102% Tax Rate? Really?
Investment manager James Ross last week told New York Times columnist James Stewart that his combined federal, state, and local tax rate was 102 percent. No doubt, Ross did pay a lot of tax to the feds and the two New Yorks, city and state. But did he really pay more than all of his income in tax?
No, he did not.
As Stewart made clear past the wildly misleading headline (“At 102%, His Tax Rate Takes the Cake”), Ross’s tax bills totaled 102 percent of his taxable income, a measure that omits all exclusions, exemptions, and deductions. Using that reduced measure of income inflates Ross’s effective tax rate far above the share of his total income he paid in taxes.
Deeper into his column, Stewart explains that Ross’s tax bill was just 20 percent of his adjusted gross income (AGI), a more inclusive measure that does not subtract out exemptions and deductions. Because he took advantage of many preferences, Ross’s taxable income was only a fifth of his AGI, resulting in that inflated 102 percent tax rate. But even AGI doesn’t include all income. Among other things, it leaves out tax-exempt interest on municipal bonds, contributions to retirement accounts, and the earnings of those accounts. Ross almost surely paid less than 20 percent of his total income in taxes
Stewart’s article demonstrates the common confusion about effective tax rates, or ETRs. There are many ETRs, depending on which taxes you count and against what income you measure them. Including more taxes drives up ETRs. Using a broader measure of income drives them down. And interpreting what a specific ETR means requires a clear understanding of both the tax and income measures used.
The Tax Policy Center has just released new tables that demonstrate what happens to ETRs when you include more taxes and or use alternative income measures. In 2011, for example, the federal individual income tax averaged 11.5 percent of AGI but just 9.3 percent of total cash income, the much broader measure of income that TPC generally uses for its analyses. Adding payroll taxes boosted those ETRs to 20.4 percent of AGI but just 16.5 percent of cash income.
The highest income 20 percent of households paid an average of 17.3 percent of AGI in individual income taxes in 2011. That’s the measure the media used recently when they reported the tax rates paid by Mitt Romney (13.7 percent), Newt Gingrich (31.5 percent), and Barack Obama (24.1 percent). Measured as a share of the broader cash income measure, ETRs for the top 20 percent are lower—just 14.9 percent. We don’t know total cash income for Romney, Gingrich, or Obama so we can’t compare their ETRs under this measure.
Add in payroll taxes—both employer and employee shares—and the highest income households paid 20.9 percent of their cash income in taxes. And if you tack on their shares of the corporate income tax and the estate tax, their effective tax rate hit 24.5 percent.
Now look at middle-income households. In 2011, they paid 4.1 percent of their AGI in income taxes but just 3.2 percent of their cash income—nearly 12 percentage points less than the rich. The income tax is quite progressive. Include regressive payroll taxes and their ETR jumps to 12.1 percent, about 9 percentage points less than the highest income households. Add their (relatively modest) share of corporate income and estate taxes, and their ETR is only slightly higher—12.6 percent, or about half that for the top 20 percent.
The bottom line is you can use these numbers to tell many different stories, some more valid than others, depending on the taxes you include and the income measure you use. The broadest measure of income provides the most meaningful gauge of the relative impact of taxes on households. Narrower measures can yield absurd results—James Ross didn’t pay 102 percent of his income in taxes—and ignore important differences in households’ ability to pay.
It’s fine to tell those different stories but essential that any analysis compares equivalent ETRs, calculated for the same taxes using the same income measure. Combining apples and oranges may make a good fruit salad but it yields poor analysis.