The U.S. tax system uses an "Effective Marginal Tax Rate" model. The EMTR is applied on ranges of earned taxable income. Each taxpayer pays roughly the same amount on his or her income within these ranges. According to the IRS, the EMTR schedule for 2011 is:
|Tax Rate||Income Range||Taxed|
|10%||$0 – $8,500||$8,500|
|15%||$8,501 – $34,500||$25,999|
|25%||$34,501 – $83,600||$49,099|
|28%||$83,601 – $174,400||$90,799|
|33%||$174,401 – $379,150||$204,749|
Everyone paying income taxes pays the same 10% on his or her first $8,500. So, to calculate a person's "Composite Real Rate" you must average (in a manner of speaking) what he or she pays in overall taxes on earned taxable income. For example, if you earn $80,000 in taxable income in 2011, your taxes are $16,125.10. That's a Real Rate of 20 percent. Yes, the marginal rate is 25%, but the Real Rate of tax is weighted towards the 15% bracket.
An income of $150,000 a year? The Real Rate is 24 percent. And that's not the "real rate" as most of us would think of a "real" tax rate. Why is that? Because taxable income is not even close to what most people actual earn. Earned income and taxable income are two different things in government speak.
So, let's get more complicated. When there was a 94% top rate in 1944-45, there were so many deductions and exclusions that the taxable income was not comparable to someone's entire income. First, the top rate started at $200,000, which today is equal to $2,413,059.90 — so the maximum EMTR would apply only to incomes of $2.5 million. But, that's still taxable income, not earned income.
In 1944, you could deduct business meals, all business travel, all forms of interest payments, and much more. You could even deduct spousal travel expenses on a business trip! (Why travel alone?) Companies could also "loan" or "provide" almost anything to an employee, from an apartment to standard benefits. It was possible to shelter tens of thousands of dollars from taxable income. Three-martini lunches and expense accounts were important realities, skewing tax calculations.
As a result of deductions and exclusions, even the theoretical maximum Real Rate of taxation at 60% in 1944 overstates taxation dramatically. The reality? On earned income, the richest U.S. taxpayers paid close to 40 percent of their earned incomes in taxes in 1944. We simply didn't count much of the compensation as taxable income.
Allow me to introduce you to Hauser's Law. Published in 1993 by William Kurt Hauser, a San Francisco investment economist, Hauser's Law suggests, "No matter what the tax rates have been, in postwar America tax revenues have remained at about 19.5% of GDP." This theory was published in The Wall Street Journal, March 25, 1993. For a variety of reasons, we seem to balance tax collections within a narrow range.
Since 1945, U.S. federal tax receipts have been fairly constant in terms of Gross Domestic Product (GDP), with taxes ranging from 15 to 20 percent of GDP. The graph is as follows:
When people demand higher taxes on the rich, usually phrased as paying a "fair share," they are ignoring how our tax system has functioned historically. We could create more brackets, to tax the top 1% at a higher rate once again, but the net increase in tax revenues wouldn't be dramatic. Why not? Because government spending is near historical highs: we are spending at near-WWII levels. It would be nearly impossible to tax enough to pay the federal bills, and doing so would likely crush the economy.
So, how could we address income inequality if not through increasing taxes? That's really what people are asking when they demand fairness. The real complaint is the gap between rich and poor. I'll address that issue in an upcoming blog entry.