Friday, January 10, 2014

Progressive Income Tax Rates

In the United States, as with most countries in the world, we have what is referred to as progressive income tax system. This works through the use of gradually increasing tax rates as income increases. These tax rates are referred to as marginal tax brackets which means that you are only taxed on the next dollar earned when income is high enough to move from one rate to another. As an example, below is the 2013 federal rates for a family filing married jointly.
  • 10% on taxable income from $0 to $17,850, plus
  • 15% on taxable income over $17,850 to $72,500, plus
  • 25% on taxable income over $72,500 to $146,400, plus
  • 28% on taxable income over $146,400 to $223,050, plus
  • 33% on taxable income over $223,050 to $398,350, plus
  • 35% on taxable income over $398,350 to $450,000, plus
  • 39.6% on taxable income over $450,000.
As evident during presidential elections, the progressive tax system is a hotly debated topic. There is a minority that believe we should do away with the whole thing and go to a flat tax but more often the debate centers around whether the rates should be raised (Democrats) or lowered (Republicans). But one thing which largely does not get addressed is whether the structure of the current system is adequate or fair.

As shown above, for a married couple filing jointly, the highest rate is 39.6% for all income over $450,000. But if the reason for having a progressive tax system is out of a sense of fairness, then why does the top rate stop at an income level which is relatively low?

To demonstrate, lets look at the the effective tax rate at various income levels for a family filing married filing jointly, no kids, taking the standard deduction (the effective rate is the actual average percentage of income tax paid):

$50,000        - tax $3,608          - 7.216%
$100,000      - tax $11,858        - 11.858%
$200,000      - tax $37,866        - 18.933%
$400,000      - tax $103,772      - 25.943%
$800,000      - tax $259,615      - 32.452%
$1,600,000   - tax $576,415      - 36.026%
$3,200,000   - tax $1,210,015   - 37.813%
$6,400,000   - tax $2,477,215   - 38.706%
$12,800,000 - tax $5,011,615   - 39.153%
$25,600,000 - tax $10,080,415 - 39.377%
$51,200,000 - tax $20,218,015 - 39.488%

As is evident from the above calculations, there is a great deal of progressiveness for various levels of income till you reach about a million and a half dollars of income. At that point, it becomes considerably less progressive. At around six and a half million, you are essentially at a level of income where you are being taxed at a flat rate of something close to 39%.

So if in 2013 you were lucky enough to be a highly compensated person such as Robert Downey Jr ($75 million), Tiger Woods ($78 million), or Apple CEO Timothy D. Cook ($377 million), then you really aren't part of the progressive tax system. For these individuals, an annual variance of a few million dollars will have essentially no effect on their effective tax rate as it will still be around 39%. Does that seem fair?

My point isn't that we need to stick it to the rich or even that they aren't paying their fair share. It's simply that in the United States, we talk of having a progressive federal income tax but in actuality, once you reach a high enough income level, it is essentially a flat tax. It seems to me that if we are going to have a progressive system it should apply to all levels of income.

As it stands, when politicians talk about the rich, they are talking about anyone who is in the top tax bracket. But how can we compare someone who makes $400,000 a year to someone that makes $20,000,000 a year? They are not the same. They do not have the same means. If we are going to have a progressive system shouldn't they be taxed differently?

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