The word ‘margin’ is often used when describing statistical, financial or economic data. Slim margin; margin of error; working on thin margins; large margin; margin calls; etc. Of greater note is the position of prominence this word occupies within our tax code.
All Americans know the phrase ‘marginal tax rate.’ But do any of us truly understand its application. Is it possible that the term is actually irrelevant? Given the vagaries of our tax code, perhaps we should use the word edge. May even cliff, if not precipice.
Benjamin Franklin once said, “It would be a hard government that should tax its people one-tenth part of their income.” Considering his comment, I suspect he is turning over in his grave. The lowest marginal income tax rate currently assessed under the IRC is 10% and the highest is 39.6%. We can no longer even dream of a time when the government would “…tax its people one-tenth part…”
Our income tax code mandates progressive marginal tax rates . The system is designed to tax higher income at higher rates. With the myriad exceptions written into our tax code, however, the desired result is not always achieved. In fact, that is more often the case than not.
Thus far I have used the word ‘marginal’ when describing tax rates. Although the 2013 Tax tables dictate a marginal rate of 28% when taxable income for a married couple filing jointly exceeds $150,000, the tax liability would not equal $42,000. The following example demonstrates how marginal rates are applied to that $150,000.
10% of $17,850 (total income exceeds the top value of the first bracket) +
15% of $54,650 (difference between the top value of the first two brackets) +
25% of $73,900 (difference between the top value of the 2nd and 3rd brackets) +
28% of $3,600 (difference between total income and the bottom value of the 4th bracket)
This calculation results in a tax liability of $29,466, or 19.6%, on taxable income of $150,000. However, under our existing marginal tax rate system, this taxpayer would be described as ‘being in the 28% bracket’ not a 20% bracket (which, as an aside, does not exist.) Tax liability may be reduced by eligible tax credits, lowering the actual tax liability even further.
Thus the myriad tax exclusions, preferences and credits render marginal rates, in large measure, irrelevant. A more appropriate term to describe the actual tax burden is the effective rate. This calculation can be made by dividing either taxable income or total income by the total tax liability.
To the extent that preferences, deductions and credits serve to reduce income, or lower taxes, the best method to determine the vertical or horizontal equity of a tax is to calculate the effective rate paid by a taxpayer using total income.
The above taxpayer received total income of $170,000. Subtracting exemptions and the standard deduction produced taxable income of $150,000. In this example, therefore, the effective tax rate paid on total income is 17.3% as opposed to the 19.6% paid on taxable income
If we compare two other taxpayers with this taxpayer, we uncover some significant differences in the effective rate paid on total income when different types of income are involved. Each of the three taxpayers is married and files jointly, with no dependents and claims the standard deduction. Each taxpayer reports adjusted gross income of $170,000 and taxable income of $150,000 as stated previously.
Our first comparison considers a taxpayer who received total income of $200,000 including $30,000 of tax exempt interest income. Reported total income was $170,000 resulting in taxable income of $150,000. His tax will be just as shown above, $29,466, but the effective tax rate paid on total income is 14.7%, two and one-half percent lower than the taxpayer described earlier.
A second comparison involves a taxpayer who earns total income of $170,000, half of which comes from capital gains. Even with identical taxable income to that earned by the first taxpayer, instead of the tax liability shouldered by our previous two couples, this taxpayer incurs a lower tax liability of $20,486. The effective tax rate paid on taxable income is 13.6%. The effective rate paid on total income is 12%. Tax liability for this taxpayer is calculated using the Qualified Dividends and Capital Gains Worksheet, using lower, fixed rates, rather than by using the marginal tax rate tables.
Even these comparisons do not tell the entire story. If total income reported on two separate returns is identical, it can derive from income actually received that is markedly different for tax purposes due to tax preferences. Box 1 on Form W-2, reported on Line 7 on Form 1040 can show the same dollar amount but may not report total actual compensation. To demonstrate this, compare two taxpayers who each report $170,000 in total income. Apply the same circumstances as used before: married, with no dependents.
Our first husband and wife each work for a company that has a 401K retirement plan. Nearing retirement age, they both elect to make the maximum contribution totaling $46,000 between them. Each employer also matches contributions up to 3% of income. The total contributions to their two retirement accounts approximate $52,480. Actual compensation earned, including employer matching contributions totaled $222,480. Adjusted gross income reported is $170,000 with taxable income equaling $150,000. Tax liability is the same as the very first example, $29,466. Effective rate paid on taxable income is 19.6%. Effective rate paid on total income is 13.2%.
Our second couple is also nearing retirement and being just as conscientious as the earlier couple, likewise set aside $46,000 for retirement. Their employer did not have a retirement plan so there was no additional funding for their retirement. Although they report total income of $170,000, they report lower adjusted gross income of $157,000 producing a lower taxable income of $137,000. They receive a lower tax bill of $26,108. The effective tax rate paid on taxable income is 19%; the effective tax rate on total income is 15.3%, two percent higher than the previous couple.
Summarizing this last example, couple number one actually earned $222,480 and incurred a tax bill of $29,466. Couple number two earned $170,000, over fifty thousand less, and although they paid a lower total tax of $26,108, their tax liability was higher as a percentage of their income.
Considered another way, the first couple effectively paid tax of $3,358 on marginal income of $52,480. That equates to a marginal tax rate of 6.4% assessed on the additional income.
You might think that this example can’t be right but it is. In the infinite wisdom of those who drafted our tax code, couple number one is allowed to set aside $46,000 for retirement, receive additional funds from their employer for their retirement and is allowed to exclude that entire amount from taxable income. The second couple, setting aside the same $46,000, can only exclude $13,000 from their income.
In practice, taxpayers also incur unexpected and unintended marginal rates as a result of other preferences and credits within the tax code. The Earned Income Tax Credit (EITC) is one such credit. Eligibility for EITC is based on income received by working. The amount of the EITC a taxpayer can receive increases as income increases, up to a maximum credit amount. In 2013, a taxpayer with three children, filing jointly could receive a maximum credit of $6,044. The maximum credit amount decreases when income exceeds $22,890 and ceases completely when income exceeds $51,568.
As an example, if a taxpayer with three children earned total income that approximated $22,875, a properly completed return would reflect a zero income tax liability. The taxpayer would have no income tax liability and would actually receive a payment from the IRS totaling $9,025 entirely due to refundable credits (EITC – $6,044; Additional Child Tax Credit – $2,981). Thus, earned income plus refundable credits would produce after tax income of $31,000. Even considering payroll tax, this taxpayer would realize disposable income of $29,250.
Because the subject of this post is marginal rates, let’s examine the marginal rate incurred by this taxpayer on additional earned income. Consider the tax impact if her income more than doubles. In this scenario, the taxpayer reports earned wages of $51,570. As a result of that additional income she would lose eligibility for EITC. That equates to a marginal rate of 21.1% paid on the $28,695 in additional income. For 2013, a married taxpayer would not be subject to that marginal rate until income exceeded $72,500.
What is the encouragement for this taxpayer to work harder, to work longer? With earned income of $51,570, our taxpayer realizes disposable income of $48,536. Compared with the wages cited in the earlier example her gross income increased by $28,695 yet disposable income only increased by $19,186. Considering income tax, payroll tax and lost credits, the taxpayer surrendered $9,509 of the additional income. What is the effective marginal rate paid on the ‘additional income?’ The answer – 33.1%. With income just above $50,000, this taxpayer is effectively assessed a marginal tax rate not ordinarily applicable until income approaches $400,000. Now THAT is a marginal rate.
Given the vagaries, complexity, inconsistencies and inequities of our tax system, we are all living on the margin. Does earning higher income move a taxpayer into a higher bracket or push him over the edge?
Maybe, just like the donkey tells the audience during the movie Shrek, "I'm a donkey on the edge!" Under the Internal Revenue Code it might be better said that we are all living on the edge – of an abyss!
Have to go check out my rappelling ropes. Maybe do a little rock climbing.
I’ll drop in on you later!