January 20, 2012

Effective Tax Rate

Robert has decided to announce his federal income tax rate paid in the years 2008, 2009, 2010. He does this because it is a good way to discuss the somewhat confusing question of what a person actually pays in federal taxes as a percentage of income.  A question that Robert is sure most American's cannot answer about their own tax returns, which is one of the biggest problems in US society today.

There are at least three ways to answer the question "How much federal income tax did you pay this year as a percentage of your total income?"

First, one could answer the question by giving one's "marginal tax rate."  This is the answer that perhaps many (unthinking) Americans would give to the question stated above.  The problem is that it is a nonsense answer.  The marginal tax rate for a given tax return is the rate at which the last dollar earned by the taxpayer during the year is taxed. It IS NOT an answer to the question "How much federal income tax did you pay this year as a percentage of your total income?"

Second, one could answer the question by giving one's so-called "effective tax rate." The term "effective tax rate" does not, as far as Robert knows, have a universally recognized definition. He believes that what most people mean when they say "effective tax rate" is the amount of tax an individual or firm pays when all government credits are applied, divided by income that has been reduced by government allowed deductions. Robert believes that using a person's effective tax rate is certainly a better way to answer the above question than answering with a marginal tax rate (which is nonsense), but the effective tax rate measure is also a poor way to answer because when calculating the effective tax rate one subtracts from income all government allowed policy deductions (such as exemption deductions, charitable deductions, retirement account contribution deductions, and mortgage interest deductions).  By giving this answer, one understates income and thus overstates the percentage of one's income paid in tax.

One might most straightforwardly and honestly answer the question above by giving the amount of tax one pays without application of credits, divided by base income without government policy deductions (such as exemption deductions and mortgage interest deductions).  Stated another way, using this approach, one measures taxes as a percentage of net income, where net income is gross income less the allowable and customarily measured costs of generating that gross income. For employees, who earn wages, gross income and net income are generally the same amount. This definition recognizes that to give an intellectually honest answer to the question above, one must not reduce the amount of one's base income by the amount of policy deductions, which are, after all, ways the government reduces taxes. Robert will call the tax rate determined using this method the "True  Tax Rate."

So, using the definitions above, here are Robert's, and thus the Pierce Family's,  federal tax rate numbers:

2008
Marginal Tax Rate: 28%
Effective Tax Rate: 22.0%
True Tax Rate: 17.5%

2009
Marginal Tax Rate: 28%
Effective Tax Rate: 23.4%
True Tax Rate: 18.2%

2010
Marginal Tax Rate: 15%
Effective Tax Rate: 17.7%
True Tax Rate: 8.2%


Here's a link to the Tax Policy Center page that tells the same story (see second table down).  Note that the definition of "Effective Tax Rate" used by the Tax Policy Center appears to be the same as what Robert defines as "True Tax Rate."

http://www.taxpolicycenter.org/taxfacts/displayafact.cfm?Docid=456

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