Fixing the Broken Tax System

          Yesterday morning I found a Yahoo! News article from the Associate Press by Stephen Ohlemacher entitled: “Super rich see taxes fall dramatically.”  The same article was in my Albany Times Union under the headline: “Tax day a good day to be rich.”  I found the same article also published on the Fox News website, under this headline: “Nearly half of U.S. households pay no income tax to Feds.”  

            It looked like everyone might be coming under fire for not paying enough taxes.  The Yahoo! News headline was intriguing coming from the AP, given that Republicans want to reduce taxes paid by the super rich even more.  Here’s what Mr. Ohlemacher had to say:

          “As millions of procrastinators scramble to meet Monday’s tax filing deadline, ponder this: The super rich pay a lot less taxes than they did a couple of decades ago, and nearly half of U.S.households pay no income taxes at all.

          “The Internal Revenue Service tracks the tax returns with the 400 highest adjusted gross incomes each year. The average income on those returns in 2007, the latest year for IRS data, was nearly $345 million. Their average federal income tax rate was 17 percent, down from 26 percent in 1992.

          “Over the same period, the average federal income tax rate for all taxpayers declined to 9.3 percent from 9.9 percent.

          “The top income tax rate is 35 percent, so how can people who make so much pay so little in taxes? The nation’s tax laws are packed with breaks for people at every income level. There are breaks for having children, paying a mortgage, going to college, and even for paying other taxes. Plus, the top rate on capital gains is only 15 percent.

          “There are so many breaks that 45 percent of U.S. households will pay no federal income tax for 2010, according to estimates by the Tax Policy Center,  a Washington think tank.”

            Starting off with a flourish about the low effective tax rates for the very wealthy, the article quickly drops that topic and hurries on to the assertion that everyone’s avoiding taxes:  For openers, it occurred to me, there might be some households in poverty for which income is simply too low to incur income tax liability, and to characterize such families as part of a 45% group taking ultimate advantage of tax “breaks” seems, well, a bit disingenuous.  According to David Leonhardt in his New York Times, article of April 13, 2011, it is indeed a misleading statistic.

Yes, 47% of Households Owe No Taxes. Look Closer 

            “That’s the portion of American households that owe no income tax for 2009. The number is up from 38 percent in 2007, and it has become a popular talking point on cable television and talk radio. With Tax Day coming on Thursday, 47 percent has become shorthand for the notion that the wealthy face a much higher tax burden than they once did while growing numbers of Americans are effectively on the dole.

          “Neither one of those ideas is true. They rely on a cleverly selective reading of the facts.  So does the 47 percent number.

          “All the attention being showered on ’47 percent’ is ultimately a distraction from that reality.

          “The 47 percent number is not wrong. The stimulus programs of the last two years — the first one signed by President George W. Bush, the second and larger one by President Obama — have increased the number of households that receive enough of a tax credit to wipe out their federal income tax liability.

          But the modifiers here — federal and income — are important. Income taxes aren’t the only kind of federal taxes that people pay. There are also payroll taxes and investment taxes, among others.  And, of course, people pay state and local taxes, too.

          “Even if the discussion is restricted to federal taxes (for which the statistics are better), a vast majority of households end up paying federal taxes. Congressional Budget Office data suggests that, at most, about 10 percent of all households pay no net federal taxes. The number 10 is obviously a lot smaller than 47.”

          The entire article is informative, but suffice it to say here that a simplified notion of a tax system giving everyone tax “breaks” hardly begins to address whether the system of taxation in this country, and in particular federal income taxation, is fair.

Super rich see taxes fall dramatically

          Let’s go back to the lead-in discussion about taxes paid by the super rich:  “The Internal Revenue Service tracks the tax returns with the 400 highest adjusted gross incomes each year. The average income on those returns in 2007, the latest year for IRS data, was nearly $345 million. Their average federal income tax rate was 17 percent, down from 26 percent in 1992.  * * *  The top income tax rate is 35 percent, so how can people who make so much pay so little in taxes?”

          Good question, but Mr. Ohlemacher doesn’t answer it.  Since the marginal rate was 40% before the Bush tax cuts, that might help explain the 26% average effective rate in 1992.  But what about the 17% average rate in 2007?  Ohlemacher says: “The nation’s tax laws are packed with breaks for people at every income level. There are breaks for having children, paying a mortgage, going to college, and even for paying other taxes.” 

          All right, but if you’re making $345 million in a year, your credit for dependant children (in all likelihood) won’t get your effective rate down very far.  Nor will mortgage interest (if you have one), college expenses or deductions for other taxes.  Mr. Ohlemacher adds this, however: “Plus, the top rate on capital gains is only 15 percent.”

          Oh yeah, capital gains!  That might do it:  If most of your $345 million consists of returns on investments, which frankly has to be the case, then you’re paying a 15% rate on most of your income.  

          That would explain an average 17% rate for the top 400:  Consider this graph, which shows how for higher incomes capital gains and dividen income become hyperbolically a higher share of total household income.  This data is for 2003, but we can assume the pattern remains the same today.      

            If you are making less than $200,000, the favorable capital gains tax rate is not a significant factor in your overall rate.  It starts to get significant, though, as your income approaches $1 million.  Again, the 400 had an average income of $345 million in 2007.  Projecting on the graph up to that from $1 million, we can see that almost all of the income of the top 400 is capital gains and interest income.

          This graph shows that people making over $200,000 are in the top 3%, and $1 million incomes are in the top 1%:

            

          Almost all of the financial wealth, and thus the opportunity for capital gains, is held by the super rich.  Here is the pie chart for 2007:

         

           The top 10% hold more than 90% of investment wealth, and more than half is held by the top 1%, so the capital gains benefits that drive the income tax liability of the very rich are unavailable to the vast majority of Americans.  In fact, if you are not in the top 3% of incomes (over $200,000), as shown above, less than 5% of your income  qualifies for the lower capital gains rate.

         Ordinary Americans pay taxes on ordinary income.  Here are the tax brackets for married couples:

0-8,375                        10%

8,375-34,000              15%

34,000-82,500           25%

82,500-171,850          28%

171,850-373,650         33%

373,650-                       35%

          In order to qualify for the 15% rate on ordinary income, household taxable income would have to fall in the 8,375-34,000 range.   The official poverty level in 2011 in the United States is $22,350 for a family of four.  Therefore, incredibly, only household incomes falling at, near, or below the official poverty line qualify for a tax rate as low as the super rich enjoy on all of their investment earnings! 

          Incomes for the middle class, obviously, are taxed at higher rates.  This is important: The higher your income is over $1 million, the higher the percentage of you income is taxed at the lower capital gains rate.   This is a regressive tax system.

The Tax System is Beyond Unfair – It’s Destructive.

            We argue in this blog that the escalating inequality of incomes and wealth (as shown in the pie chart above) have occurred because the marginal income rate was reduced below 70% in the Reagan Administration.  The wealthy have garnered in an estimated $12 trillion since then, wealth that would and should have been held by the middle class and the bottom 99%.  And they financed that wealth accumulation with federal debt.

          As long as the marginal rate stays below 70%, this improper wealth transfer will continue.  The 35% rate is only half of what it should be, and in these circumstances, we see Republican proposals surface to lower the marginal rate to 25%.  Already, we have seen, they very wealthy are paying taxes on most of their income at the even lower 15% capital gains rate, a rate ordinary Americans with little or no wealth can’t quality for unless they are living in poverty.

          It’s essential to get the marginal tax rate up to at least 50-55%, for starters.  And, obviously, the capital gains rate must be substantially increased.  I would suggest a graduated capital gains tax: It could be kept lower for those in low-income tax brackets who are trying to establish a bit of wealth (after all that has befallen them), but it should be at least equal to the marginal income tax rate for incomes over $1 million.

         People, it makes no sense to talk about trashing Medicare, Medicaid and Social Security in these circumstances.   It’s come down to this, and it’s not just a matter of fairness: It’s a matter of survival.

JMH –4/19/11

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