Who Really Pays Income Taxes?
Is the federal income tax irrelevant? For some people, it seems to be, based on recent tax figures compiled by CCH INCORPORATED. But while federal income tax is becoming a relatively insignificant burden for an increasing number of low-to-moderate income families, wealthy families and many individuals still pay a significant percentage of their incomes as tax. Decreases in taxes built into a 2001 law and scheduled to become effective in future years will bring significant additional benefits to married couples, families with children and high-income taxpayers, but the basic pattern of who pays the most will not change.
Preliminary IRS statistics for the year 2000, the latest year for which data is available, show that top-end taxpayers--those reporting $200,000 or more in adjusted gross income--paid 45 percent of all federal income taxes, although they made up only 2 percent of all taxpayers that year.
In contrast, returns showing less than $15,000 in adjusted gross income were 30 percent of total returns, but accounted for less than 1 percent of tax paid. In fact, many in this bottom echelon received, rather than gave, at the federal tax payment window. The earned income tax credit provided checks to many in the bottom tier of wage-earners.
"The earned income tax credit started out in life as the 'negative income tax' in the writings of economist Milton Friedman," noted CCH principal federal tax analyst Mark Luscombe, JD, CPA, LLM. "The name has changed, but the concept hasn't."
Beginning with the introduction of the child tax credit in 1997 legislation and continuing through the major tax bill of 2001, a series of measures have spread the benefits of greatly reduced taxes up the income scale--especially if taxpayers fit the right demographic. The new 10-percent bracket, increased child credits and other provisions have already reduced the tax burden for families with children, and may wipe out federal income tax as a serious concern for families with modest incomes in the near future.
Here's the 2002 income tax picture for a family of four, with two children who both qualify for the $600 child credit and $40,000 in total income, $500 of which is put into a deductible IRA and which in turn qualifies for a $50 retirement savings credit:
| Sample Moderate Income Family |
|---|
| Category |
Dollar Amount |
| Total Income |
$40,000 |
| Deductible IRA |
$500 |
| Adjusted Gross Income |
$39,500 |
| Standard Deduction |
$7,850 |
| Personal Exemptions |
$12,000 |
| Taxable Income |
$19,650 |
| Tax |
$2,351 |
| Less Credits |
$1,250 |
| Tax Due |
$1,101 |
The income tax due is less than 3 percent of the family's total income. But there are even better things to come, by and by. The child credit is due to rise to $1,000 per child by 2010 and relief from the so-called "marriage penalty" will gradually increase the standard deduction for all joint filers over the years 2005-2009, while they also will get the advantage of an expanded 15-percent bracket in future years, as well.
If the remaining child credit, marriage penalty and rate reductions of the 2001 tax law were to be implemented immediately, our sample family's income tax would practically disappear, falling to only $69, or $119 dollars if the retirement savings credit vanished, as it is scheduled to after 2006:
| Sample Moderate Income Family with Accelerated Tax Breaks |
|---|
| Category |
Dollar Amount |
| Total Income |
$40,000 |
| Deductible IRA |
$500 |
| Adjusted Gross Income |
$39,500 |
| Standard Deduction |
$9,400 |
| Personal Exemptions |
$12,000 |
| Taxable Income |
$18,100 |
| Tax |
$2,119 |
| Less Credits |
$2,050 |
| Tax Due |
$69 |
But although income taxes would be negligible in this scenario, such a wage-earning couple would still be paying 7.65 percent of their earnings as FICA tax to fund Social Security and Medicare.
For Singles, Taxes Are Different
Does anyone with a modest income feel a real bite from the income tax? Yes--the unmarried taxpayer without children.
Here's what the tax picture looks like for someone in that category today, assuming a $40,000 salary with $2,000 set aside for retirement (which doesn't qualify for the retirement savings credit because of income phaseouts) and no itemized deductions:
| Sample Moderate Income Single Filer |
|---|
| Category |
Dollar Amount |
| Total Income |
$40,000 |
| 401(k) Contribution |
$2,000 |
| Adjusted Gross Income |
$38,000 |
| Standard Deduction |
$4,700 |
| Personal Exemptions |
$3,000 |
| Taxable Income |
$30,300 |
| Tax |
$4,534 |
| Less Credits |
$0 |
| Tax Due |
$4,534 |
People in this situation are paying more than 11 percent of their pre-401(k) income to the federal treasury. Future decreases in top tax rates would help someone in this situation only very slightly, trimming the tax bill to $4,480--a decrease of $54.
"Both now and in the future, being married and having children, with the associated tax credit, will make an enormous difference for people with modest amounts of income," Luscombe said. "While in recent years there has been a strong political sentiment for minimizing the marriage penalty, in the future, we may see single people and childless couples vocally upset about the share of taxes they bear relative to families with the same income," Luscombe added.
One thing that would benefit both singles and married couples would be a moratorium on payroll taxes.
A payroll tax holiday for the first $10,000 in earnings would deliver $765 in tax relief to most single taxpayers and one-earner married couples, and up to $1,530 to married couples who both work. This has been proposed as an economic stimulus measure by some liberals and some conservatives on the grounds that this kind of tax reduction leads quickly to stimulative consumer spending.
Taxes Are Different at the Top
The top end of the income spectrum benefited from rate decreases in the 2001 tax law, but is locked out of many tax-lowering provisions in the laws and must cope with some others that are precisely designed to make sure that the wealthier pay more. In addition to the progressive structure of the tax brackets, high-income taxpayers are often shut out of benefits such as the child credit and the new retirement savings credit by "phaseout" provisions. They often cannot make use of the full value of their itemized deductions and personal exemptions because of other phaseouts.
Using 2002 tax rates, here's what the tax picture would look like for a family of four with wage earners commanding $250,000 in salary and contributing 10 percent of it on a pre-tax basis to a 401(k), assuming they took $50,000 in itemized deductions:
| Sample High Income Family |
|---|
| Category |
Dollar Amount |
| Total Income |
$250,000 |
| 401(k) Contribution |
$25,000 |
| Adjusted Gross Income |
$225,000 |
| Itemized Deductions |
$50,000 |
| Amount Phased Out |
$2,631 |
| Deductions after Phaseout |
$47,369 |
| Personal Exemptions |
$12,000 |
| Percentage Phased Out |
16% |
| Exemptions after Phaseout |
$10,080 |
| Taxable Income |
$167,551 |
| Tax Due |
$40,676 |
Under current law, the family loses $4,551 in deductions and exemptions due to phaseouts. They don't qualify for the credits that so greatly eased the tax bite for the $40,000 family. More than 16 percent of their total pre-401(k) income goes for federal income tax.
If future provisions on the marriage penalty, tax rates and the phaseouts for itemized deductions and personal exemptions were in place today, here's how their financial picture would improve:
| Sample High Income Family with Accelerated Tax Breaks |
|---|
| Category |
Dollar Amount |
| Total Income |
$250,000 |
| 401(k) Contribution |
$25,000 |
| Adjusted Gross Income |
$225,000 |
| Itemized Deductions |
$50,000 |
| Amount Phased Out |
$0 |
| Deductions after Phaseout |
$50,000 |
| Personal Exemptions |
$12,000 |
| Percentage Phased Out |
0% |
| Exemptions after Phaseout |
$12,000 |
| Taxable Income |
$163,000 |
| Tax Due |
$36,065 |
Their taxes decrease by more than $4,000 and income tax as a fraction of their pre-401(k) income drops to roughly 14 percent.
"The implementation of the tax-saving provisions of the 2001 law--whether that happens sooner or later--will save this family a significant amount of money, but they still end up paying more in tax than many people earn as their entire income," Luscombe observed. "Families like this will benefit significantly from tax reductions, but they still end up bearing a large part of the total income tax burden."
What's more, this family is at the lower end of the top tier of taxpayers. Millionaires and billionaires, despite the best efforts of their tax advisors, usually pay much more.
"It may not be much consolation to someone of modest means who has to scrape and borrow to pay his light bill, but very few wealthy individuals escape the income tax, and they provide a large chunk of all the income tax paid," Luscombe said.
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Posted March 15, 2003.
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