SANFORD -- The recent hullabaloo over Mitt Romney's tax returns has left many Americans scratching their heads when it comes to taxes. Depending on where you get your news, you are likely to hear arguments that range from "the rich pay nothing" to the "poor pay nothing," and even "Warren Buffett's secretary pays everything," none of which is entirely correct. The political debate on the issue of taxes amounts to roaring thunderclaps that drown out the subtle and intricate nuances that are important to understanding tax policy.
In light of Mitt Romney's recent tax disclosures and President Barack Obama's remarks at the State of the Union, here's a primer of the debate over marginal and effective tax rates.
Congressional Budget Office data clearly prove that federal income tax rates are generally progressive. Progressive rates mean that as your income increases, you pay more - that is, your income is taxed at a higher rate - in taxes. Whether you like them or not, progressive tax rates are based on the idea that those with higher incomes have a greater ability to contribute more to the government.
On the whole, both marginal tax rates and average tax rates are progressive, but what's the difference between the two different rates and why does the distinction matter?
Marginal tax rates are the rate paid on your last dollar of income. When individuals talk about their tax bracket, they are often referring to their marginal tax rate, the highest rate at which their income is taxed. Marginal tax rates are published by the IRS, and it is important to remember that all income is not taxed at the highest marginal rate. You pay no income taxes on your first few thousand dollars of income, a higher rate on the next few thousand, and so on, until you get to your highest level of earnings and your highest marginal tax rate.
So what percentage of income do you pay in federal income taxes overall? That question is answered by calculating your average or effective tax rate. The effective tax rate divides actual taxes paid by income from all sources. Mitt Romney and Warren Buffett have both come under fire for paying less than the average American, but it's really their effective tax that is being discussed, not their marginal rate. This distinction is important if we are to truly debate whether these Americans are "paying their fair share."
Effective tax rates are different for every taxpayer because different taxpayers have different incomes as well as different combinations of exemptions, deductions and credits. Exemptions are fixed amounts that reduce taxable income for yourself and your dependents. There are many tax deductions and, like exemptions, they reduce the income on which tax is calculated. Unlike exemptions and deductions, tax credits reduce, dollar-for-dollar, an individual's tax bill. The amount and types of income you earn, as well as the amount of exemptions, deductions and credits available to you all affect your effective tax rate.
With an understanding of those basic terms, consider who actually pays taxes.
According to 2009 data from the Tax Foundation, people making over $200,000 paid 49 percent of all federal income taxes, with a full 20 percent being paid by people with incomes over $1 million. In contrast, people making between $100,000 and $200,000 paid 25 percent of all federal income taxes. Everyone making less than $100,000 contributed 25 percent of the total collected. The 12 percent of taxpayers with the highest incomes are paying three quarters of all individual income taxes.
Comparing average tax rates, people who make over $200,000 have effective tax rates that range from 19 percent to 26 percent on average. People making under $100,000 have average tax rates ranging from zero to 8 percent. Looking at Mitt Romney's recent tax returns, we find he had an effective rate of 15 percent, certainly less than some of the wealthy elites, but well above most Americans.
Whether you think rich people pay too much or too little in total taxes, the fact remains that the well-off in America pay a significant portion of the taxes collected. Regardless of how we structure the tax system, additional taxes on the wealthy are not enough to eliminate or even significantly reduce projected federal budget deficits - there simply are not enough wealthy taxpayers to fix the budget deficit. Anyone who is serious about improving the long term fiscal outlook of the United States will conclude that some combination of federal spending cuts and increased federal revenues will be required.
The question now is, is there any chance of these issues being addressed and resolved during an election year, or will our politicians continue to skew the line between the marginal and effective tax rates as a tool to trick and confound the voting public?
