What Do You Know About Taxes?: A Tax Policy Primer, Part 1

Everyone has an opinion on taxes. Most people don’t know what they’re talking about. This is a series of posts explaining our system of taxation and providing some tools to think about tax policy. This post is a whirlwind tour of federal income taxes in the US.

We have an income tax. With an income tax, its pretty important to define income so we know what to tax. The definition of income that we use is all consumption plus changes in wealth. When you get your paycheck, you either spend it (consumption) or save it (increasing your wealth). You’re entire paycheck is generally income. If someone gives you a corn dog to eat, that’s consumption and therefore income. Yes, that corn dog really is taxable, but the IRS rarely performs corn dog audits. If today your stocks are worth $100 and next year they are worth $150, you’ve gained control over $50 more dollars worth of stock. That’s a change in wealth. That $50 is income.

I have a confession. I’ve already lied to you. We don’t exactly have an income tax under our definition of income. That’s because our system of taxation requires a change in wealth to be “realized” to be taxed. You have to get control over that change in wealth to be taxed. With the stock example, you would not be taxed on the $50 gain until it is sold or exchanged for something else. You can’t do anything with the $50 gain until you turn it into cash, so courts have said you can’t tax that $50 until you do something with it. A savings account, on the other hand, pays out its interest regularly, and those gains are taxed as income whenever they are received. That’s because you can spend that gain right away.

OK, you’re not taxed on the $50 gain until you sell the stock, so what? Actually, not getting taxed on this gain is pretty important. Money has “time value”. Getting money today is more valuable than getting money 10 years from now. That’s because you can take the money you get today and turn it into more money over the course of ten years by investing it. This time value works in reverse as well. Paying a tax later is better for you than paying a tax now because you can take the money that would have been taxed and turn it into more money. For example, if a taxpayer can defer paying $100 worth of tax for 10 years and make a 5% annual return on the $100, she’ll have $162 after ten years. She pays the $100 in tax after ten years, but she gets to keep $62, a net loss of only $38. So if you pay now, you lose $100, and if you pay in ten years, you only lose $38. Waiting to pay tax is highly advantageous.

In addition to “realization”, our tax system favors allocation of capital into certain financial assets with preferable “capital gains” tax rates. When you sell the stock after holding it for a year, the capital gain is taxed a either 10% or 15%. Wage income is taxed at anywhere from 10% to 35%. This advantage in capital gains rates is one reason why the people who make the most income in America pay a lower percentage of their income in tax than the middle class. The top 10% of all earners own 90% of all financial assets. We’ll talk about the intellectual foundation for lower capital gain rates later.

Income from financial assets gets the benefit of realization and preferred rates. On the other hand, your entire paycheck is taxed immediately at higher rates regardless of whether it is consumed or saved. Realization and capital gains rates make our tax system more like a wage tax than a pure income tax.

Aside from favoring financial income over wage income, the other defining features of our income tax is progressive marginal rates. Maybe you’ve heard a story of someone not wanting to take a raise or a promotion because it would put them into a higher tax bracket. I know I have. This story is about someone who does not know anything about taxes and is told by someone who does not know anything about taxes. If you’re ever at a fancy cocktail party and hear a story of this nature, I give you permission to grab the storyteller mid-sentence and throw them down a flight of stairs.*

“Marginal” rates mean that each dollar you make is not taxed the same. Once you cross into the next tax bracket, only the amount into the next bracket is taxed at the higher rate. “Progressive” rates means that greater income is taxed at higher rates (we’ll talk more about progressivity in future posts). Lets say your boss comes to you and says, “Peter, my boy, that was a great idea to put Prozac adds on Good Morning America. That program is such a waste that viewers can’t help but feel depressed, and sales are up, up, up! We’re giving you a $5,000 raise.” The only problem is that you make $29,700 a year. If you make one dollar more you’ll go from the 15% bracket to the 25%!!! But fear not, only $5,000 will be taxed at 25% with the wonder of marginal rates. The first $7,300 you make will be taxed at 10%. From $7,300 to $29,700, you will be taxed at 15%. These ranges are true for everyone, no matter if you’re Warren Buffett or a patron of the $3.99 Chinese buffet. Declining this raise, dear pharmaceutical advertiser, would be oh-so-silly. An American taxpayer can never lose money by making more money.

Maybe readers who are a little lighter in the wallet are thinking, “You just said my first $7,300 is taxed at 10%, but I made a little more than that and still got all my taxes refunded. How can this be?” The answer is the standard deduction. The standard deduction allows you to subtract (deduct) the minimum amount of income that the government deems necessary to live from taxable income. You didn’t make enough to entice the taxman.

Now you have a basic understanding of how our tax system works. It has progressive marginal rates, deductions, and elements of both an income and a wage tax. You’ve got a foundation to think about tax policy. For any tax policy, there are three questions: What effect will the tax policy have on the budget? What effect will the tax policy have on the economy? What are the ethical implications of the tax policy? We’ll take on each of those questions in turn.

* I have no authority to give permission to throw people down stairs. Please do not throw anyone down the stairs, no matter how dumb their stories.

  • James Shanahan

    Sometime in 2008, I should have been thrown down a flight of stairs.

    • Anonymous

      Its good to know you’ve seen the light.

  • Ryan Bleek

    This is a must read on the definition of income and tax policy: http://www.themoneyillusion.com/?p=7091

    Not sure how much I agree with it, but it is quite thought-provoking. Also, I find impressive the level to which Sumner engages with his commenters, not just on this post.

    • Anonymous

      The first example he gives is a variation on Irving Fisher’s parable of the three brothers. It purports to show that taxation on capital gains is unjust because the present value of the tax of the brother who has greater capital gains is greater than the brother who consumes the initial sum. I had to write a response this parable on my tax policy exam. I’m just going to be lazy and post my answer:

      I think in the parable of the three brothers, Fisher is equivocating being taxed differently with
      being taxed unjustly. Certainly the brothers start in the same place, but their choices lead to different
      outcomes. The outcomes that produce greater economic resources are subject to greater tax. The
      amount of tax is contingent on the amount of resources at each brother’s disposal over the life of
      the sum, not the initial sum. That is, they are taxed on where they finish, not where they start.
      Fisher makes an determination on fairness ex post on an ex ante state of affairs when it seems more
      appropriate to judge fairness on the final state of affairs.

      I think Kaplow and Warren are getting at what I try to express in the last paragraph. The issue is a
      definitional one. Fisher takes present value to be the representation of absolute value, but I think it is
      just as reasonable to say accession to wealth regardless of its discount is absolute value. Brother 3 only
      gets to consume less than $12,000 from his $10,000. On the other hand, Brother 1 gets to consume
      $15,700 and Brother 2 gets to consume $17,250 over the first 30 periods, and they are still entitled to
      more wealth. Given this opportunity to consume, I hardly think it is necessarily unjust that the present
      value of their taxes are greater. By only measuring value in terms of present value and discounting at
      the rate of return, the outcome Fisher’s parable is already decided.

      Maybe there is some headway to be made from the declining marginal utility of money. Brother 2 gets
      the most money out of the brothers, it is worth less to him, therefore, it is just to tax him more, even in
      terms of present value relative to those situated equally.