If you make more than about $33,500 a year, your federal income tax burden is probably lighter than you think.
The portion of your income that you pay in taxes is your “effective tax rate.” But when politicians and pundits talk about effective tax rates, the data they typically use relies on an incomplete measure for income. Use an incomplete measure for income and your tax rate calculation comes out high.
In a new analysis the Tax Policy Center, a nonpartisan Washington research organization, used a wider measure of income to calculate effective tax rates. The rates are much lower using this broader measure of income.
The Tax Policy Center computer model of the tax system, which estimates how changes in the law would affect tax burdens, has repeatedly made projections that subsequent events showed were accurate. The center is a joint project of two Washington research organizations, the Urban Institute and the Brookings Institution. The George W. Bush administration went out of its way to praise the reliability of the center findings even when they were not helpful to administration policy.
The incomplete measure is called “adjusted gross income,” or AGI. This is the number on the last line of the front page of the standard tax return.
To get a fuller picture, the Tax Policy Center used what it called “cash income” to calculate effective tax rates. This included municipal bond interest, government benefits and many of the other items that are excluded from AGI. Use this fuller measure of income and the share of income that goes to taxes falls.
In its new analysis, the Tax Policy Center found that the discrepancy between these two ways of measuring tax rates varies significantly between different income groups.
For the middle fifth of taxpayers, those with cash income between $33,542 and $59,486 a year, the average tax burden is 4.1 percent of adjusted gross income but only 3.2 percent of cash income. So these middle-income people are paying almost one percentage point less of their income in federal income taxes than they might imagine based on the popular debate.
One percentage point may seem small, but for people in this income group it means they are actually paying one fifth less in income tax than they might think.
The percentage point discrepancy widens as incomes increase. For the next fifth of taxpayers, those earning between $59,486 and $103,465, the average federal income tax is 8.2 percent of AGI but only 7 percent of cash income, a difference of 1.2 percentage points. For the top fifth, those earning more than $103,465, the average federal income tax is 17.3 percent of AGI but only 14.9 percent of cash income.
For the top tenth of one percent – whose combined income comes close to equaling that of the bottom 50 percent of taxpayers – the disparity is even greater. The tax rate is 23.6 percent of AGI but only 19.8 percent of cash income, a difference of 3.8 percentage points.
As valuable as the Tax Policy Center’s report is, the center acknowledges that it understates the disparity for people at the very top. The reason for this is that the computer model cannot capture certain kinds of income that are only available to the very wealthy. For example, Congress considers the personal use of corporate jets to be income. But, under rules Congress set in 1985, only a small fraction of the real value is included in AGI. Unfortunately, the Tax Policy Center’s model does not capture the remainder as part of cash income.
For the 40 percent of Americans on the bottom of the income ladder, using AGI to measure income also distorts the effective tax rate calculation, but in a different way.
On average, people in the bottom 40 percent receive money from the federal income tax system rather than pay money into it, so their effective tax rates are negative.
This is because the first $19,000 of income for a couple was free of income tax last year. At the same time, they may have received cash payments such as the Earned Income Tax Credit for the working poor or the Child Tax Credit for parents of children. These tax credits are not included in AGI, but the Tax Policy Center counts them as cash income.
The payments the poorest fifth of taxpayers – those who made less than $16,812 last year – get on average from the tax system amount to 12.3 percent of their AGI. But, when calculated against cash income, these payments amount to only 5.8 percent. So, the AGI method overstates the amount this group is getting from the tax system.
For most of us – those in the middle class and above – our effective tax rate is lower than politicians say. So smile a bit today. The cost of civilization is not as high as you’ve been told.