Tuesday, January 31, 2012

Taxes - Not so hard, but never fun

It's tax time.  

Unless you are a hermit, you have to know. These guys, and others are everywhere.

If that isn't enough, anyone paying any attention to politics over the past few years has been inundated with sound bite after sound bite about income taxes, who pays how much, "The Buffet Rule", the Fair tax, fair share, flat taxes, marginal rates, effective rates, etc. etc.

Just about everyone is confused.  Why?  The tax code is over 70,000 pages long?  Who can know all of it?

Fortunately, though, the fundamentals are pretty simple... 

although most people are thoroughly confused.  It think its the size and complexity of all those tax forms that do it.  Every one of those 70,000 pages makes itself felt somewhere on one of those forms.  But the basic "drive train" of the income tax system is not too complicated.  You don't need to know how to work the climate control or On-Star in order know how to start the engine and drive. You don't need an accounting degree or even high school math.  Regular old 4th grade math should do it.

It's called a progressive income tax.  

Progressive means that for each additional dollar you earn, you owe a greater percentage of that dollar in tax. It's been this way since Woodrow Wilson needed to pay for WW I.

For a single person, this is how it progresses.

income from to is taxed at
 $                        -    $               8,500 10%
 $                 8,500  $             34,500 15%
 $               34,500  $             83,600 25%
 $               83,600  $          174,400 28%
 $            174,400  $          379,150 33%
 $            379,150  ....and up  35%

You pay 10% for the first $8500 you earn.  So, if you make exactly $8500, you pay $850 in tax.

Now, for the tricky part.

Then on the next dollar you earn, you pay 15% or an additional $0.15.  So, if you make $8501 you pay $850 plus $0.15 = $850.15.  If you made $8502, you'd pay $850.30 in taxes.

And so on.....

Each step in the table is commonly referred to as a "tax bracket".  If you make $50,000, you are in the 25% tax bracket.

A common misconception is that your tax is: your income X your tax bracket rate.   WRONG. That would be a variable rate flat tax.  Our income tax is progressive.

For married people filing a joint tax return the tax brackets are:

income from   to  is taxed at
 $                            -    $                 17,000 10%
 $                        17,000  $                 69,000 15%
 $                        69,000  $               139,350 25%
 $                     139,350  $               212,300 28%
 $                      212,300  $               379,150 33%
 $                      379,150  ....and up  35%

That's it. That's our progressive income tax.

But wait, there's more....how about some exemptions?

People have to eat and have a place to live and they can have kids that eat and require shelter as well.  In order to give people a break, the tax code allows a certain amount of income to be exempted from taxation.

For each person in your household, you get a $3400 exemption.  For a family of four, that adds up to $13,600.   That means you get to subtract that amount from your income before you figure your taxes.

For a family of four with an income of $70,000, they get to adjust their income down to $56,400 using their exemptions.

And, even more....how about some deductions?

The government also wants to help you own your own house and they want you go give to charity because these things improve our society, so they allow you to deduct mortgage interest and charitable donations from your income, too.

They also allow deductions for other necessary and/or desirable things such as work expenses, heath care, education, child care, etc.... within certain limits.

But, even if you don't pay a mortgage or give to charity or pay for your own health care, you still get to make a deduction.  It's called the standard deduction.  For a married couple, it's $11,900.

So, that family of four with the $70,000 income only owes tax on 70,000 gross income - 13,600 exemption - 11,900 dedcution = $44,500.  This family is in the 15% tax bracket and their effective tax rate is 8.3% (gross income of $70,000 and tax of $5825 give an effective tax rate of 8.3%, just divide!)

Here's the breakdown in table form:

Example: family of four
Dad  $                      35,000
Mom  $                      35,000
Kid 1  $                                -  
Kid 2  $                                -  
Dad  $                     (3,400)
Mom  $                     (3,400)
Kid 1  $                     (3,400)
Kid 2  $                     (3,400)
 standard deduction   
   $              (11,900)
 adjusted income   
   $                 44,500
tax calculation
from to is taxed at tax owed
 $                                   -    $                      17,000 10%  $         1,700
 $                        17,000  $                      69,000 15%  $         4,125
 $                        69,000  $                   139,350 25%  $                -  
 $                      139,350  $                   212,300 28%  $                -  
 $                      212,300  $                   379,150 33%  $                -  
 $                      379,150  ...and up  35%  $                -  
total  $        5,825
effective tax rate 8.3%

Another example.  Married couple, no kids, each earns $80,000.  (Chances are these guys will itemize their deductions because their mortgage interest and charitable giving will add up to more than $11,900, but I'll leave it at $11,900 for the example)

These guys are in the 28% bracket and have an effective rate of 17.3%

Dad  $                      80,000
Mom  $                      80,000
Kid 1  $                                -  
Kid 2  $                                -  
Dad  $                     (3,400)
Mom  $                     (3,400)
Kid 1
Kid 2
 standard deduction   
   $              (11,900)
 adjusted income   
   $               141,300
tax calculation
from to marginal tax rate tax owed
 $                                   -    $                      17,000 10%  $         1,700
 $                        17,000  $                      69,000 15%  $         7,800
 $                        69,000  $                   139,350 25%  $       17,588
 $                      139,350  $                   212,300 28%  $             546
 $                      212,300  $                   379,150 33%  $                -  
 $                      379,150  ...and up  35%  $                -  
total  $      27,634
effective tax rate 17.3%

Capital Gains are different - sometimes

So, what's all this noise about the "Buffet Rule" and Mitt Romney only paying 15% effective tax rate?

It's something called long term capital gains.  They get taxed at a lower rate.  Why?  The presumption is that you want people investing in the stock market for the long haul, not just buying low at 9AM and selling high at 3PM.  It's good for the economy to get people investing long term, so, the government gives you an incentive to do it.  So, there is a different, lower rate for long term capital gains.

An example.  You buy one share of Ford stock at $12 today and hold it for 10 years, selling it at $22 dollars.  You have a capital gain of $10 ($22-$12), and owe the long term capital gain rate of 15% or $1.50 in tax on it.  If you didn't hold it "long term" you would just have to count the gain as part of your regular income.

Here's some history on this.  

It's actually a bit surprising who did what, when.

Since pretty near the beginning of the income tax, there has been a different tax rate for long term capital gains.  Sometimes it varied, getting lower the longer you held the investment. Sometimes, it was all at a flat rate.

The biggest change in recent history occurred during the Reagan administration in 1986 when the tax code was greatly simplified.  They did away with any differentiation for capital gains income.  Capital gains of any kind were taxed as regular income.  When this was true, guys like Buffet and Romney would have paid nearly 28% in taxes, the top tax rate at that time.

This was Reagan's idea. Surprised?  There was a trade-off.  The tax brackets were flattened and their number reduced at the same time, so the uber-wealthy had their regular income taxed less heavily.  But, Reagan and a Democratically controlled House agreed to an implemented these changes.

So, how'd we get here?

1997.  Bill Clinton.

Surprise, again!

He lowered the tax rates on long term capital gains to 20%. George W. Bush cut them further to 15%.

So, a guy like Buffet who gets all his income from long term capital gains, pays about 15% in tax while his secretary, who presumably is decently paid and in the 25% tax bracket, probably pays closer to 20% effective tax rate.

What next?

I have no idea.  Should long term capital gains be taxed lower than ordinary income?  Does the incentive help the economy? Who knows?  Nobody is even talking about it.  All the heat is on tax brackets.

President Obama has proposed raising the rate on the top bracket and/or creating a new, top bracket.  Neither he nor anyone else has even whispered about changing the tax rate for long term capital gains.

Maybe the way out is to do another round of tax simplification ala 1986 and whittle the tax code back down to 20,000 pages or so.

Maybe just cap long term capital gains income at no more than ordinary income.  You make $1,000,000 at your day job and $5,000,000 in long term capital gains, you pay the regular tax rate on $4,000,000 of your capital gains.

Maybe, just let all of the Bush tax cuts expire.  Though both Republicans and Democrats are against this, they don't seem to be able to agree on alternative.

Maybe replace the income tax with a consumption tax.  Buffet buys a yacht, he pays 30% sales tax.  Of course, that means no more dancing statue of liberties gracing the street corners every winter - although they'd probably be replaced with some other no-value-added life form.

There are a lot of ways to skin this cat.  They all better get moving and pick one!