If you’re living and working in the U.S. then you know today is that most infamous of “holidays,” Tax Day. You are either rushing to finish your taxes and get it to the post office before they close or are smugly sitting back and relaxing because you finished your taxes ahead of time to avoid the last-minute rush.
As one of the latter who already received and spent most of my refund weeks ago on new clothes and buying the geeky t-shirt quilt Mary made to raise money for SkepchickCON (which my cat has since claimed for himself — See featured photo), I thought today would be a perfect day to bust some myths about taxes. These are meant to apply only to tax system of the U.S. though there may be parallels to systems used in other countries.
Myth #1: Progressive income tax systems encourage people to work less or avoid promotions because if you make enough more money to cross into a higher tax bracket, you’ll actually be taking home less money after paying taxes.
This myth is based on a misunderstanding of how tax brackets actually work.
A progressive tax system is one in which the more money you make the higher the percentage of your total income you pay in taxes. The federal US income tax follows this model, so the richer you are the bigger a chunk of your income the government takes out. How much the government takes is determined by which tax bracket you fall into.
As an example of the myth that making more money at your job could actually cause you to have less take-home money, let’s consider the following example using only two tax brackets:
Up to $20,000 pay 10%
Over $20,000 pay 20%
Let’s say we have someone who makes $19,000 a year. She is is in the bottom tax bracket and pays 10% of her income or $1900 a year to the government in income tax. She gets to keep $17,100 a year. She has been working hard at her job and is offered a promotion with a salary increase. In her new position, she’ll make $21,000 a year, pushing her into the higher tax bracket.
According to the myth, she will now owe 20% of her income in taxes, coming out to $4200. She will get to keep $16,800. In other words, even though she had a raise of $2000 per year, she’s actually taking home $300 less money than she was before ($17,100 before her promotion versus $16,800 after her promotion). She would have actually been better off not getting a promotion at all and so under the progressive income tax system she is discouraged from working harder and making more money.
Except that’s not really how tax brackets work. When you cross over into a new tax bracket, you only pay the higher percentage on the money that falls into that bracket and you continue to pay the lower percentage on the income that falls below it. This is why another name for a tax bracket is a “marginal tax rate.” “Marginal” in this context refers to the tax rate of the last dollar of your income. A person in a higher tax bracket still pays the lower tax rate on the dollars earned that fall below that bracket.
So, our hypothetical woman who is making $21,000 a year doesn’t actually pay 20% of her total income in taxes. She would pay 10% of the first $20,000 ($2000) and 20% of the final $1000 ($200) for a total of $2200 or 10.5% of her income. She takes home $18,800 after paying her taxes, which you’ll notice is much higher than the $17,100 she was making pre-promotion. There is never a point where getting paid more money would result in her taking home less money after taxes.
This is how progressive income taxes work in the U.S. Tax brackets only apply to the amount of income that falls into that tax bracket, not to your entire taxable income.
Myth #2: Flat taxes are fairer because everyone pays the same amount.
It’s tempting to think that rather than have any tax bracket system at all, it might be more fair if everyone just paid exactly the same percentage of their income in taxes. This is called a flat tax. My home state of Illinois has a flat tax of 5% so in theory, every citizen of Illinois pays 5% of their annual income to the State. Fair, right?
Well, in theory perhaps, but in practice not so much. The problem is that income tax is not the only tax that Illinoisans pay. Sales tax and property tax make up a large portion of the money that state and local governments take in and both of these types of taxes are regressive systems in which the poor pay a higher share of their income in taxes than the rich.
Although sales tax, for example, is the same for everyone (9.25% in Chicago) it disproportionally affects the poor. That’s because the less money you make the higher proportion of your income you are spending on goods and services that require you to pay sales tax. If you’re making a lot of money, you’re likely to be putting a larger portion into a savings account or investments rather than spending it.
This handy chart from the Institute on Taxation and Economic Policy (ITEP) shows the estimated amount of money that Illinoisans in each income group paid in various types of state and local taxes in 2013.
Although income tax remains fairly flat due to the flat tax rate that is written into the Illinois constitution, sales tax and to a lesser extent, property tax is highly regressive. When you look at the overall effective tax rate being paid by Illinoisans, you’ll see that the lowest 20% pays almost 14% of their total income in taxes while the top 1% pay something closer to 5% of their income in state and local taxes.
It doesn’t seem particularly fair to have the richest people in the state chipping in the least. The income tax would be fairer by being progressive because it would take the burden off of the poor who are already paying most of the other types of state and local taxes and shift that burden to the rich who have been paying less than their fair share for a long time. Even if you believe that everyone should be paying the same percentage of their income in taxes, regardless of how much money they are making, then you should be all for a progressive income tax system.
Myth #3: No-income tax states have low taxes and still manage to get by just fine. They are proof that we can still have a thriving economy while keeping taxes low.
There are seven states in the U.S. that have no income tax at all. States like Texas use themselves as proof that the government just doesn’t need all that money. They are getting by just fine on the low, low taxes THANK YOU VERY MUCH.
Except that just because a state doesn’t have an income tax doesn’t actually mean they have low overall taxes. Generally, they make up for it by increasing other types of taxes such as sales tax and property tax, which we already saw from myth #2 are some of the most regressive forms of taxes.
Texas is a perfect example because even though they have no income tax and like to brag about how low their taxes are, especially when compared with high-tax states like California, when you look at the overall tax burden on Texans things start to look a lot less rosy.
If you are a Texan in the bottom 80% of income, you are actually paying more in taxes to your state and local government than you would if you were living in California. Only the top 20% of Texans make out better than Californians.
Additionally, tax systems that rely on the poor for their revenue end up taking in less money overall. So if you are middle or low income in Texas, you are paying more in taxes than you would if you were in California and getting less government services in return. Paying high taxes while getting hardly any services back from your state seems like a pretty raw deal, but this is often the reality in states that don’t have an income tax.
Myth #4: Tax Deductions are a way for the government to save people money without spending any money.
Actually, tax deductions are equivalent to the government giving you money as an expenditure. Let’s say you owe the government $100 in taxes. The government then gives you a deduction so that they no longer take the $100 from you. You now have an extra $100. Yay you!
But consider if the government did take $100 from you but then wrote you a check for $100. You would end up exactly the same as if they had just given you a deduction. In fact, from the government’s point of view a deduction is equivalent to taking the money from you and then writing you a check to give it back. On the government’s books, the deduction they give you is considered an expenditure. In fact, from their side it’s actually called a tax expenditure.
It may seem more like a philosophical discussion, but in Washington politicians who are against increases in government spending are often the same ones that are fighting to increase deductions for people and corporations even though those two policies work against each other. Deductions are spending. Deductions are equivalent to the government writing a check to a person or corporation. If these anti-government spending politicians really wanted to decrease spending, they would be fighting against many unneeded deductions rather than adding more.
It’s not that all deductions are bad, but by treating deductions as a loophole for the government to spend more money while not actually “spending” money, it can quickly lead to some pretty crazy tax policies that result in more tax dollars going to people who don’t need it rather than those who do. Giving a tax deduction to the richest people in our society is equivalent to handing them a welfare check.
Also, it’s worth mentioning here that thinking about tax deductions as spending is not some crazy left-wing conspiracy to raise taxes. In fact, even Reagan understood that tax deductions are government spending and result in spending priorities where the people who need government assistance the least end up getting the most. That’s why he sponsored and fought hard to pass the bipartisan Tax Reform Act of 1986, which among other things simplified the tax code by cutting deductions for the rich in order to lower taxes on the poor and middle class.
Whether you think the government is spending too much or too little, you should be against complicated system of deductions and loopholes in the tax code that end up giving so much of our tax dollars to the people who need it the least. Deductions aren’t a fancy way to lower taxes. They are the equivalent of government spending and should be thought of that way. Only then can we decide if we’re really allocating our spending in the best manner possible.
Happy Tax Day everyone. May you all get your taxes done on time and receive large refunds.