tax structures would be replaced by a system in which every taxpayer is subject to the same marginal tax rate.

Proponents of a flat tax system argue that it would simplify the income tax structure because most deductions would be eliminated. A simpler tax system would have a smaller administrative burden and thus would be more efficient.

Opponents of a flat tax argue that it would shift a significant amount of the tax burden from the wealthy to middle class Americans. Thus, they think a flat tax system does not have enough vertical equity. Vertical equity is the principle that taxpayers with a greater ability to pay taxes should pay larger amounts. Vertical equity is a justification for wealthy people to pay more in taxes than poor people.

Under "H.R.1040", the Armey-Shelby Flat Tax proposal of 1997, every worker would pay 17% of what is left of their total annual income from all wages, salaries, and pensions after subtracting a personal allowance. The only four allowances would be:
- $23,200 for a married couple filing jointly- $14,850 for a single person who is the head of a household- $11,600 for a single person who is not the head of a household, - $5,300 for each dependent child
No other tax credits or deductions would be used. The entire tax return form would be simple enough to fit on a postcard.
Source: U.S. Rep. Dick Armey's flat tax summary web site.
Because of the personal allowances, taxpayers would not pay the same percentage of their income in tax. For example, Rep. Armey suggested that given the exemptions shown above, a family of four earning $25,000 would owe no tax. A family of four earning $50,000 would owe 6%, and a family of four earning $200,000 would owe14% in tax.

The flat tax proposal would also eliminate the marriage penalty, almost double the deduction for dependent children, and end multiple taxation of savings.

Social Security and Medicare payroll taxes would not be affected under the flat tax proposal. Social Security benefits would not be taxed.

Businesses would take their total income, subtract total expenses and if the result is a positive amount (profit), pay tax on that amount at a rate of 17%. Expenses would include purchases of goods and services, capital equipment, structures, land, wages and contributions to retirement plans.

Critics of the Armey-Shelby Flat Tax proposal note that much of the complexity of the current system would remain. Businesses would still need to withhold taxes from workers’ wages and record keeping for businesses would not be significantly reduced. Some people would still have an incentive to cheat on their taxes.

According to the U.S. Treasury Department, the Armey-Shelby Flat Tax proposal would have added $138 billion to the annual budget deficit (in 1996 dollars). Even at the break even rate of 20.82%, Rep. Armey’s plan would increase taxes sharply on all income groups except those earning more than $200,000 a year. (Others believe that the break-even rate would have to be considerably higher than the Treasury’s estimate.)

The flat tax proposal of Malcolm S. Forbes, Jr., was similar to Rep. Armey’s. Mr. Forbes suggested larger exemptions from the wage tax: $13,000 per taxpayer plus $5,000 per child. Forbes also considered retaining the earned-income tax credit. Based on the U.S. Treasury's analysis, the Forbes's proposal would have resulted in a revenue shortfall of between $180 and $210 billion a year (in 1996 dollars). Others believed the revenue losses would be much larger.



A flat tax is a type of income tax in which every taxpayer is subject to the same marginal tax rate.

Lump-Sum Taxes / Poll Taxes / Head Taxes

An example of an extremely efficient tax is a lump-sum tax. A lump-sum tax is a tax that is the same monetary amount for every person. For example, a lump-sum tax might require every person to pay $50. The marginal tax rate of a lump-sum tax is equal to zero. If a person earns additional income, he or she does not pay any additional lump-sum tax. A lump-sum tax is very efficient because it does not reduce people’s incentive to work because the tax does not vary with their income. There is also very little administrative burden. The only records that need to be kept are whether each person has paid the tax. For example, the government does not need any information about a person’s income to levy a lump-sum tax.

Lump-sum taxes are also called poll taxes or head taxes because they have been imposed as a prerequisite for voting and are assessed per person (i.e., per head).

According to the Smithsonian National Museum of American History, poll taxes were used in the late 19th and early 20th centuries in the United States by local governments in the former Confederacy and neighboring states as part of an effort to reestablish a society based on white supremacy :

Poll taxes required citizens to pay a fee to register to vote. These fees kept many poor African Americans, as well as poor whites, from voting. The poll tax receipt displayed here is from Alabama:

Denying black men the right to vote through legal maneuvering and violence was a first step in taking away their civil rights. Beginning in the 1890s, southern states enacted literacy tests, poll taxes, elaborate registration systems, and eventually whites-only Democratic Party primaries to exclude black voters.
The laws proved very effective. In Mississippi, fewer than 9,000 of the 147,000 voting-age African Americans were registered after 1890. In Louisiana, where more than 130,000 black voters had been registered in 1896, the number had plummeted to 1,342 by 1904.

Here is a poll tax receipt from Jefferson County, Louisiana in 1917:


It was not until January 23, 1964 that the ratification of the 24th Amendment to the U.S. Constitution made it illegal to use poll taxes as a requirement for voting in federal elections.

AMENDMENT XXIV
Passed by Congress August 27, 1962. Ratified January 23, 1964.

Section 1.
The right of citizens of the United States to vote in any primary or other election for President or Vice President, for electors for President or Vice President, or for Senator or Representative in Congress, shall not be denied or abridged by the United States or any State by reason of failure to pay poll tax or other tax.

Section 2.
The Congress shall have power to enforce this article by appropriate legislation.

See also: "Margaret Thatcher and the Lump-Sum Head or Poll Tax".

Marginal Tax Rates Versus Average Tax Rates

To help understand how a tax structure could be more efficient, it may be useful to distinguish between average and marginal tax rates.


Marginal Tax Rates Versus Average Tax Rates

The average tax rate is the total taxes paid divided by total income.

The marginal tax rate is the tax paid on an additional dollar of income.

The average tax rate measures the sacrifice made by a taxpayer. The marginal tax rate measures how much the tax system discourages people from working.


An Example to Illustrate the Difference Between Marginal and Average Tax Rates

According to the table at the top of page 258, if a single worker had $30,000 of taxable income in 2005, the worker would owe $4,165 in federal income tax.

· 10% federal income tax on the first $7,300 of taxable income

· 15% federal income tax on income earned above $7,300 but less than $29,700

· 25% federal income tax on income earned above $29,700 but less than $71,950

The worker owes $730 on the first $7,300 of taxable income.

(.10)($7,300) = $730

The worker owes $3,360 on the taxable income above $7,300 but less than $29,700.
$29,700 - $7,300 = $22, 400
Thus, the worker pays 15% tax on $22,400 of his or her income.
(.15)($22,400) = $3,360

The worker owes $75 on the taxable income above $29,700 but less than $71,950.

$30,000 - $29,700 = $300
Since the worker’s taxable income is $30,000, the worker pays 25% tax on $300 of his or her income.
(.25)($300) = $75

Thus, the total federal income tax owed is $4,165.

Federal income tax owed = (.10)($7,300) + (.15)($22,400) + (.25)($300)
. = $730 + $3,360 + $75
= $4,165

The average income tax rate is the tax paid divided by income. If the workers total income is $30,000, then this worker’s average tax rate is:

average tax rate = $4,165 / $30,000 = 0.138 or 13.8%

The marginal tax rate is the tax paid on an additional dollar of income. If this worker earns additional income above the current $30,000, it will be taxed at 25%. (See the table for 2005 on page 258.)

Thus, this worker’s average tax rate is 13.8% and the marginal tax rate is 25%. The worker is paying 13.8% of his or her income in federal income tax. This represents the sacrifice the worker is making to financially support the federal government. The marginal tax rate is significantly higher in this case. If this person chooses to work more (and increase his or her income above $30,000 per year), the government will be owed 25 cents of each additional dollar earned. This may reduce the person’s incentive to do the additional work. If the person works enough to earn an additional $1,000, the federal government will collect $250. Thus, the worker’s disposable income increases by only $750.

Social Insurance Taxes

...

The Individual Income Tax

The Individual Income Tax

These marginal tax rates for a single taxpayer in 2003, 2004, and 2005 are listed below.

Federal Income Tax Rates: 2005
On Taxable Income . . .
The Tax Rate is . . .
Up to $7,300
10%
From $7,300 to $29,700
15%
From $29,700 to $71,950
25%
From $71,950 to $150,150
28%
From $150,150 to $326,450
33%
Over $326,450
35%
This table shows the marginal tax rates for an unmarried taxpayer. The taxes owed by a taxpayer depend on the marginal tax rates up to his or her income. For example, a taxpayer with income of $26,000 pays 10 percent of the first $7,300 of income, and then 15 percent of the rest.

Federal Income Tax Rates: 2004
On Taxable Income . . .
The Tax Rate is . . .
Up to $7,150
10%
From $7,150 to $29,050
15%
From $29,050 to $70,350
25%
From $70,350 to $146,750
28%
From $146,750 to $319,100
33%
Over $319,100
35%
This table shows the marginal tax rates for an unmarried taxpayer. The taxes owed by a taxpayer depend on the marginal tax rates up to his or her income. For example, a taxpayer with income of $26,000 pays 10 percent of the first $7,150 of income, and then 15 percent of the rest.

Federal Income Tax Rates: 2003
On Taxable Income . . .
The Tax Rate is . . .
Up to $7,000
10%
From $7,000 to $28,400
15%
From $28,400 to $68,800
25%
From $68,800 to $143,500
28%
From $143,500 to $311,950
33%
Over $311,950
35%
This table shows the marginal tax rates for an unmarried taxpayer. The taxes owed by a taxpayer depend on the marginal tax rates up to his or her income. For example, a taxpayer with income of $26,000 pays 10 percent of the first $7,000 of income, and then 15 percent of the rest.

Source: U.S. Internal Revenue Service
http://www.irs.gov

The Sources of U.S. Federal Government Revenues

The two largest sources of revenue for the U.S. federal government are the individual income tax and social insurance taxes. Social insurance taxes were created by the Federal Insurance Contributions Act (FICA), the 1939 law that authorized the Internal Revenue Service to collect additional taxes from the paychecks of workers to support the Social Security and Medicare programs.