Marginal Tax Rates vs. Effective Tax Rates
With the Republican presidential primaries in full swing, we’ve seen a lot of attention focused on the income tax rates paid by the candidates. In a debate earlier this month, Mitt Romney, who is very wealthy, commented that he thought his income tax rate was around 15%. This brought an outcry from the media that complained how it is unfair for a multi-millionaire like Romney to pay taxes at a lower rate than average Americans.
I have received a number of questions from clients and readers on this very topic, so let me try to explain how this can be. You have to understand the difference between the marginal tax rate and the effective tax rate. Under our progressive tax system, income is taxed at graduated rates. The current statutory income tax brackets range from 10% to 35%. An individual’s marginal tax rate refers to the portion of income that is taxed at the highest tax rate ” not the rate for the entire amount of income earned.
[For the tax professionals and accountants in our audience, I should add that the marginal rate is not just the statutory percentage but includes all credits, hurdle, phase outs and the Alternative Minimum Tax that can cause the rate to be above or below the statutory tax rate.]
The effective tax rate, meanwhile, is the amount a taxpayer pays in taxes as a percentage of total income. Here is an example: If you file your federal tax return as a single taxpayer, had taxable income of $75,000, and paid $15,332 in federal income taxes, then your marginal rate would be 28%, but your effective rate would be 20.4%. That lower rate reflects the fact that you paid tax on portions of your income at the 10%, 15% and 25% rates, as well as the final portion at 28%.
The average effective federal tax rate for American taxpayers is 11%, according to an analysis of 2009 IRS data by the Tax Foundation, a non-profit research organization. For individuals with adjusted gross income of $50,000 or less, the average effective tax rate is less than 5%, according to the Tax Foundation. The table below illustrates the average effective tax rate paid by Americans at various income levels based on 2009 data from the IRS.
In Romney’s case, the majority of his annual income is reportedly derived from his investments that produce mainly capital gains, which are currently taxed at a flat rate of 15%. Under pressure, Romney released his 2010 tax return and estimates for 2011 recently, so we’ll know more details about how much he pays in taxes, and at what rates, in the days just ahead.
Warren Buffet likes to complain that he pays a lower tax rate than his secretary, but his situation is much like Romney’s. Most of Buffet’s income is in the form of capital gains that currently enjoy the lower tax rate of 15%.
The difference in marginal rates and effective rates can be confusing because the media throws out tax rates but they rarely define which rate they’re referring to. Hopefully, this discussion helps.
Millionaires: Tax the Rich, But Not Us
Most millionaires say they think the rich should pay more taxes, but when it comes to them individually, they disagree. There are a couple of reasons for this. PNC Financial Services Group, the sixth largest US bank, recently surveyed 555 millionaires (those with investable assets of $1 million or more, excluding real estate) across America.
Surprisingly, 71% said they believe the wealthy should pay more in taxes and give more to charity. But in the same survey, 49% said that the higher tax rate should not apply to them but only to super-rich types like Warren Buffett.
It is obvious that almost half (49%) of the millionaires surveyed don’t consider themselves wealthy. Unfortunately, the survey didn’t ask the respondents to identify just what level of wealth should trigger the higher tax rates that 71% said they favor.
At the same time, 41% said that if their tax rates were increased, they would change their investment strategy, presumably to try and avoid paying more taxes “ surprise, surprise! 24% said they would reduce their commitments to charities if their taxes were increased.
What does this tell us? A lot of wealthy people like to say they’re in favor of higher taxes on the rich because it feels good and is politically correct. But when it comes down to actually paying more, almost half think the higher tax rate shouldn’t apply to them. The other thing it tells us is that a lot of millionaires honestly don’t think they’re wealthy by today’s standards.
Finally, a new Rasmussen poll taken last week found that 47% of likely voters would support a presidential candidate who promises to raise taxes only on the rich, while only 36% said they would support a candidate who opposes all tax increases. Another 18% weren’t sure. President Obama’s message of higher taxes on the rich is resonating, sadly. Unfortunately, Obama’s definition of rich is families making over $250,000 a year.
[Dan’s Comment: If you have a million dollars of equity in real estate or whatever, you’ll soon be included in Obama’s definition of rich!]
Gary D. Halbert is the president and chairman of Profutures, Inc. Subscription rates for Forecasts & Trends is $197 for 12 issues and may be obtained by visiting his website at www.profutures.com.