Our government is debating what to do about future tax revenues. This is a big issue because there is a gaping hole or gap between what the government plans to spend and the money it will have to make those expenditures. When I was a teenager is was pretty cool to have a small hole in my Levis. But when the hole got big enough I had to buy a new pair of jeans. As you probably know if you live on the planet Earth the US government is spending more than a trillion dollars each year MORE than what they bring in. When governments have such gaps they have to go into debt. This means that each year they have to sell government bonds to the public of a trillion dollars or more. Selling bonds is usually pretty easy but at some point the public begins to wonder if the government will have the resources to pay the interest each year and then the principal balance when the bonds mature. We see this playing our daily with respect to the bonds of Greece, Ireland, Italy and several other places. The result is not pretty. Bloody street demonstrations are just one visible sign of how painful it becomes when people begin to worry that governments are in financial trouble.
In short, the US government is very preoccupied with reducing this fiscal gap. Both parties want to see this gap managed better. The fiscal cliff is just one aspect of this gap. A year ago policymakers said the fiscal gap was so worrisome that they agreed to enact a poison pill of sorts to put pressure on themselves to enact legislation to reduce the gap. This poison pill was an agreement to put in a very tough short-run solution to the gap – one that raised taxes and lowered both military and non-military spending. Most of us thought – wow – these legislators are really serious. Of course they won’t want to take such an awful pill. Of course, they will legislate something before the end of 2012. They had a whole year to get the job done. But alas, they didn’t. They talked and they accused and they argued and they spat and they even had an election. Yet still no agreement.
So as I write it is November 20 – two days before we Americans gorge ourselves with turkey and JD to celebrate Thanksgiving. We read and hear the news that Senator Reid will not even think about some solutions. Boehner has drawn the line or at least obfuscated the line with respect to other solutions. But one thing remains clear – to solve the problem of the fiscal gap means that two lines have to meet somewhere down the road. The gap will close only when the spending line meets the tax revenue line. This means that spending must grow more slowly in the future and it means that tax revenues must grow faster.
At least for the purpose of this blog – as the title indicates – I want to focus on tax revenues. So I am not going to get into spending this time. As I see it the problem with tax revenues has many dimensions but one really important one is definitional. Many people do not know what the term means. It is a little like sport fans who want to talk about football. If it is a talk between two Hoosiers we probably are referring to American football and probably a game between lackluster teams like Indiana University and Purdue. Two Europeans would instead be talking about a game we Americans refer to as soccer. If an Aussie and a Kiwi are involved in a football discussion it would be a totally different game. So if we are sitting in the 3 Alley Pub in Itaewon – a place where a lot of foreigners congregate in Seoul – and someone says football – it could take a long time before the group can figure out what they are really going to talk about.
The same thing goes with taxes. In the same discussion you might hear all these terms bandied about – taxes, revenues, average tax rates, marginal tax rates, tax base, percent of income, value added, and more. If people are not familiar with the differences and distinctions of these terms, then it is hard to have a good conversation. So perhaps it is worthwhile to work on this language issue.
My above discussion of the gap concluded that tax revenues will have to not only grow but probably grow more quickly. Much of the tax discussion focuses on income tax. Income tax revenue equals the tax rate a person pays times the income they earn. So if Charles makes $100,000 this year and finds himself in the 28% tax bracket, he then pays $28,000 in income taxes, right? WRONG. Wrong for several reasons.
First, Charles may receive $100,000 this year from his wages, interest, and so on – but Charles has deductions. Whether or not he files a Schedule A, Charles will have some deductions so the income that is actually taxed will be lower than $100,000. Charles gave a lot of money last year to the Georgia Tech Foundation for the Advancement of Beer. Some might call this a tax loophole but Charles loves beer and the foundation appreciates the gift. Anyway, let’s say that his deductions come to $30,000. This means that Charles pays tax only on $70,000. A taxable income of $70,000 puts Charles in the 25% bracket so he will pay $17,500 in taxes. Right? WRONG.
Charles might be in the 25% bracket – or what we call the marginal tax rate – but the total amount of income taxes he pays depends on all the other marginal tax rates for incomes below $70,000. To break it down he pays:
$870 = 10% on income up to $8700
$3,390 = 15% on the income above $8700 up to $35,300
$8,675 = 25% on the income above $35,300 up to the $70,000
If Charles pays $12,935 on a taxable income of $70,000 then his AVERAGE TAX RATE is 18.5%. Charles has a marginal tax rate of 25% and an average tax rate of 18.5%
Arrgghhh. Don’t you just love math! But without knowing the difference between income, taxable income, marginal tax rates, and average tax rates – you do not really understand the current debates.
For example, the goal is to raise tax revenue. Tax revenue is defined as taxable income times the average tax rate. This definition is not debatable. A bourbon whiskey has a definition. It is not debatable. What you do to increase your intake of bourbon is an interesting question. What we do to raise tax revenues is also an interesting question.
So the formula says you can raise tax revenue in only two ways – raise the average tax rate or raise the taxable income. That’s it. Those are the only two ways to increase income tax revenues. But here is where the fun begins.
How can you raise the average tax rate? How can you raise taxable income?
The government can increase the national average tax rate by legislating an increase in the marginal tax rate of any or all of the income tax brackets. Presently in the USA the marginal rates for individuals or couples are 10%, 15%, 25%, 28%, 33%, and 35%. By increasing the marginal rate for any of the income categories the average rate paid by the country will increase. Of course if you only raise the rate for the richest people paying 35% -- only the richest will pay a higher marginal and average tax rate. Everyone below will pay the same marginal and average rates as before. So you can see the political issue. You want to increase the nation’s average tax rate. But the question is whose ox gets gored? You can gore everyone or you can gore those only with higher incomes. Either way you can raise the average national tax rate.
You can raise taxable income in several ways. One way is through policies that increase economic growth that raises earned incomes. A second way is by what some people call widening the tax base. Widening the tax base means either having more people pay tax or by having fewer loopholes or deductions from earned income. We know many very poor people in US do not pay income taxes. Some of them could be added by reducing the earned income tax credit. A more popular remedy is to reduce deductions of people with higher incomes. We have more deductions in the US tax code than Apple has i-phones. Popular deductions are for mortgage interest paid on a primary residence. Charitable giving is another one.
EVERY TAX LOOP-HOLE is in place for what someone at some time thought was a really good reason. I got a tax break one year because I bought a new furnace. This benefit was given to me because it was more fuel efficient that the old one, I was helping the country’s battle against air pollution. One year I got a tax deduction because I drank more than 100 bottles of JD. I forget why I got that deduction and I am sure that is not why the IRS has been calling me repeatedly lately.
So here is the political issue. Whether it is the average tax rate or the taxable income, there is much to debate with respect to who bears the burden of the new policy to remove the fiscal gap and how the new policy affects the country at large. Any policy that raises marginal tax rates often hits the wealthier people the most, but has ramifications for US economic growth. Any increase in marginal and average tax rates will impact consumer spending, national saving, business profitability, investment, innovation, stock market, and exchange rate. Any policy that increases the tax base will have impacts on charitable organizations, housing construction, and so on.
The fiscal gap has got to go. Tax revenue has to increase. Average tax rates, some marginal tax rates and/or loopholes have to be changed. Some groups will pay more than others. The nation’s economic growth and ability to increase income will be impacted negatively for a time. Democrats were born on Venus. Republicans came from Mars. We need a solution. Hopefully this little primer on tax revenues helps you to better understand the difficulties.