Marginal vs. Average Tax Rates

Can't tell if he was being intentionally misleading or just dense.

That aside, I've always thought to calculate average tax rate off AGI is itself misleading. AGI is your income, after you've subtracted who-knows-what deductions/exemptions from it. Different people will (be able to) subtract different things, or not very much at all, depending on how well their lifestyle conforms to the government's idea of what merits deducting (e.g. a renter and a homeowner, same income, similar mortage/rent - the homeowner deducts his mortgage interest, thus has a lower AGI, thus 'paid a higher tax rate'? Sorry no)

The real average tax rate is: how much did you have to pay to the government, divided by how much did you bring in. The one thing we know is that's not what any of these numbers are.

I find it a bit odd to find this discussion here. The real problem is that when discussing tax policy those that want lower taxes ALWAYS use the marginal tax rate instead of the real tax rate that most people and corporations actually pay to "prove" we pay too much taxes.

No inconsistency, tim. The marginal rate is most relevant when considering the effect of taxes on the marginal incentive to work. Dr. Palmer was trying to make an argument from fairness, in which case total effective tax rate makes more sense.

In any case, Dr. Henderson's point was that it's not appropriate in any context to compare one person's total effective tax rate to another person's marginal income tax rate.

I'm surprised that the WSJ would publish that letter, seeing as how it's obviously misleading. Of course, it would also be nice if we included FICA, state, local, and sales taxes as well as fees in the "tax" calculation, to come up with a more accurate "government burden calculation". While we're at it, we should throw inflation in there, too. It's unfortunate that that number is nearly impossible to know unless one carefully tracks every financial transaction s/he makes throughout the year, but it would make for some interesting data points if done on a decent scale across different income groups.

tim,

Agreed, marginal rates are misleading. The best metric would be 1-A/B where A = how much money you've kept after tax time, and B = how much money your employer had to pay to employ you (plus investment income, etc). This also takes into account the effect of state, local, and property taxes obviously.

I submit this metric would make taxes seem far more onerous than simply looking at marginal federal rates on AGI.

Marginal rates are basically meaningless - they shouldn't be compared at all in my opinion. Effective rates are the way to go, but even there one should be cautious because there are substantial differences person-to-person in the ratio of taxable income vs. total compensation.

Just to use me for an example, my family's wage and other income was about $85k last year, but we received substantial non-taxable benefits so the value of our total compensation was about $115k. Our taxable income after deductions was $55k. We paid almost $10k in taxes including FICA. What is our effective rate? If you use total compensation, it's 8.7%, if you use total income, it's 11.76%. If you use taxable post-deduction income, it's 18.2%.

Personally, I think taxes based on total compensation is the best metric to compare taxes between individuals.

@Sonic charmer, I believe you are incorrect in your statement re AGI. AGI is the figure at the bottom of page 1 of Form 1040. This is BEFORE itemized deductions (or the standard deduction) and exemptions.

tim, as Bill points out, AGI is computed BEFORE deductions.

This entire discussion points to the problem with simplifying taxes. Half the complexity is determining what is income. Self employed people get to deduct half of their self-employment taxes from their AGI. This is to make their taxable income comparable to the person whose employer pays half the Social Security and Medicare taxes. Would a flat tax get rid of that adjustment?

Personally, I don't think that we need a simpler tax code. We need a stable tax code with low marginal rates. But we clearly need to understand the difference between average rates and marginal rates.

I believe you reach AGI by talking gross income and excluding non-taxable items-- 401k, cafeteria plans, schedule C deductions, the many fringe benefits of being president, etc. From AGI you deduct itemized expenses (or standard deduction).

And your expenses are treated very differently based on your employee classification. And your tax advisor.

And then you pay the AMT supplement, depending on where you live (effectively).

Until we assess it more sensibly, we'll never have sensible information to compare against.

(Comparisons between individuals suffer further because taxes are assessed against a single calendar year's income. President Obama made a lot of royalties when his book first hit, then very little when he ran for prez (unless he collected Senator wages), and then back up as president. Which year is a fair comparison?)