How Progressive is the US Tax System?
The Enormous Amount of Federal Taxes paid by the Wealthy
Those earning the most do pay the largest amount of actual dollars in taxes. The following graph indicates how much that is.
Ouch! I can feel their pain. Percentages are abstract. Real dollar amounts are just that — Real. It is easier for most of us to grasp the actual numerical amount that we must pay in taxes.
On the top end of the income scale, those making $100K per year pay $34K in taxes, $500K pay $152K a year, while those earning a million dollars pay $400K in taxes. On the bottom end of the scale, those making $50K/year pay $15K in taxes, while those making $10K/year only pay $1500 in taxes. In other words, those earning $500K/year pay a 100 times more in taxes than those earning $10K/year.
When we look at actual amounts of taxes paid rather than percentages, the amounts paid by the wealthy do appear to be staggering. It is understandable that those who call for tax relief for the wealthy would focus upon the enormous dollar amount paid in taxes. Yet these numbers are only part of the picture.
The Enormous Disposable Income of the Wealthy after Federal Taxes
Comparing tax percentages is one method of determining relative fairness. Another mode of comparison has to do with Disposable Income, i.e. how much money is left to spend after taxes are paid. This money is real. You can take it to the grocery store for food; make a rent or mortgage payment with it; or even buy a yacht or take a world cruise. A comparison of Disposable Incomes may shed more light upon economic reality for the taxpayer than do abstract Tax Percentages.
The following graph shows the disposable income that each income bracket has after taxes.
The real discrepancy between rich and poor strikes home. While the rich pay a higher tax percentage, they still have an enormous amount of money left over after taxes. For instance, the Disposable Income of those earning $30K per year is $20K; for the $150K earner it is over $100K; for those earning $500K, it is over $300K; for those making million dollars a year, it is over $600K to do with as they please; and so on up the income ladder.
Despite higher tax percentages, the real take home pay of the high wage earners dwarfs that of the average wage earner with his 5-digit income.
The Homeowner Interest Deduction provides a Great Tax Write-off
We’ve examined tax percentages, actual taxes paid, and disposable income after taxes in order to clarify our understanding of the tax burden on American wage earners. However, the prior analysis has not yet considered the effect of Tax Write-offs on these figures. Let’s see what happens to these comparisons when we include a standard Tax Write-off, the Homeowner’s Interest Deduction, in our analysis.
A vast majority of Americans make either rent or mortgage payments in order to secure living quarters. There is virtually no difference between a mortgage or rental payment in terms of the monthly budget. Both chunks of money are due at a regular time each and every month.
Although the effect of a payment on the monthly budget may be the same, the effect of the computation of Federal Taxes is far different. For those making Rent payments, there are little or no tax deductions. However for those making Mortgage payments, the interest on a home loan is Tax Deductible.
For the sake of illustration only, let us examine a typical American scenario to compare the difference in the percentage of taxes paid by a Homeowner versus a Renter. For purposes of comparison, let us assume that individuals pay 25% of their income to rent or mortgage. Of course typically, those making less pay a much greater percentage, while those making more pay a smaller percentage. Under this formula someone making $30K per year would pay $7500 per year towards housing ($625 per month). On the other hand, someone making $80K would pay $20,000 per year in rent ($1,667 per month).
If these individuals are Renters, none of this money is tax deductible. However if these individuals are Homeowners, then annual interest on their mortgage is tax deductible. Typically 80% or more of their mortgage payment is interest on the loan principle. For someone making $200K, this homeowner deduction could amount to an $8,000 reduction in personal income taxes paid to the federal government. Those making $500K per annum could save $33K in federal income taxes and those making one million per year have a whopping $71K in additional disposable income. It is evident that this Home Owner’s Mortgage Deduction reduces the tax burden substantially. In contrast, the Renter making an equivalent payment gets no such tax benefit.
While this is a hypothetical example, it is by no means unusual. In general, those who are wealthier are more able to own homes — in which case, the interest on their mortgage payment would reduce their tax liability. Those who are financially challenged, i.e. poorer, are far more likely to rent — in which case, none of their payment is tax deductible.
The following graph compares the tax percentage paid by wage earners, both hourly and salaried, before and after the Homeowner’s Interest Deduction. The red bar represents the percentage of federal taxes paid by those who are able to take advantage of the Home Mortgage Interest Deduction. This percentage includes Social Security Taxes and the Federal Income Tax after the Mortgage Interest Deduction. The taller grey bars represents the percentage of Federal Taxes paid on wages, but without the Mortgage Interest Deduction (as was illustrated in the graph entitled ‘Percentage of Income to Taxes: Social Security + Income Tax’). The difference in the size of the grey and red bars is based solely upon this one itemized deduction.
(Note: The Social Security Tax comes directly from every paycheck. There are no exemptions, write-offs or refunds, as there may be on an individual’s personal tax return. In other words, this Working Class tax is unaffected by the many Itemized Deductions that are employed to reduce the tax liability of wealthier Americans.)
Adjusted Tax Percentage for those with a Homeowner’s Interest Deduction
We made 3 assumptions in producing the above graph:
1. The homeowner spends 25% of his income in home mortgage payments.
2. Typically, 80% of the mortgage payment is interest. This interest is used as an itemized deduction on the Federal Income Tax Return.
3. The tax benefit for those making $60K/year or less was negligible. Consequently no mortgage deduction was calculated for those tax brackets. As such, the red and grey bars are identical up to the $60K bracket.
What can we learn from this graph?
This readily available homeowner’s mortgage interest deduction further minimizes the progressive nature of our federal income tax system. When only the Federal Income Tax is considered, the tax percentage difference between the $60K and the million dollar wage earners is 21% — arguably quite progressive. When the regressive Social Security Taxes are included, the tax percentage difference between these two tax brackets drops dramatically to 12%. Clearly the inclusion of Social Security Taxes greatly dampens the progressive nature of the Federal Tax System.
Further, when the mortgage interest deduction is taken into account, the tax percentage difference drops to 5%. This itemized deduction further diminishes the progressivity of the tax system — approaching the status of a flat tax. In other words, those with a million dollar salary pay just a slightly higher percentage of their income in taxes than those earning $60K per year. Check out the following table for some specific comparisons of selected tax brackets.
It is evident from even a cursory examination of the above table that the standard Mortgage Interest Deduction (only available to Homeowners) further flattens the progressivity of the Tax Percentage Curve. Once the interest deduction and Social Security Taxes are taken into account, those wage earners making $60K and above pay a fairly equivalent percentage of their income in federal taxes. For instance, there is a negligible difference — a mere 4.8% — in the Tax Percentage between those earning $60K and those earning a million dollars per year. Ironically, for those earning huge salaries, a simple way to reduce income taxes might be to purchase an even more expensive home.
Note: this discussion only addresses the tax advantages of the mortgage interest deduction. The mortgage interest deduction is only one of many tax write-offs available to wealthier citizens, which are unavailable to those near the lower end of the pay scale. Each of these tax write-offs further reduces the tax percentage that the prosperous pay and consequently reduce the progressivity of the federal tax system. It would be fair to say that some of our wealthiest citizens claim tax benefits that completely eliminate the progressivity of the tax system.
This brings us to yet another advantage to the homeowner’s interest mortgage deduction. Currently for an individual to qualify for itemized deductions (Schedule B), s(he) must have at least $6100 in annual tax-deductible expenses (the Standard Deduction). For many taxpayers, reaching the threshold of the Standard Deduction is not possible without the interest mortgage deduction.
Because of the large amount of the annual interest payment, most Homeowners achieve the level of the $6100 base deduction. Once this threshold has been reached all the other potential tax deductible expenses are available. Examples include medical expenses, state tax payments and business expenses.
In other words, the mortgage interest deduction makes possible other tax write-offs that are frequently unavailable to the Renter. One accountant says that mortgage interest is the ‘doorway’ to itemized deductions. Without mortgage interest, most taxpayers are unable to itemize any deductions that reduce taxable income.
Disposable Income after Taxes & Rent/Mortgage Payments
Thus far our discussion has focused upon the relative tax percentages on a range of income tax brackets. We’ve also examined these same tax brackets for disposable income after taxes. Let us now add an additional level of clarification by considering disposable income after taxes and rent or mortgage payments have been subtracted.
An individual with a $60K income pays $12K in rent, if he is lucky, and $18K in taxes. This leaves him $30K for the rest, including food and clothing. The millionaire with his beautiful home with its enormous $250K mortgage payment and his federal taxes of $300K (assuming no other write-offs) has $450K remaining in disposable income. In other words, despite buying an expensive house and paying a rather large tax bill, the wealthy still have an abundance of income left to do with as they so choose.
The preceding analysis is only suggesting that the ‘tax burden’ of the rich is a myth. When the Homeowner Interest Deduction is included, all income levels, except those on the lowest rungs of annual income, pay about 30% of their income in taxes. More importantly, the disposable income of the wealthy after mortgage and taxes is still many times greater than the entire annual income of the middle class wage earner. Not only do the wealthy pay the same tax percentage as everyone else, they have an enormous amount left. In other words, taxes are not truly a burden for the wealthy, and are more imagined than actual.
Social Security Taxes: A Burden upon the Working Poor
In contrast, even though they pay a much smaller percentage, these taxes are a real burden upon the Working Poor. There is a large percentage of the work force that could be considered as members of the Working Poor. Many are unable to even find full time employment. For the purposes of our discussion, we chose to define the Working Poor as full time workers who make between $8 to $12 per hour.
Let’s start with a minimum wage employee, someone making $8 per hour. Suppose this individual works a normal 40-hour week for 52 weeks per year. This translates into roughly $17K per year — gross income. Employing the same computations yields about $21K annual income at $10 per hour and approximately $25K annual income at $12 per hour.
This is not their take-home pay. This is how much these individuals earn before taxes. The Social Security Tax is taken out of their paycheck no matter how little they earn, and these individuals must still also pay some of their hard-earned money in income taxes.
We then subtract these Federal Taxes from the Annual Income to arrive at the Take-Home Pay, both annual and monthly. For comparison, the table also shows the Federal Taxes and Take Home Pay of individuals making $100K and $500K per annum. While the differences in Federal taxes paid are large, the disparities in Take-Home Pay are even more striking. These figures are shown in the table below.
The following table shows what happens when Rent is added into the computations. We assumed that the individual would pay 25% of their Take Home Pay in Rent. Of course, paying $300/month and even $400/month in Rent is unrealistic in many, if not most areas of the country. The individual must utilize this disposable income to purchase food and clothing, as well as take care of medical expenses and transportation. In other words, the Working Poor, if they are lucky, have just money enough left over to pay for necessities.
In addition the higher paid individuals probably have their medical costs taken care of by health insurance that is provided by their company. In other words, these individuals can pay for the necessities, food, clothing, and transportation, and still have plenty of disposable income left over for luxuries, including vacations and such.
In summary, even though the minimum wage employee pays a smaller percentage of his income in taxes, this tax bite impacts his ability to pay for necessities. In contrast, even though the higher paid individuals in our society pay a much higher percentage of their income in taxes, their disposable income after their mortgage payment is certainly large enough to afford the luxuries of life. Instead of the Rich needing ‘relief’ from the tax ‘burden’, it is the Working Poor that need the ‘relief’.
Although tax relief for the poor may be warranted, the point of this article is to defuse the notion that the tax burden on our wealthier citizens necessitates tax relief. Some apologists for this form of ‘tax relief’ even claim the well-to-do are being unfairly singled out by tax policies that represent class warfare. These pundits go so far as to suggest that the rich experience a form of discrimination that is similar to that suffered by Jews in Nazi Germany, blacks in South Africa under apartheid or a slave on an American plantation. This article was written to dispel these mistaken notions.
Obsessive Attachment to Tax Injustice taints Life’s Experience
One more perspective is worthy of consideration when discussing the justice of the overall tax system — the psycho-emotional aspect. There may be a mistaken impression that more money equals more happiness. Most scientific studies indicate that once necessities are taken care of, money and happiness lack a strong correlation. In other words, the less affluent can be as ‘happy as a millionaire’, if rent, food and other survival needs are met.
I work in the fine dining restaurant business and have experienced unhappy millionaires, unable to even enjoy the gourmet food and the company of their family. I have also known happy dishwashers, always smiling and laughing despite the drudgery of their work. Personally, I am extremely content with my life, despite making only $40K per annum. I am surrounded by love and have the opportunity to surmount life’s daily challenges. Of course, these are merely anecdotal illustrations that support the results of the experimental studies.
Making sense of the experimental results is straightforward. Although money can make the body happy, humans are emotional beings. As such, both the health of our attitudes and our relationships with others are far more important than how much money we have. A loving relationship with partner, friends, children and work mates has a deeper influence upon our state of mind than our ability to spend money. Perhaps our greatest happiness flows from loving relationships, which, while difficult, are possible for both rich and poor alike.
It is possible for any of us to taint our emotional state with thoughts of envy and greed. Dwelling in these negative emotions diminishes our capacity to enjoy what we do have — our simple joys and pleasures. To fully appreciate Life’s bounty, it is necessary for all of us, whether rich, poor or in-between to release obsessive attachments to the things of this world, whether they be material or immaterial. Otherwise, we won’t be able to fully experience the delicious taste of food, the beauty of a sunset, and more importantly the love from partner, family and friends.
Our concerns about the perceived injustices of our tax structure can become this sort of obsession. Whatever tax bracket we may be located in, we are not immune from concerns about the justice of the American tax system. If we are wealthy, we may resent the fact that we pay thousands, or even hundreds of thousands of dollars, more than our fellow citizens. If we are less well off, we may resent the enormous discrepancy between our take-home pay and that of the wealthier segments of society.
The figures make it manifestly clear that the large wage earners pay an enormous amount of money in taxes. The actual amount of out-of-pocket federal taxes does seem large. We understand the concern. We experience similar pain when we pay the 15% Self-employment tax on my wife’s jewelry business every year. Although only several thousand dollars, it is painful to let go of this money. This is a natural human emotional reaction. We suffer when we must let go of something that is valuable to us. This is neither greedy, nor immoral, nor a sign of a substandard individual. It is very, very human.
Entire religions have been devoted to the goal of assuaging human suffering. Several schools of thought attempt to assist us to release our excessive attachment to our desires for things — both material and immaterial. Some strongly suggest that obsessively holding onto our attachments is one of the roots of suffering. In this sense, clinging to our money generates emotional suffering, whether rich or poor.
Instead of desperately moaning about our tax contribution to the greater society, we must attempt to release this money willingly, if not gladly. This ‘letting go’ process purifies our emotional state and allows us to experience Life more fully. The inability to let go may even become an obsession that can generate very negative attitudes. Releasing this attachment to our money, although healthy, is not particularly easy.
All the mental energy invested in regrets, anger, or bitterness about the perceived ‘tax burden’ splits our attention. With our attention split, we can’t appreciate the Present as fully. The Now is tainted. Regardless of our income status, our ability to truly appreciate Life’s many treasures is polluted when we obsess about the amount of money we pay in taxes. The money obsession threatens our emotional standard of living.
Perhaps the split attention that results from overly mourning the loss of income to taxes is particularly acute among those inhabiting the higher tax brackets. The magnitude of their tax payments is indeed sizeable, but that is only part of the picture. Our wealthier citizens still have an even more sizeable amount left over to purchase the finer things in life. To truly appreciate these luxuries, it is necessary to let go of an obsessive emotional attachment to their inevitable federal tax contribution.
Just as the wealthy can torture themselves by dwelling upon how much they pay in taxes, the less well off can suffer similar psycho-emotional effects. The less wealthy may be tempted to resent the dramatic disparity between rich and poor in disposable after-tax income. They may also be angered by the plethora of income tax write-offs that are primarily available to those with higher incomes. Fuelled, these types of resentments can turn into bitterness, which will certainly taint Life’s soup.
We should never allow an obsession with the perceived injustices of our tax system to undermine our ability to appreciate the important things in Life. Let us attempt to solve the surmountable challenges of our own existence and count the love that surrounds us as a blessing. Reiterating, moaning about how much we don’t have or about how much we must surrender in taxes only pollutes our experience. Let go of the bitterness of comparison in order to enjoy life more fully.
The intent of this line of thinking is not to suggest that we should happily ignore perceived injustices in our tax system. We should hope for and, when we can, act for a more just assessment of taxes. In this light, check out the article Why America can afford Social Security for a more in depth discussion of possible improvements in America’s approach to taxation.