We are hearing a lot everywhere these days about tax rates and many people are asking how increasing the taxes would really help, if at all. Let’s take a look at the practical, effective and psychological effects of tax increases, especially on the highest income earners. Before we do that, let’s talk about tax rates.
Marginal Tax Brackets vs. Effective Tax Rates
A marginal tax rate is the amount of tax that applies to each additional level of income. Under the Tax Cuts and Jobs Act of 2017, taxpayers are divided into seven brackets: 10%, 12%, 22%, 24%, 32%, 35% and 37%. These percentages are your marginal tax rates (tax brackets). To see which bracket you’re in, you must first determine your filing status: single, married filing separately, married filing jointly (and qualifying widow/ers with dependent), or head of household. Then, check which bracket you fall under using the amount of money you make per year.
One of the most common mistakes is assuming that if you fall into the 20% tax bracket, for example, that you will pay 20% on all of your income. That isn’t true. You only pay that rate on the amount within that bracket.
For example, if you are single and make $50,000 per year. Your standard deduction for 2020 is $12,400.
$50,000 – $12,400 = $37,600 (This is the amount you pay tax on.)
Your tax brackets are:
- $0 – $9,700 = 10% = $970.00
- $9,701 – $39,475 = 12% = $3,572.88
- Total Tax Liability = $4,542.88
$4,542.88 as a percentage of your total $50,000 income is 9%.
9% is your effective tax rate.
The key idea here is just because you are in a certain “tax bracket” doesn’t mean that you are paying that much in taxes. Additionally, with other credits, deductions and proper planning, it is possible to reduce your tax liability.
Increasing Tax Rates On The Wealthy
One popular idea, often touted by those running for political office is what we call the Robin Hood Theory. Take from the rich and give to the poor. But, the real question is, does increasing top tax rates on the wealthy really help us in the average income ranges?
Historically, when tax rates increase, they increase across the board. There may be higher increases on the top income earners, but they tend to still increase for everyone. This happens through not only changes in tax brackets, but also changes in deductions, credits and other means. In 2018, for example, you had a personal exemption of $4,000 per person in your household. That came right off the top of your income. In 2019, that went away causing many people to experience lower refunds and owing when they hadn’t previously. But back to the high income earners…
According to TaxFoundation.org, “High tax rates come with a high economic cost, they raise less revenue than the casual observer might think, and they fall heavily on the entrepreneurial sector. Moreover, they do little to address the more fundamental explanation for the widening gap between rich and poor: the globalization of labor markets.
High tax rates discourage work, saving and entrepreneurship. They also encourage taxpayers to rearrange their tax affairs to receive more of their compensation in less heavily taxed forms and to take greater advantage of the myriad tax preferences in today’s tax code.
Every time a taxpayer makes a decision based on tax considerations rather than economic merit, we all lose. It wastes resources by redirecting them to less productive uses. The cost of high tax rates is not trivial. Research on the major changes in tax rates over the last several decades finds that the behavioral responses can be large. This research generally finds that for every 1 percent decrease in the after-tax reward from earning income, taxpayers reduce their reported income by about 0.4 percent.”
The Widening Gap between the Rich and Poor (The Wealth Inequality Gap)
One of the most common arguments of higher tax rates is to make sure that those who make the most money pay their fair share. This thought process for higher tax rates is flawed. The widening gap between the rich and poor is a trend that began several decades ago and in unrelated to tax rates for any level of income or tax policy, in general.
The globalization of labor markets over the past several decades means that labor in the developing world now competes directly with labor in the United States. This puts pressure on earnings growth for at least the lower half of the wage distribution in the U.S. Highly skilled labor, those with advanced degrees and some portion of business owners have not yet experienced as much competition globally, but even those trends are changing.
You cannot solve the problem of competition by increasing tax rates. The effect would be less money for innovation that could be used to create jobs in new or less-competitive markets.
But Wouldn't Increasing Tax Rates On The Wealthy Help The National Debt?
During President Clinton’s first term after the tax increases, revenues rose 7.4% per year and the national debt increased $730 billion. During his second term after the tax cuts, revenues rose 8.7% per year and the debt was reduced by $409 billion.
The problem is not how much money is coming in. The problem is how it’s being spent.
Think of it this way…If the average person has a bad problem with debt and gets a small raise at work, what are they most likely to do with the raise? Save the difference? Pay down debt? Most people would simply increase their spending because of the increase in income. That is why debt is such a problem for most Americans. Both average Americans and the federal government are in the same boat. As income increases, so does spending.
One of the biggest truths in financial consulting is that there are only 2 things you can do to become financially free: spend less money or make more money. For most people, a good target would be a combination of both. However, there is only so much taxation people can stand. At some point, spending has to decrease.
Look at the taxes that didn’t exist at the turn of the last century, for example:
- Accounts Receivable Tax
- Building Permit Tax
- CDL license Tax
- Cigarette Tax
- Corporate Income Tax
- Dog License Tax
- Excise Taxes
- Federal Income Tax
- Federal Unemployment Tax (FUTA)
- Fishing License Tax
- Food License Tax
- Fuel Permit Tax
- Gasoline Tax (currently 44.75 cents per gallon)
- Gross Receipts Tax
- Hunting License Tax
- Inheritance Tax
- Inventory Tax
- IRS Interest Charges
- IRS Penalties (tax on top of tax)
- Liquor Tax
- Luxury Taxes
- Marriage License Tax
- Medicare Tax
- Personal Property Tax
- Property Tax
- Real Estate Tax
- Service Charge Tax
- Social Security Tax
- Road Usage Tax
- Recreational Vehicle Tax
- Sales Tax
- School Tax
- State Income Tax
- State Unemployment Tax (SUTA)
- Telephone Federal Excise Tax
- Telephone Federal Universal Service Fee Tax
- Telephone Federal, State and Local Surcharge Taxes
- Telephone Minimum Usage Surcharge Tax
- Telephone Recurring and
Nonrecurring Charges Tax
- Telephone State and
- Telephone Usage Charge Tax
- Utility Taxes
- Vehicle License
- Registration Tax
- Vehicle Sales Tax
- Watercraft Registration Tax
- Well Permit Tax
- Workers Compensation Tax
Are Politicians Really Selfless?
Call it conspiracy theorist, realist or whatever you would like to call it, but there is the valid point that rarely gets talked about. Are all politicians really selfless?
That’s not so much a political question as it is a human nature question. Would you willingly and knowingly do something that would harm your financial future?
The majority of our government officials would fall into the highest tax brackets that get discussed. Knowing the effects of it on their own personal finances, do you feel it would be something you would vote for if you were in their shoes? Unless there were already a way around it…