Showing posts with label tax burden. Show all posts
Showing posts with label tax burden. Show all posts

Thursday, August 25, 2011

CHART: Average Federal Income Tax Rate by Income Group (1998-2008)

(Click image to enlarge)


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Wednesday, August 24, 2011

Is Warren Buffett Paying His "Fair Share"?

I have tremendous respect for Warren Buffett. I own shares in Berkshire Hathaway and he and his group of companies have generated some reasonable gains over the years.

But, is Mr. Buffett right? Do the superwealthy like him pay less than their "fair share" of taxes as he seemingly claims is his New York Times editorial? Mr. Buffett's non-scientific technique was to ask 20 of his employees how much tax they pay.

Likewise, Mr. Buffett didn't distinguish between income taxes, sales taxes, corporate taxes, estate taxes, or payroll taxes. I'll focus on federal income taxes, which generates one of the largest shares of revenue for the federal government. Payroll taxes (Social Security and Medicare) are another matter that I'll cover in a later post. Likewise, Mr. Buffett didn't distinguish between MARGINAL tax rate or EFFECTIVE tax rate. The MARGINAL rate is the amount that you pay on each additional dollar of income. The EFFECTIVE rate is how much you pay in total taxes, divided by your total income. The EFFECTIVE rate is nearly always less than the MARGINAL rate, although most people remember the MARGINAL tax rate because it usually seems so extreme. See "Pretty Pictures and a Political Rorschach Test" to see how marginal rates have changed over time.

Unfortunately, Mr. Buffett's non-scientific sample of 21 taxpayers represents just 0.000015% of the total population of 140 million taxpayers, or about 1 in 6.664 MILLION taxpayers. In statistics, this is called a non-representative sample. Given that Mr. Buffett by himself is also a member of an elite group, the Top 400 taxpayers, any result will be highly skewed.

Wouldn't it be great if we could use real IRS data and could validate if wealthy taxpayers were indeed not paying their "fair share"? Oh wait, we can! The IRS provides freely downloadable summary statistics for all income taxes filed by year, income group, etc. Groups like the Tax Foundation and the Tax Policy Center use this data to report on how the tax burden falls on taxpayers.


According to Warren Buffett's editorial, he paid $6,938,744 ($6.938 MILLION) in federal income taxes in 2010, representing 17.4% of his taxable income. So, is Warren Buffett scamming the system? The average tax bill for all taxpayers in 2008 (the latest year of data from the IRS), was $7,373, down from $7,911 in 2007. The average taxpayer paid 12.24% of his taxable income in federal income tax in 2008. Taxpayers in the Top 0.1% population paid an average $1,357,143 in taxes in 2008. Warren Buffet paid over $5 MILLION more! The Top 0.1% also paid 22.7% of their total income as income tax. Warren Buffet paid about 5.3% less. However, Mr. Buffett is 80 years old and like many others his age, he likely receives considerable income from long-term capital gains, which are presently taxed at 15%. Likewise, being a shrewd investor and having lived through prior times with much higher tax rates, Mr. Buffett likely has an extensive portfolio of tax-free municipal bonds and U.S. Treasuries, but this is conjecture.

To summarize ...
  • Warren Buffett paid significantly more in absolute dollars than did the average taxpayer ($6.938 MILLION vs. $7,373).
  • Warren Buffet paid a higher percentage of adjusted income in taxes than the average taxpayer (17.4% vs. 12.24%) but less than those in the Top 0.1% of taxpayers (17.4% vs. 22.7%)
(Click image to enlarge)

QUESTION: Does Warren Buffett pay more or less of the total share of income taxes than his total share of income?

Let's determine how much he made last year. He claims that he paid $6.939 MILLION in taxes and had a 17.4% effective tax rate. Divide $6.939 MILLION by 17.4% and you derive that his adjusted gross income was around $39.878 MILLION (a nice job, if you can get it!). Because 2010 tax data isn't yet available, I'll mix some apples and oranges using the top-line 2009 tax summary data. In 2009, the total US adjusted gross income (for tax purposes) was $7.63 TRILLION. The total 2009 federal income tax bill was $865.95 BILLION.
  • Warren Buffett's share of total U.S. income = 0.00052% ($39.878 MILLION / $7.626 TRILLION)
  • Warren Buffett's share of total U.S. income tax bill = 0.00080% ($6.939 MILLION / $7.626 TRILLION)
As do most wealthy taxpayers, Warren Buffett also pays a higher share of the total tax bill than his total share of US income. In fact, Warren Buffett pays 53% more in taxes than his share of income ((share of taxes / share of income) - 100%). A number greater than 0% indicates that the taxpayer is taxed on both income and on a fraction of accumulated wealth. A number less than 0% indicates that the taxpayer potentially receives government services that are subsidized by all other taxpayers.



(Click chart to enlarge)

Using 2008 historical data for the Top 0.1% taxpayers (again, Mr. Buffett is in the Top 400 group or the Top 0.0003%), his share of taxes versus total income should be around 85%. His tax payments current are more in line with the Top 1% to 5% of taxpayers. If this Top 0.0003% taxpayer wants to keep up with the Top 0.1% of taxpayers, then his 2010 tax bill should be in the neighborhood of $11.128 MILLION instead of a "measly" $6.939 MILLION. However, if he wants to pay 22.7% of his income as tax to match the Top 0.1%, then he only needs to contribute another 5.3% of his income or $2.144 MILLION. Instead of waiting for the slow-moving Congress to take action, Mr. Buffett is free to voluntarily write a check for an addition $2.114 MILLION or $4.189 MILLION or more, unless perhaps he has better use of that money such as investing in the U.S. economy and creating jobs--two actions that the federal government that is seemingly incapable of doing.

The last time that Congress attempted to address "inequalities" in the U.S. tax code, it created the ill-conceived and poorly-constructed Alternative Minimum Tax (AMT). AMT was originally targeted at just 155 high-income taxpayers, who paid $0 in income tax but broke no law and merely followed existing U.S. tax code. Ultimately, because AMT was not indexed to inflation, it impacted millions of middle-class taxpayers (myself included).

Back to our fundamental question: Does Warren Buffett pay his "fair share" of income tax? He pays significantly more taxes than the average taxpayer, both in total dollars, as a percent of his income, and as a percent of his share of total income. Could he pay more? Undoubtedly. Is he paying his "fair share"? First, tell me what your definition of "fair share" is.

You know what we're not discussing while wasting time on the definition of "fair share"? TAX REFORM! I believe that all sides agree that our current income tax system is antiquated and internationally un-competitive. Generally, you get less of whatever you tax. The U.S. government currently taxes work (jobs), investments, and savings. Instead, we should be taxing consumption! But, there will likely be no changes until the next major crisis.
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Sunday, March 20, 2011

Pretty Pictures and a Political Rorschach Test


"The power to tax is the power to destroy"
John Marshall, Chief Justice of the United States (1801-1835)
A recent blog post regarding U.S. income tax caught my eye. The post included an aesthetically beautiful infographic from data artist Stephen Von Worley and his Data Pointed blog that, according to multiple blog posts, purports to show once again that those #@*&# rich people are just not being taxed enough.

Unfortunately, as an engineer and scientist, I have a number of problems with the infographic. One problem is that the original chart is mislabeled, based on the data that it presents as I will explain below. Another problem is that many people apparently misinterpreted what the chart actually tells you.

Infographics, though often useful, are essentially "visual statistics," which reminds me of a favorite quote.

"Statistics are like bikinis. What they reveal is suggestive, but what they conceal is vital." -- Aaron Levenstein
Why the Chart is Mislabeled
The original post proclaims "The tax man cometh, and to illustrate the inequities of his cleft-hoofed embrace, we’ve charted the shift in U.S. income taxes from rich to poor over the past century." Unfortunately, the data behind the chart does NOT show this.

The chart claims to show relative tax burden, which in the post is defined as "the amount of tax due relative to the long-term average at each income level."

So what does the infographic actually show? After some reverse engineering, it actually shows the relative change in marginal income tax rate compared to historical averages. Keywords here are "relative change, " "marginal income tax rate," and "historical averages" It’s a common mistake, but high marginal tax rates DO NOT equate to actual tax burden or increased revenues for the government. High marginal tax rates do affect behavior and dissuade earning and investment plus encourage tax avoidance strategies.

Choose Your Average
The non-obvious distortion is that the chart relies on historical averages. Averages themselves can be greatly deceiving.
"Then there is the man who drowned crossing a stream with an average depth of six inches." -- W.I.E. Gates

"The average human has one breast and one testicle." -- Des McHale
Fist, a little background information. Since the inception of the federal income tax, the top marginal tax rate ranged from 7% to 94%. The chart below is color coded according to a chart used later in this post. The source data is available here.

Marginal Tax Rate for Top Income Category, by Year (1913-2011)
Meanwhile, for the bottom tax bracket, the tax rate varied from a low of 0% in the 1970's/1980's to a high of 23% during the New Deal, World War II.

Marginal Tax Rate for Bottom Income Category, by Year (1913-2011)

The average marginal tax rate for top earners was over 59%, with a standard deviation of ±25% for the specified 99 year period (1913-2011) since the 16th Amendment was passed. If considering the entire 235-year history of the United States, the average drops to 25%. If using just the last 25 years, then the historical average is 35.8%. Choosing the specific time period dramatically affects the average.

Relative Difference in Top Marginal Tax Rate Compared to
Historical Average, by Year (1913-2011)

Marginal tax rates for all income taxpayers were at historic highs for twenty years, from 1944 to 1963. For upper income taxpayers, the top marginal rate was 90% or more. Even for the bottom of the income ladder, the rates were over 20%.

However, there was a ten year period (1977-1986) when the marginal rate for lower-income taxpayers was 0%--zip! Mathematically, these zeroes reduce the average. For example, the average marginal tax rate for low-income taxpayers over the thirty-year period (1944-1963, 1977-1986) drops to 13.7%.

The History Embedded in the Charts
With due apologies to Stephen Von Worley for mashing up two of his beautiful infographics, here is some of the history of the U.S. income tax embedded in the charts. The numbered annotations are described below.

Marginal Tax Rate

This is an excellent infographic showing how the marginal tax rate changed over time. The tax rate is presented as a heat map. The higher the tax rate, the closer the color is to white hot. The lower the tax rate, the closer the color is to cool black. The data is also adjusted for inflation, which shows the effect of "bracket creep" over time.

Original, unmodified image:

I re-oriented this graphic to match the "tax burden" chart.

(click image to enlarge)



Changes in Marginal Tax Rate Compared to Historical Average

This is an aesthetically beautiful infographic showing how the marginal rates changed compared to their historical average, over the lifetime of 99-year history since the 16th Amendment was ratified.

Original, unmodified image:

(click image to enlarge)

Note 1:Two lines are added to the United States Constitution upon ratification of the 16th Amendment, legalizing federal income tax.
"The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration."
Congress subsequently passed the Revenue Act of 1913. The 18 pages of legislation imposed a federal income tax ranging from 1% to 7%, depending on income. The 1913 federal income tax form and instructions are simple and run just four pages.

Note 2:
Due to the costs of World War I, Congress passes the War Revenue Act of 1917 and the Revenue Act of 1918, dramatically increasing the top marginal tax rate to 67%, then to 77%.

Treasury Secretary Mellon understood the negative impact on the high level of taxation.
"The present system is a failure. It was an emergency measure, adopted under the pressure of war necessity and not to be counted upon as a permanent part of our revenue structure. The high rates put pressure on taxpayers to reduce their taxable income, tend to destroy individual initiative and enterprise, and seriously impede the development of productive business…. Ways will always be found to avoid taxes so destructive in their nature, and the only way to save the situation is to put the taxes on a reasonable basis that will permit business to go on and industry to develop."
Note 3:
Due to the unpopularity of the Wilson Administration and World War I, Warren G. Harding was elected President, along with solid Republican majorities in Congress. Congress reduced tax rates by passing the Revenue Act of 1921.

Note 4:
Congress, under the leadership of President Coolidge, reduced all income tax levels by passing the Revenue Act of 1926. The bottom marginal rate was reduced to 1.5%. The top marginal tax rate was reduced to 25%.

Note 5:
The Republican Congress had previously passed the disastrous Smoot Hawley Tariff, heavily opposed by Democrats. Democrats made major gains in the Congressional election of 1930.

Congress, under President Hoover, increased income taxes for all income levels by passing the Revenue Act of 1932. The bottom marginal rate was increased from 1.5% to 4%. The top marginal tax rate was increased from 25% to 63%. It was the largest peacetime tax increase in U.S. history, up to that point.

The combination of bad policy and increased taxation lead to disastrous unemployment, shifts in economic activity, and decreased investment activity. Welcome to the Great Depression.

Note 6:
Congress, under the President Franklin Roosevelt (FDR), passes the "soak the rich" tax policies of the Revenue Act of 1935 (The Wealth Tax Act) and the Revenue Act of 1936. Top marginal tax rates increased to 79%.

Roosevelt’s leadership was challenged by previous Democratic Presidential candidate, Alfred E. Smith, in his famous 1936 radio address, "Betrayal of the Democratic Party."

Note 7:The immense costs of the "New Deal" policies of FDR's Administration plus World War II lead to the highest marginal tax rates for all income levels. Top marginal rates reach an astonishing 94%. Even low-income taxpayers faced a 22.2% rate.

The United States emerged from World War II with its industrial and manufacturing capacity relatively untouched. Much of Europe and Asia were enslaved by oppressive Communist regimes. India was seduced by the unfulfilled promises of Socialism. The United States helped rebuild Europe and Japan and was engaged in a Cold War with the Soviet Union and the Communist Chinese.

Because the United States was essentially the only game in town for those that enjoy Western-style democracy, the federal government could continue to oppressive tax rates.

Note 8:
The Revenue Act of 1964 cut all income tax levels by about 20%. Top rates were reduced to 70% while bottom rates were reduced to 14%.

The tax cut was made popular by Democratic President John F. Kennedy and was an attempt to spur the U.S. economy. Unfortunately, President Kennedy was assassinated before the legislation was finally enacted.

Note 9:The Tax Reduction and Simplification Act of 1977 essentially reduced bottom tax rates to 0% for the next ten years. Top rates were unaffected.

This 0% rate effectively reduces the historical average for lower income taxpayers and causes the "birds eye" pattern in chart of relative marginal tax rates.

Note 10:Congress passes Economic Recovery Tax Act of 1981 (ERTA), better known as the Kemp-Roth tax cut. Top rates were reduced to 50% while bottom rates remained at 0%.

Tax brackets indexed to inflation, reducing "bracket creep." Note how the white line in the tax brackets chart flattens after this point.

Note 11:
Congress passes the Tax Reform Act of 1986, eventually reducing top tax rates to 28%, their lowest levels in modern history. The act also increased bottom tax rates from 0% to 14%.

Although many consider it the second Reagan Tax cut, the act was officially sponsored by Democrats, Richard Gephardt of Missouri in the House of Representatives and Bill Bradley of New Jersey in the Senate.

Note 12:
Congress passes the Omnibus Budget Reconciliation Act of 1993, raising top marginal tax rates from 28% to 39.6%.

The act received no Republican votes and was opposed by some Democrats. Vice-President Gore provided the tie-breaking vote in the United States Senate.

Note 13:
In response to recession from the Dot-Com bubble, Congress passes the Economic Growth and Tax Relief Reconciliation Act of 2001. The act is also known as the first of the Bush tax cuts. Rates were reduced at all levels. The top marginal tax rate was reduced to 35% while the bottom marginal tax rate was reduced to 10%.

In response to the further recession caused by the September 11, 2001 World Trade Center terrorist attack, Congress accelerated some of the changes by passing the Jobs and Growth Tax Relief Reconciliation Act of 2003.

The Open Question
So the question remains, are marginal rates too low for top income earners?

By international comparison, no.

The marginal tax rate is less important than the effective tax rate. Despite the official tax rate, how much to people really pay. This is measured as the tax paid divided by the adjusted gross income.

The Tax Foundation tracks this information (see Table 8), but only since 1980. Using their information, the following chart shows that top tax payers pay more as a share of the adjusted gross income (AGI). The calculations for AGI changed with the 1986 tax law, which results in the apparent spike on the chart.

Because top taxpayers have more income, they would also pay more taxes in absolute dollars, even if their tax rates were the same or lower. However, the chart shows that high-income taxpayers do indeed pay a larger share of their income in taxes than do almost all income classes.

Average Effective Tax Rate by Income Class and by Year
This effect is also obvious looking at the amount of share of revenue contributed by different income levels. Not surprisingly, high-income taxpayers pay the bulk of U.S. income tax.

See also ...

"The Rich Don't Pay Taxes" Lie: Purposely Deceptive, Or Backed Up by Data?

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