Q. I always heard that the richest people in the United States do not pay much income tax because of all the loopholes. I also heard that it is the middle and upper middle-income people that pay the most. Now I've heard different. What is the truth?
---Q.L., by e-mail from Dallas
A. The wealthy can probably afford to pay more taxes. But higher income households pay the bulk of all federal income taxes.
In 2001, the last year for which this analysis from the Internal Revenue Service is available, the 1.3 million returns representing the top 1 percent of all taxpayers collected 17.5 percent of all income and paid 33.9 percent of all income taxes. To be in the top 1 percent you needed an adjusted gross income of at least $292,913.
In addition, their share of total taxes paid had risen steadily from 1986. It was 25.7 percent then. So the well off are paying more of the taxes collected even though their average tax rate declined from 33.1 percent to 27.5 percent.
Households in the top 25 percent had adjusted gross incomes of at least $56,085. They paid taxes at an average rate of 18.08 percent. They earned 65.2 percent of the income and paid an impressive 82.9 percent of all income taxes.
The average tax rate for the top 25 percent declined slightly from the 1986 average of 18.72 percent. I'll bet my next paycheck that $56,085 isn't the income most people have in mind when they imagine the fat cats at the top of the income pyramid. But there it is. Most of the glitzy life so visible in advertising is priced well beyond the purchasing power of that threshold earner or family.
The same analysis shows something you would hope for: the average tax rate paid declines as income declines. The top 1 percent paid at an average rate of 27.5 percent. The top 10 percent paid at an average rate of 21.4 percent. The top 25 percent paid at an average rate of 18.1 percent.
The bottom 50 percent, meanwhile, paid at an average tax rate of 4.1 percent, down from 5.6 percent in 1986. If your adjusted gross income was $28,528 or less, you were in the bottom 50 percent. The bottom half also paid only 3.97 percent of all income taxes paid.
The only true remaining "loophole" for very high-income people is that they can often control how their income is received. They may, for instance, elect to collect more of it as dividends and capital gains. These are taxed at only 15 percent. The top one-tenth of one percent--- those with incomes of at least $1,324,487--- paid at an average tax rate of 28.2 percent in 2001. My bet is that the 2003 figures, when released, will show only a modest decline in average tax rate for this group.
Are we missing something here?
Yes, quite a bit. The tax we actually experience isn't just the federal income tax. It is the combination of the employment tax and the income tax. Add the two together and the tax burden as a percent of income flattens dramatically. This is particularly true for the marginal tax rate paid--- the tax rate on the last dollar of income.
Because once your earned income exceeds the wage base maximum--- $87,900 this year--- only the 1.45 percent employee portion of the Medicare tax comes out of the paycheck. The 6.2 percent taken for Social Security stops coming out.
As a consequence, a household with a taxable income of $58,100 can pay taxes at a marginal rate of 32.65 percent (25 percent federal income tax rate plus 7.65 percent employee portion of the employment tax). A household with 6 times the income pays taxes at a marginal rate of 36.45 percent (35 percent top marginal tax rate plus 1.45 percent Medicare portion of the employment tax).
This comparison, by the way, would be worse if we considered the real burden of the employment tax. While the "employer" portion is another 7.65 percent, it is a tax on labor. Those who are self-employed see the full burden of the tax, 15.3 percent.
Viewed this way, the $58,100 household pays taxes at a 40.3 percent rate (25 percent federal income tax plus 15.30 percent employment tax), while a household with 6 times the income pays at a lower marginal tax rate, 37.9 percent (35 percent federal income tax rate plus 2.90 percent full Medicare tax rate).
Similarly, a household with only $25,000 of taxable income pays at a top marginal rate of 30.3 percent--- not that much lower than the 38.9 percent rate paid by the household earning about 13 times as much. As I said, when you add the income and employment tax together, the tax burden flattens quite a bit.
Neither political party discusses the combined marginal tax rate because it isn't in their interest. They do well when we point fingers at each other. The last thing either party wants us to figure out is that they're fleecing us all.
Scott Burns is the retired Chief Investment Officer of AssetBuilder, the creator of Couch Potato investing, and a personal finance columnist with decades of experience.